Uncertainty and Recourse to Short-Term Contracts 1. Revised June 2003

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1 Uncertainty and Recourse to Short-Term Contracts 1 by Brigitte Dormont 2 and Marianne Pauchet 3 Revised June 2003 JEL classi cation : J23 ; J63 Keywords: Labour Demand, Adjustment Costs, Panel Data 1 This work was conducted in the Département des Etudes Economiques d Ensemble of Insee. We are grateful to Laurence Allain, Francis Kramarz, Pierre Picard and CREST seminar participants for helpful remarks, and to Eric Maurin, Constance Torelli and Sylvie Lagarde, who gave us access to the DMMO data source. All remaining errors are our own. 2 Corresponding author: Université Paris-X Nanterre, Théma, bât G, UFR SEGMI, 200 Avenue de la République, Nanterre Cedex, France. Tel : 33/1/ Fax : 33/1/ dormont@u-paris10.fr. 3 Université Paris X-Nanterre, Théma, and ACOSS, marianne.pauchet@acoss.fr

2 ² Abstract. The purpose of this paper is to study the relationships between labour demand, uncertainty and the use of exible labour contracts. We test whether recourse to short-term contracts is a way of adjusting employment and compensating for the rigidity of long-term contracts, when rms face uncertainty. We use a panel of 915 French manufacturing rms, for which we combined microeconomic information both about worker ows and rms economic performance. This rather original sample enables us to measure, at the rm level, uncertainty regarding rms revenues. We nd that higher uncertainty reduces the sensitivity to exogenous shocks of the hiring and ring rates for workers on long-term contracts. Adjustments on short-term contracts are used to compensate smaller reactions or inaction on longterm contracts. In addition, more workers hired on short-term contracts improve total labour exibility, while protecting long-term workers from ring. Our data allow us to show between- rm variability as regards production volatility and recourse to short-term contracts. Since uncertainty levels have a high between- rm variability, our results throw into question the relevance of economic policies aimed at uniformly lowering ring costs. 2

3 1. Introduction. The purpose of this paper is to study the relationships between labour demand, uncertainty, and the use of exible labour contracts. Currently, short-term contracts amount to only 4 % of the total employment stock of French manufacturing establishments with more than 50 workers. However, the share of short-term workers in employment has grown continuously over the two last decades. In addition, they represent a sizeable share of entries: in 2001, 67 % of total hirings were on short-term contracts. This situation results in high turn-over and large ows into and out of unemployment. The relationship between the use of short-term workers, the demand for permanent workers and uncertainty is therefore a major issue. In order to understand the impact of short-term contracts on labour demand behaviour, one has to refer to the literature devoted to adjustment costs and labour demand in the presence of uncertainty. This literature does not usually consider labour heterogeneity. It has recently shed light on the impact of linear adjustment costs on labour demand. With linear adjustment costs and various assumptions about the random shock a ecting the rm s revenue, Bentolila-Bertola (1990), Bertola (1990) and Bentolila-Saint-Paul (1994) obtain identical predictions on two points. First, they establish that an optimal behaviour for the rm can be inaction. Because of the discontinuity of marginal adjustment cost at zero, it is possible to de ne a corridor within which the optimal decision is to wait (no hirings and no rings). Second, they show that higher adjustment costs imply fewer hirings and rings, when hiring and ring decisions do occur. Hiring and ring costs (H and F) have direct and indirect e ects on the optimal number of hirings and rings. For instance, higher ring costs make rms more reluctant to hire because of the indirect e ect of F: one hiring on a long-term contract today implies a direct cost of H today but also an indirect cost of F if the worker has to be red tomorrow. Another noteworthy result appears in Bentolila-Bertola (1990) as well as in Bertola (1990) : they both establish that the negative e ect of ring costs F on hiring is strengthened when uncertainty is higher. This conclusion can also be deduced from Bentolila and Saint-Paul (1994): reactions (hiring or ring) to exogenous shocks (such as a change in the wage cost) are smaller when uncertainty is higher. 3

