The Interaction of Minimum Wage and Severance Payments in a Frictional Labor Market: Theory and Estimation

Abstract: We introduce a minimum wage and severance payments in an equilibrium labor market model with search frictions. We analyse how these policies affect endogenous job creation and destruction decisions and, more generally, the general equilibrium allocation. We structurally estimate the model’s parameters using data from Chile, a country where labor market regulations prescribe high severance payments and minimum wage; we build three subsamples corresponding to three different levels of educational attainment. With the resulting sets of estimates we perform a quantitative welfare analysis. We reach three main conclusions. First, when the dispersion in wages found in the subsample is low and the share that workers receive from the surplus their job generates is at an appropriate level, the economy’s maximum welfare level is reached in a policy-free environment; on the other hand, if the workers’ share is too low, the maximum level of welfare can be attained using any of the following possibilities: severance payments or a minimum wage by themselves or an appropriate combination of these two policies. Second, as dispersion in wages increases, the minimum wage, by itself, can no longer reach the economy’s maximum level of welfare. Third, when the dispersion in wages is high enough, no policy in isolation can attain the economy’s maximum level of welfare, and a particular combination of labor market policies is required.

Keywords: search model, minimum wage, severance payments, welfare.