Severance payments in an economy with frictions

We construct a general equilibrium model to evaluate the quantitative effec ts of severance payments in the presence of contractual and reallocational frictions. Key elements of the model are establishment level dynamics, impe rfect insurance markets, and variable search decisions. In contrast to prev ious studies that analyzed severance payments in frictionless environments, we find that severance payments can have large positive effects on employm ent and welfare. This result is a consequence of search being costly and of wage contracts being rigid. Moreover, we find that the firing penalty role of severance payments is much more important than their insurance role. (C ) 2001 Elsevier Science B.V. All rights reserved.