4 Contract heterogeneity is taken into account in labour demand models with adjustment costs by Saint-Paul (1991), Bentolila and Saint-Paul (1992) and Kandell and Pearson (1997). The latter do not introduce adjustment costs, but consider permanent workers who can not be red. Bentolila and Saint-Paul study the introduction of xed-term contracts in Spain during the 1980s. They do not take hiring costs into account and focus on the behaviour of a rm facing an adverse shock. Within this framework, the authors show that the use of exible labour contracts is a way of limiting adjustments on long-term contracts. In a symposium devoted to temporary work, Booth et al. (2002 a ) try to understand the reasons for its extension in the EU. Noting that there is no relationship between restriction on temporary contracts and the proportion of temporary jobs, they put forward the hypothesis that recourse to temporary jobs depends positively on employment protection for permanent jobs. Using a cross-section sample of 27 European countries and an OECD indicator of employment protection strictness for permanent work, they nd a positive correlation which gives empirical support to this interpretation. Temporary contracts appear to provide employment exibility in countries with strong employment protection for permanent jobs. Another way to test this hypothesis is to consider microdata within a country. In that case, one loses the variability between countries attributable to di erent institutional settings relative to employment protection for permanent jobs. However, the papers quoted above show that, for a given rm, the burden of employment protection depends strongly on the level of uncertainty regarding its revenue (Bentolila-Bertola (1990), Bertola (1990), Bentolila and Saint-Paul (1994)). In fact, rms face very di erent conditions as regards production volatility, and thus very di erent degrees of uncertainty. We use micro data to test on whether the use of short-term workers is a way to provide exibility when the burden linked to long-term workers protection is high. We will exploit the variability due to rms heterogeneity as regards uncertainty. Our empirical approach entails three steps. First, we consider a basic model of labour demand together with the breakdown of labour growth rate into several entry and exit rates. This enables us to evaluate the contribution of the various workers ows to labour demand elasticities. In the second step, we examine whether hiring and ring rates on long-term contracts react less to exogenous shocks when the uncertainty a ecting a rm s revenue is higher. In the 4

5 third step, we test whether short-term contracts are used in order to compensate a potential rigidity observed on long-term contracts. The paper is organized as follows. In section 2, we present the relevant featuresoffrenchlegislationanddescribethedataandsamplethatwillbeused for the empirical work. In section 3, we present our empirical approach. The econometric results are reported in section 4. In the last section, we discuss the policy implications of our results. 5

6 2. Data and basic facts 2.1. The French institutional setting In France, rms are allowed to hire workers on two types of contracts: shortterm and inde nite term contract. Introduced in 1979, short-term contracts are called CDD (contrats à durée déterminée). They are valid for a speci c period of time and renewal possibilities are limited (maximal duration of 18 to 24 months including renewal). If employers do not transform the short-term contract into a permanent contract, they must pay a premium equal to 10 % of the total wages paid. This premium can be interpreted as an additional wage cost rather than a termination cost. Indeed, it is de ned as a percentage of the total wages and estimates performed on French microdata revealed no signi cant adjustment costs for such short-term contracts (Goux et al, 2001). Inde nite term - or long-term contracts are called CDI (contrats à durée indéterminée) and are characterised by inde nite duration and high termination costs. A rm is allowed to re a CDI-worker in case of professional misconduct or in case of serious economic di culties. In this last case, the rm must pay substantial severance payments to the CDI-worker. Those payments are de ned by the French labour laws. They depend upon the worker s seniority. Workers with less than two years within the rm do not receive severance payments. Workers with more than two years of seniority receive 10 % of a reference monthly wage for each year of presence in the rm. This reference wage is the average wage of the worker during his/her last three months. Collective agreements do generally o er higher severance payments Data and variables We use a panel of 915 French manufacturing rms observed over the period This sample was obtained by using 3 INSEE 4 sources (see appendix 1 for details): (i) the survey Enquête structure des emplois (ESE)givesinforma- tion about the employment level and structure for each establishment with more than 20 workers; (ii) the survey Déclaration des mouvements de main-d oeuvre (DMMO) is a monthly source which records for each establishment of more than 4 INSEE stands for Institut National de la Statistique et des Etudes Economiques, i.e. National Institute for Statistics and Economic Surveys. 6

