Estimated Dynamic Industry Equilibrium Model with Firing Costs and Subcontracting
AbstractIn Chile every permanent worker is entitled to one monthly wage per year of service with a maximum of eleven wages in case of dismissal. To regain flexibility this has triggered a widespread use of subcontracting. To assess the "true costs" of the regulation, I estimate a dynamic industry equilibrium model in which firms optimally choose the division labor between subcontracted workers that are totally flexible, and permanent workers that entail tenure-dependent firing costs. To overcome the potential costs of dismissing workers, firms hire permanent workers only up to the point where their expected firing costs equal the wage premium on subcontracted workers. Hence, firms’ use of subcontracted workers is decreasing in their relative cost and increasing in the volatility of shocks. I use a simulated method of moments by fitting plant-level employment dynamics and the size distribution in the manufacturing sector in Chile. I use data from the Chilean Annual National Manufacturing Survey, which reports permanent and subcontracted workers in the establishment where they physically work.
I find that severance payments are equivalent to seven monthly wages, and that workers get tenure after 4 years. Firms are willing to pay a “subcontracting wage premium” of 10% to substitute for hiring permanent workers. A naive researcher willing to estimate firing costs without considering the subcontracting margin of adjustment, would conclude that the Chilean labor market is rather flexible. Allowing firms to subcontract in a heavily regulated environment increases output, employment and productivity; firms respond more aggressively to productivity shocks, which enhances the allocation of labor across firms and hence total factor productivity. Removing the regulation leads in steady state to an increase in average labor productivity around 1%. Restricting the use of subcontracting to improve working conditions will lead to a decrease in total output, employment and productivity.