On unobserved worker heterogeneity and employment protection

It has been claimed that employment protection aggravates problems of adverse selection if workers differ with respect to their productivity. Analyzing European and US labor law, we identify regulations which work in the opposite direction. Where employment protection legislation allows dismissals only for good cause and imposes social criteria upon the employer’s selection process in the event of redundancies, the average productivity of hireable workers is shown to improve. However, we find that the employers’ reduced freedom of choice more than offsets the productivity increase of newly hired workers and job creation is deterred by employment protection legislation. Nevertheless, low-productivity workers may favor the introduction of employment protection provisions.