7 50 workers its employment level and the number of entries and exits by type of contract. This survey has been set up to cover all of France only recently (1987); (iii) the BIC ( Béné ces industriels et commerciaux ) dataset corresponds to the Survey for Corporate Tax Return. It gives information, at the rm level, on balance sheet variables for each rm of more than 20 workers. This database cover the period One limitation of our data stems from the fact that the DMMO information does not provide any measure of the level of employment by type of contract. Moreover, we had to reduce the sample to rms with medium or large plants, which are the only ones covered in the DMMO survey (at least 50 workers). However, it was worthwhile to match the DMMO and the BIC sources. It enables us to obtain a rather original data base, with information, at the rm level, both about worker ows and rm s economic performances (see appendix 1 for the variable de nitions). Our data provides information about worker ows. Total entries (E) are divided into 3 groups: the hirings on long-term contract (HL), the hirings on shortterm contract (HS) and other entries (transfers from another establishment and unspeci ed entries). Total exits (X) are divided into 4 groups: rings of workers on long-term contract for economic reasons or for professional misconduct (FL), terminations of short-term contracts (XS), quits (V) and other exits (transfers to another establishment, retirement, early retirement, military service, end of trial hire period and sickness). We have constructed several entry and exit rates to study worker ows. Employment growth rate l : is equal to the di erence between the total entry rate e and the total exit rate x : : l = e x; where e = E=L 1 and x = X=L 1 :L 1 denotes the stock of employment at the beginning of the year. Neglecting other entries and other exits, which correspond to very small ows, we have: e ' h s + h l and x ' x s + f l + v; where h s is the hiring rate on short term contract, h l the hiring rate on long term contract, x s theexitrateonshorttermcontracts,f l the ring rate (on long term contracts) and v the quit rate. 7

8 2.3. Descriptive analysis The basic features of the data are reported in table 1. The rst two columns of table 1 give means and standard deviations for several growth rates and worker ow ratios. The most noteworthy feature is the strong contrast between the sizeable magnitude of worker ows and the small value of the employment growth rate. Entry and exit rates amount to about 18% whereas the average employment growth rate equals only 0.4%. Most entries are through short-term contracts: the average hiring rate on short-term contracts amounts to 14%, whereas the total entry rate equals 18% (table 1). The ends of short-term contracts also represent a major share of total exits: 50 % of all exits are through terminations of short-term contracts. The quitting rate is far from negligible (4.29 %). Quitting is the second most common way of exiting a rm. All these results are consistent with those found by a number of papers (see Abowd, Corbel, Kramarz (1999) and Davis and Haltiwanger (1992) for a complete descriptive analysis with U-S data). With an unbalanced sample of French rms observed over the same period, Abowd et al (1999) observe small annual employment changes together with a lot of hirings and separations. They observe that establishments with steady employment can have entry and exit rates of about 20 %.By the same way, Lagarde et al (1995) found that workers entries and exits amount to 60 % of total employment stock. In addition, the National Institute for Statistics and Economic Surveys (INSEE), in charge of the analysis of the monthly statistics, publishes entry and exit rates of about 30 %. The last two columns of table 1 present variance structures. In order to characterise the information provided by the double dimension of our data, we split the variances of our indicators (entry and exit rates as well as various growth rates) into their between- and within- rm components. Consider y it the observation of y for the ith rm in year t. The overall variance of y it, V (y it ) is equal to the sum of the between- rm variance V (y i: ) and the within- rm variance V (y it y i: ) where y i: is the rm-average of y de ned as : y i: = 1 TP y T it.therefore,wehave: t=1 V (y it )=V(y i: )+V(y it y i: ): The between- rm variance reveals the permanent di erences between rms. The within- rm component, on the other hand, characterises the temporal, or even transitory, part of the information. 8

