Dual Employment Protection Legislation and the Size Distribution of Firms

We develop a theoretical model of​ firm dynamics with search frictions and asymmetric ​firing costs for temporary and permanent workers (dual employment protection legislation, DEPL). We characterize the equilibrium labor composition that f​i​rms with different productivity choose over their life cycle, and we study the effect of DEPL on the distribution of ​firms' size and productivity. The results indicate that DEPL play similar role as a tax to big f​i​rms and a subsidy to small firms (size-dependent-policies) by distorting firm selection as well as the allocation of resources across firms, and thus generating a decline in the level of TFP. Consistent with the evidence documented in this paper, in spite of having similar labor productivity by firms' size-classes, countries with stricter DEPL that incentives or extend the use of temporary contracts have relatively smaller firms (that concentrate a higher fraction of employment), and lower aggregate productivity. In this sense the model provides new insights into the sources of the considerable differences in the fi​rm-size distributions across countries.