Labor Market Frictions, Job Instability, and the Flexibility of the Employment Relationship

We investigate the consequences of `haggling,' or inefficient bargaining, for the functioning of labor markets. For this purpose we develop a search model in which firms and workers are imperfectly informed about each others' costs of adjusting to external shocks. Agents commit to rigid employment contracts with high separation costs when frictions are high and to flexible contracts with low separation costs otherwise. A reduction in labor market frictions leads to an increase in inefficient job instability that is amplified by the switch in employment contracts. As a result some groups in society, and potentially society as a whole, can be made worse off.