Employment effect of dismissal pay in the presence of judicial mistakes

Existing studies either overlook the importance of the juridical enforcement of employment protection legislation in determining the labor market consequences of dismissal payments or else neglect the possibly judicial biases caused by a tight labor market due to the assumption of exogenous judicial errors. By calling for endogenously determined judicial errors, this paper not only traces the effect of a firing litigation on employment, but also explores the possible effects of labor market conditions on judicial mistakes. We show that worse labor market conditions (a larger dismissal pay) will induce judges to be more favorable toward fired workers (firms). Thus, a higher level of unemployment (a larger dismissal pay) will decrease (increase) the possibility of a type-1 error and increase (decrease) the possibility of a type-2 error. It is also shown that, while a policy that lowers a type-1 error will increase the employment level, a lower type-2 error, somewhat surprisingly, will not necessarily have a positive effect on employment. Besides, in departing from the findings of previous analyses, we find that dismissal pay can either increase or decrease the employment level, with this crucially depending on the probability of juridical mistakes.