Factor Misallocation and Adjustment Costs: Evidence from Italy

This paper quantifies the effects of firing costs on TFP; specifically the channel whereby the reduced willingness of firms to downsize or expand in response to idiosyncratic demand shocks in the presence of employment... [ view full abstract ]

This paper quantifies the effects of firing costs on TFP; specifically the channel whereby the reduced willingness of firms to downsize or expand in response to idiosyncratic demand shocks in the presence of employment protection legislation can lead to resource misallocation. A structural model of firm dynamics is constructed and estimated, designed to best utilise the unique opportunities offered by a dataset of Italian firms. Evidence from a real regulation, a size-dependent threshold in firing costs, is used to aid the estimation of the model, in which firms must decide whether to grow (shrink) across the threshold into a regime in which there are higher (lower) costs of reducing employment. The model is well able to deliver the levels of misallocation of labour seen in the data. A simulation exercise is conducted, designed to investigate the effect of policy reform, with the effects found to be potentially quite large.