Adding Friction to the Market
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Economics Strategy Policy Aug 1, 2011

Adding Friction to the Market

In employment, making hiring and firing easier is not always the way to go

Based on the research of

Niko Matouschek

Paolo Ramezzana

Frédéric Robert-Nicoud

When a worker interviews for a job, there is, inevitably, an elephant in the room. Neither the potential employee nor the employer knows the real value of that employee to a company. Everyone is guessing, based on incomplete information. So an employer might offer a lowball wage. Or the employee, confident of his or her abilities, might ask for a wage an employer simply isn’t prepared to offer most of its workers. In either case, both parties move on, and the labor market turns out to be less effective than it should be—all because of missing information.

Exploring the role of this missing information has been one of the major accomplishments of Niko Matouschek, an associate professor of management and strategy at the Kellogg School of Management, who, along with colleagues Paolo Ramezzana of Bates White and Frédéric Robert-Nicoud, a professor at the University of Geneva, built on the Nobel Prize–winning work of Christopher Pissarides and Dale Mortensen in order to explore the effects of liberalization of labor markets.

In the world of Economics 101, Matouschek says, a labor market is frictionless—buyers (the firms looking to hire a worker) and sellers (workers willing to sell their labor) find each other effortlessly. In reality, both firms and workers must search for one another and may never connect, leading to less than perfectly-efficient matching of the two. What Matouschek and his colleagues added to this “search” model of labor markets pioneered by Pissarides and Mortensen is an additional detail from the real world: the fact that workers and firms are very likely to have incomplete, or asymmetric, information about their true value to each other.

Previously, economists assumed that workers know exactly how much revenue a firm can generate if the worker accepts a job, and that a firm knows all of the outside employment options a potential employee might have. As a result, the two parties are able to instantly agree on a wage. The negotiation is not about fairness, but about known quantities leading the two parties to agree on the terms of trade. “Sometimes that’s a good approximation of reality, but we argue in our paper that in the labor market it’s not,” Matouschek says.

In reality, when two parties negotiate a wage, the firm doesn’t know what alternatives the employee has and the employee doesn’t know their value to the firm. In this context of asymmetric information, there is an increased chance that the bargaining will break down and the two parties will fail to form an employment relationship.

The Counterintuitive Benefits of a “Firing Tax”

Labor markets in Europe tend to be more rigid than those in the United States—that is, there are more costs associated with hiring and firing workers. Unemployment rates vary from one country in Europe to the next, as do regulations regarding acquiring or letting go of workers. Thus, Europe is a natural laboratory for looking for correlations between these regulations and employment rates. The first question Matouschek and his colleagues explored was, what happens if you reduce the tax a firm must pay when it fires a worker?

Conventional economic thinking would lead one to believe that such a “firing tax” would always be a bad thing. It would make a labor market more rigid and less efficient. Matouschek’s work revealed something surprising, however: More friction in the course of wage negotiations can be beneficial, as negotiations will be less aggressive and the parties will be more likely to arrive at a deal.

Weighing the Cost of a Tax Against the Cost of Idle Workers

When a firing tax is reduced, it has a direct benefit to firms: It makes it easier for them to fire workers who are less productive than someone else the firm could hire. This is especially true in countries with the most stringent labor protections. Such protections raise the firing tax, which makes the market less efficient.

Contrary to conventional economic thinking, in a system that more closely resembles the real world, the costs of reducing a firing tax can outweigh its benefits.

Knowing that a reduction in a firing tax has both a benefit—fewer idle workers—and a cost—inefficiencies in the hiring process that may prevent the right workers from connecting with the right firms—Matouschek sought to weigh the value of these factors against one another. The result: Contrary to conventional economic thinking, in a system that more closely resembles the real world, the costs of reducing a firing tax can outweigh its benefits.

Support for Both Sides of the Labor Market Liberalization Debate Matouschek cautions that these results do not mean it is always the case that the liberalization of labor markets is a bad idea. The results of his work are more subtle. They show that while small or incremental reductions in a firing tax can reduce overall economic efficiency, large changes in a firing tax, such as its complete elimination, ultimately lead to a more efficient labor market. “I think the basic point of this work is that it should make us more cautious about incremental liberalizations of the labor market, or, to put it another way, of the costs associated with labor market reforms,” Matouschek remarks.

“Even in the setting of this paper, if you are able to reduce the frictions in a labor market a large amount, it always makes us better off,” Matouschek says. “The results caution against small reforms—they say that you should have either no reform or a large reform, but caution against medium-size reforms.”

The results may explain why in labor markets in Europe and elsewhere there has historically been so much resistance to reforms. If Matouschek’s model is correct, then globalization could mean that, in general, labor markets get worse before they get better. Employees would have less job security but would have an easier time looking for a new job should they lose theirs. Those options could require that they be more flexible about changing employers, however, and that’s one thing the model does not reflect: psychologically, many workers could have an inherent preference for stability.

By showing both the costs of incremental liberalization of labor markets and affirming its value when large enough reforms are undertaken, this paper “brings together the economist’s and lay person’s perspective,” Matouschek notes.

Matouschek says his work does not put the lie to traditional economic thinking, exactly. “Eventually economists have it right. With enough labor market liberalization, there are so many more employment opportunities that eventually you don’t care that the relationship between workers and firms is less stable.” Yet incremental attempts to reduce friction in labor markets can destabilize them in a way that hurts both employers and employees. It is not a simple picture, but it does unify both traditional economic thought and what the layperson has already intuited about government policies and their employment prospects.

Related reading on Kellogg Insight

The Surprising Importance of Grades: Sending signals in the job market

Minimum Wage Matters: Increasing the minimum wage may not help low-wage workers

Featured Faculty

Alvin J. Huss Professor of Management and Strategy; Professor of Strategy

About the Writer
Christopher Mims is a journalist based in Washington, DC.
About the Research

Matouschek, Niko, Paolo Ramezzana, and Frédéric Robert-Nicoud. 2009. “Labor Market Frictions, Job Instability, and the Flexibility of the Employment Relationship.” European Economic Review. 53(1): 19-36.

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