Employment protection and incentives: Severance pay vs. procedural inconvenience

•I examines effects of employment protection (EP) on incentives with a search model.•I consider a situation in which all workers including shirkers are protected by EP.•EP is categorized into Severance pay (SP) and procedural inconvenience (PI).•SP is likely to increase the unemployment rate.•PI tends to decrease the unemployment rate and improve social welfare.

I consider the effects of employment protection (EP) on worker incentives in the labor market with search friction, where EP is categorized into severance pay (SP) and procedural inconvenience (PI). When firms cannot distinguish shirkers, EP seems to negatively affect worker incentives, because shirkers are unlikely to be fired. However, EP can have a positive effect on worker incentives because diligent workers are protected by EP. It is shown that the positive effect can dominate the negative one when EP is moderate. In particular, PI tends to improve the unemployment rate and welfare, while SP has a somewhat unclear effect.