Firing Costs and Flexibility

A key prediction of models of dynamic labor demand is that restrictions on firing attenuate firms' employment responses to economic fluctuations. The authors provide the first direct empirical test of this prediction using data on industrial firms in India. They exploit the fact that fluctuation in rainfall within districts, through its effects on agricultural productivity, generates variation in local demand and local labor supply. Using a measure of labor regulation strictness, they compare factories' input and output responses to these shocks in pro-worker and pro-employer districts. Their results confirm the theory's predictions: industrial employment is more sensitive to shocks in areas where labor regulations are less restrictive. They verify that their results are robust to controlling for endogenous firm placement and vary across factory size in the pattern predicted by the institutional features of labor laws in India. However, their results also indicate that the inability to adjust employment does not significantly appear to affect firm profits, suggesting that firms may be adjusting along other (unobservable) margins.