How Labor Contracts Shape Firm Success and Productivity

Labor Economics Macroeconomics Public Policy No Comments
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While extensive research has examined the effects of labor market duality on workers, its implications for firm behavior and equilibrium firm outcomes remain largely unexplored.

In Barcelona School of Economics Working Paper 1531, “Dual Labor Markets and the Equilibrium Distribution of Firms”, Josep Pijoan-Mas and Pau Roldan-Blanco study how the coexistence of fixed-term (FT) and open-ended (OE) contracts shapes firm dynamics, worker allocation, aggregate productivity, and welfare.

Using rich firm-level data for Spain, the authors show that policies restricting the use of fixed-term contracts reduce temporary employment and raise aggregate productivity through improved firm selection, but at the cost of higher unemployment and lower welfare.

Read BSE Working Paper 1531 on bse.eu

The Use of Fixed-Term Contracts Across Firms 

Using Spanish administrative data from 2004 to 2019, the authors document substantial heterogeneity in the use of FTCs across firms.  The average share of temporary workers across firms is 18%. However, the use of FTC increases with firm size in the overall economy. How much of this variation is associated with the industry, province, or phase of the business cycle in which the firm operates, and how much is specific to the firm?

The authors find that, within a given industry and province, at a given point in time, the use of FTC is rather stable across firms of different sizes (cross-section, reported in the blue line in Figure 1 below). 

However, firm-specific characteristics are of great relevance, and two counter-balancing forces operate within industry and province: larger firms are less likely to rely on FTC than smaller ones (red line or the between-firm component); but the use of FTC increases as a firm expands (green line or the within-firm component).

A line graph showing variation across different firm size bins, ranging from 2-5 to 251-500. The graph plots three data series: Within-firm variation (green line), which trends steadily upward; Between-firm variation (red line), which peaks early and then trends steadily downward toward zero; and All firm-year observations (blue line), which rises initially and remains relatively stable across larger firm sizes.
Figure 1: Temporary Share, By Firm Size: Within- And Between-Firm Variation

Notes: The green line reports the coefficients of the size dummies of a regression of temporary share that controls for aggregate anc firm-level fixed effects. The red line reports the firm fixed effects of the same regression against dummies of average firm size. The blue line reports the size dummies of a regression of the temporary share that controls for aggregate but not tirm-level fixed ellects.

Effects of Restricting Fixed-Term Contracts

The authors develop and estimate a structural model of firms’ choice between FT and OE contracts. They use the model to evaluate policies that restrict the use of FTCs.

FTCs give flexibility to firms to adjust employment to changing production opportunities. However, it increases worker turnover, which is costly to the firm, given the loss of firm-specific human capital and the need to hire new workers. Also, recruiting costs are higher for permanent positions, and they usually take longer to fill. Therefore, more productive firms (which tend to be the largest ones in an industry and location) use OECs more extensively to retain a larger share of their workers and enhance their chances of accumulating human capital on the job. Yet, as the firm expands, its use of FTCs increases, because the drawbacks of a larger share of FTCs get “diluted” once the workforce is larger.

Reducing the maximum duration of FTCs lowers the share of temporary employment and raises aggregate productivity. This productivity gain is driven by stronger firm and worker selection effects, as less productive firms are more likely to exit. However, the policy also increases unemployment and reduces overall welfare, as employment becomes more misallocated across firms.

As an alternative policy, taxing firms for their use of FTCs leads to similar qualitative results, but with smaller increases in unemployment and therefore lower welfare losses. Compared to outright restrictions, taxes on FTCs attenuate the adverse effects on labor market outcomes while preserving productivity gains.

Overall, the paper highlights that the firm side is an important dimension when assessing the aggregate consequences of labor market duality. By shaping firm selection, employment allocation, and productivity, the coexistence of fixed-term and open-ended contracts generates important trade-offs that standard worker-focused analyses may overlook.

Read BSE Working Paper 1531 on bse.eu

Key Insights

  • To fully understand the impact of labor laws, we must look beyond individual workers and consider how these rules fundamentally change the way firms behave and grow.
  • While it may seem counterintuitive, restricting temporary contracts can actually boost overall productivity by ensuring only the most efficient and successful firms remain in the market.
  • However, these productivity gains come with a significant trade-off, as limiting hiring flexibility leads to higher unemployment and lower overall economic well-being.