9 Looking at the last two columns of table 1, we rst notice that the employment growth rate is a very transitory variable, just like other growth rates (see the wage and production growth rates). Conversely, worker ow ratios such as hiring and exit rates on short-term contracts are not transitory variables. These ratios have a large between- rm variability. The use of short term labour contracts is thus a rather permanent characteristic of the rms human-resource management. Another noteworthy feature is the small share of between- rm variance observed for the ring rate on long-term contracts f l. This is by far the most transitory ratio : there are small permanent di erences between rms regarding their ring intensity. These statistics give some support to the idea that there is a link between recourse to short-term contracts and long-term workers protection. It appears here that there is no substantial di erence between rms as regards their ring behaviour (f l is mainly a transitory variable). And we will see below that rms face very di erent conditions as regards production volatility. Thus, facing the same rules of employment protection for permanent and temporary employment, rms seem to moderate the e ect of production volatility by speci c strategies of recourse to short-term contracts (h s and x s have a large between- rms variance). 3. Our empirical approach: speci cations and methods Our empirical work refers to the existing literature on labour demand with linear adjustment costs and uncertainty about the rm s revenue. Bertola (1990), Bentolila and Bertola (1990) and Bentolila and Saint-Paul (1994) all consider labour to be homogenous. When there are linear adjustment costs, the maximisation by the rm of its present discounted value of expected pro t over an in nite horizon leads to optimal decisions which can be hiring, ring or inaction. These authors show that the probability of inaction depends positively on the level of uncertainty about the rm s revenue. In addition, Bentolila and Saint-Paul (1994) show that hirings and rings, when they do occur, have smaller reactions to exogenous shocks when uncertainty is higher. It is possible to take labour heterogeneity into account and to give an interpretation of recourse to short-term contracts by a direct extension of Bentolila and Saint-Paul s model (1994). We can specify a strictly concave production function with short-term and long-term workers who are assumed to be imperfect substitutes. In addition, we can assume that there are linear ring and hiring costs 9

10 on long-term contracts and no adjustment costs for short-term contracts 5. In this framework, the predictions derived by Bertola (1990), Bentolila and Bertola (1990) and Bentolila and Saint-Paul (1994) apply to permanent workers. As to short-term workers, they should play a compensating role. On the whole, we obtain the following predictions. First, an increase in uncertainty should reduce the sensitivity of hiring and ring on long-term contracts to exogenous shocks. Second, short-term contracts should be used to compensate lower reactions or inaction on long term contracts. The rst theoretical prediction we aim to test concerns decisions about hirings and rings on long-term contracts. As shown is the descriptive statistics, hirings and rings on long-term contracts represent a rather small proportion of worker ows in and out the rm. Thus, it seemed appropriate to us to establish a link between the traditional labour demand equation and its breakdown into several equations of hiring and ring behaviour by type of contract. Our empirical approach entails three steps. First, we consider a basic model of labour demand together with the breakdown of the labour growth rate into several entry and exit rates. This enables us to evaluate the contribution of the various workers ows to labour demand elasticities. In the second step, we concentrate on the elasticities of the speci cations describing hiring and ring rates on long-term contracts and examine whether their magnitude are in uenced by the uncertainty a ecting the rm s revenue. In the third step, we test whether short-term contracts are used to compensate a rigidity observed in long-term contracts A basic model of labour demand: the contribution of various worker ows We rst consider a basic model of labour demand. Each rm i is supposed to keep the right to manage employment and to be a part of a monopolistically competitive industry. The maximization of its pro t for given capital stock and wage leads to a static labour demand equation. Written in rst di erences of 5 This adjustment costs speci cation is in accordance with the results obtained by Abowd and Kramarz (1999), who thoroughly studied adjustment costs on French micro data. On French microdata, Goux et al. (2001) found no signi cant hiring and termination costs for short-term contracts. 10

