Risk Sharing in a Dual Labor Market

Abstract

In OECD countries, the labor market features a coexistence of open-ended, permanent jobs subject to strict employment protection and fixed-term, temporary contracts. This paper introduces a search-and-matching model of a dual labor market - divided between permanent and temporary jobs - with risk aversion and dynamic employment contracts. Optimal contracting entails a trade-off between commitment and the flexibility of separation, a novel rationale for the coexistence of permanent and temporary jobs. The paper shows that this coexistence emerges when (i) firms find it optimal to provide insurance to workers, (ii) the firms' commitment ability is limited, and (iii) the match-quality distribution has enough dispersion. In this setup, firing costs are potentially associated with welfare gains for both employed and unemployed workers.