Privately optimal severance pay

Abstract

This paper constructs an equilibrium matching model with risk-averse workers and incomplete contracts to study both the optimal private provision of severance pay and the consequences of government mandates in excess of the private optimum. The privately-optimal severance payment is bounded below by the fall in lifetime wealth resulting from job loss. Despite market incompleteness, mandated minimum payments significantly exceeding the private optimum are effectively undone by adjustment of the contractual wage, and have only small allocational and welfare effects.J.E.L. classification codes: J23, J64, J65.

Job displacement risk and severance pay

“…Complete asset markets are not crucial for this result as long as bargaining is efficient, as shown by Fella and Tyson (2013). 39 The assumption that workers have all the bargaining power in wage negotiations still implies efficient bargaining, but substantially simplifies the model computation.…”

“…Fella and Tyson (2013) build an incomplete-market version of Mortensen and Pissarides (1994) and use it to characterize the privately-optimal size of severance pay and show that Lazear's (1990) neutrality result (approximately) holds despite asset market incompleteness. Alvarez and Veracierto (2001) were the first to study the welfare effects of severance payments in an incomplete market setting.…”

Labor-market frictions, incomplete insurance and severance payments

“…Pissarides [2004] establishes that optimal employment contracts should include a severance pay component so as to help workers smooth consumption. Fella and Tyson [2013] provide the foundations for privately-optimal severance payments in response to government mandates. Although their model features risk-averse agents and incomplete asset markets, they rule out wealth effects to obtain tractability (they use a constant absolute risk-aversion utility function).…”

“…It is unclear, however, how one should use the data on the reason for job separation to inform the model's calibration. It is likely that the reported reason for job separation itself is endogenous to SP, since this might affect the decision of firms and workers to label the job separation a quit or a layoff(Fella and Tyson [2013],Postel-Vinay and Turon [2014]). 14 In the model, we measure the replacement ratio by taking the ratio between b i and the average wage.15 The job finding probability is θq (θ).…”

Understanding the Determination of Severance Pay: Mandates, Bargaining, and Unions*

“…Two recent papers cover similar topics. The paper closest to ours is that of Fella and Tyson (2013), who build an equilibrium matching model with savings and incomplete markets, and contrast the optimal provision of severance pay bargained by the model's agents to mandated levels. The key difference to our paper is that Fella and Tyson do not address the role of unions.…”