11 logarithms (i.e. in growth rates), the speci cation is the following: : : lit= " k : kit +" w : w it +" q : qs it +consts (3.1) lit and : kit are, respectively, the rst di erences of the log of employment and : : gross capital. qs it is the rst di erence of the industry output log. w it is the rst di erence of the wage log (including social contributions) of rm i, de ated by the output price of the relevant industry. Constants are time dummies included to take into account a time e ect common to all rms. In the subsection devoted to the variable de nitions, we showed that we can write the employment growth l : as a linear combination of entry and exit rates: : l = h s + h l x s f l v; (3.2) where h s is the hiring rate on short term contract, h l the hiring rate on long term contract, x s the exit rate on short term contracts, f l the ring rate (long term contracts) and v the quit rate. The speci cation (3.1) is static and rather simple. However, it o ers the advantage to be linear. Then, we should nd for the labour demand elasticities " k ; " w and " q thesamedecompositionthanthe linear combination (3.2) we have shown between employment growth rate and its components. Taking as an example the wage elasticity, one has: " w = " hs w + "h l w "xs w "f l w "v w : (3.3) In our rst step, we estimate the labour demand (3.1), then models explaining each of the entry and exit rates appearing in (3.2) by the same explanatory variables. These estimates shed light on the in uence of hirings and rings on short and long term contracts on the magnitude of labour demand elasticities A variable coe cient model In the second step we concentrate on the elasticities of the equations explaining the hiring and ring rates on long-term contracts (h l and f l ). If uncertainty actually lowers the hiring and ring rates on long term contracts, elasticities should be decreasing functions (in absolute value) of the uncertainty a ecting the rm s revenue. To test this prediction, we specify a variable-coe cient model, where the elasticities of the hiring and ring rates on long-term contracts are random and vary accross rms according to an indicator of the uncertainty, denoted ¾ i, which a ects the rm s revenue and to a rm speci c error term i: Consider 11

12 for example the wage elasticity " w;i in the equation relative to the hiring rate on long-term contracts h l. One has 6 : " w;i = " w;0 + " w;1 ¾ i + w;i (3.4) Thewageelasticityisnomorea xedparameter" w like in the rst step of our study, but a random coe cient with a xed part " w;0 and a variable part " w;1 ¾ i : Estimation methods allow us to evaluate the parameters " w;0 and " w;1 : According to our prediction, the wage elasticity should be a decreasing function (in absolute value) of uncertainty. Therefore, we expect opposite signs for " w;0 and " w;1 ; i.e. " w;0 :" w;1 < 0: Thesamereasoningappliesfortheotherelasticities" k;i and " q;i of the equation explaining the hiring rate on long-term contracts h l : Again, if uncertainty reduces reactions of h l to shocks on capital growth and industry output growth, one should have 7 : " k;0 :" k;1 < 0 and " q;0 :" q;1 < 0: The same approach in terms of variable coe cient model will be applied to the equation explaining the ring rate on long-term contracts f l : Tosumup,amoderatingrole of uncertainty should lead to opposite signs for the xed and variable parts of the elasticities estimated for the hiring and ring rates on long-term contracts. The panel structure of our sample o ers the possibility to evaluate, at the rm level, the uncertainty a ecting the rm s revenue. We can exploit the individual time series available for each rm i, to compute individual standard deviation of various variables. We measure uncertainty by ¾ i, the standard deviation of the rm s output growth rate q : 8 it computed for the ith rm over the period Basic descriptive statistics of ¾ i are presented in the following table. They show that rms face very di erent conditions as regards production variability. Basic features of the uncertainty indicator ¾ i (%) mean standard deviation 6.37 median rst quartile 7.77 third quartile For sake of simplicity, we denote " w;i instead of " h l w;i. 7 Where " k;0 (respectively " q;0 ) denotes the xed part of " k;i (respectively " q;i )and" k;1 (respectively " q;1 ) denotes the variable part of " k;i (respectively " q;i ). 8 The GMM estimator allows us to deal with the fact that q : it is not exogenous. Other results were obtained by using alternative measures of uncertainty (available on request). 12

13 3.3. Testing the compensating role of short term contracts In the third step, we focus on the decisions relative to the short-term contracts. Are they actually used in order to compensate a potential rigidity observed on long-term contracts? We rst estimate the relationship between the variations of workers on short-term and on long-term contracts. Second, we use again a variable-coe cient speci cation in order to evaluate the in uence of the share of short-term employment on labour demand behaviour Estimation methods We have chosen to specify the labour demand in growth rates for two reasons: rst, we wanted to exploit the available information about short and long term contracts, which is on workers ows 9. Second, on panel data, one generally considers an error component speci cation, where the overall error term, u it,issplit into two independent terms : u it = i +» it. i is a rm-speci c e ect which may be correlated with the explanatory variables and» it is an i.i.d error term. Under these theoretical hypotheses, it is usual to write the equation in rst di erences, in order to eliminate the individual speci c e ect i (on the rst-di erenced equation, the residual will therefore be equal to» it» it 1 ). Given our theoretical framework, w : it, : kit and qs : it in (3.1) are exogenous. However, all of these explanatory variables are likely to be a ected by measurement errors. Indeed, our measure of the wage is actually in uenced by the number of hours worked and by the composition of the work force, while the dependent variable (employment growth rate) is not in uenced by any of these. This could induce a correlation between the disturbance and the wage. Moreover, since capital is computed on the basis of balance sheet data 10, it is likely to be measured with errors; and so is the industry output because rms have multiproduct activities and their categorisation into a given industry only depends on their main product. Because of these potential measurement errors, the explanatory variables are not strictly exogenous: they may be correlated with» it. We assume that E(x it» it ) 6= 0and E(x it» it+ )=0if > 0; where x it is the level of any explanatory variable. This comes down to assuming (i) that the explanatory 9 We have no information about the splitting up of the overall employment stock into its short- and long-term components. 10 Notice that the capital has been correctly de ated. Indeed, we included a correction to take into account the fact that scal lenghts of life underestimate the actual service lives of capital stocks. 13

14 variables are predetermined but measured with errors, (ii) that the measurement errors are not autocorrelated. To deal with this potential non-exogeneity of the explanatory variables, we estimate our speci cations by the generalized method of moments (GMM) de ned by Arellano and Bond (1991) for panel data sets. Blundell and Bond (1998) and Blundell et al.(2000) have shown that the rst-di erenced GMM estimator de ned by Arellano and Bond can be subject to the problem of weak instruments. They suggested to specify the model in levels and to use lagged rst-di erenced endogenous variables as instruments. An optimal estimator can then be obtained by combining in a system the rst-di erenced and the level GMM estimators. It is important to underline here that our information is reduced to worker ows: it limits us to a model speci ed in growth rates, and therefore to the estimator of Arellano and Bond. Our information about workers ows is relative to the years But the estimation period is reduced to , because of the lags involved in the model speci cation. However, observations relative to the period (which can be found in the BIC data set) can be used as instruments for our GMM estimates. The GMM estimator makes it possible to estimate the variable-coe cient model speci ed in order to evaluate the impact of uncertainty on labour demand. Consider for example the equation relative to the hiring rate on long-term contracts h l : : : : h l;it = " k;i k it +" w;i w it +" q;i qs it +consts +» it» it 1 (3.5) From (3.4), one has: 8 " k;i = " k;0 + " k;1 ¾ i + k;i >< with : " w;i = " w;0 + " w;1 ¾ i + w;i >: " q;i = " q;0 + " q;1 ¾ i + q;i We suppose that j (equal to ( kj wj qj ) 0 ) is uncorrelated with k : it, (3;1) : qs it, ¾ i and» it for all i; j; t: Inaddition,weassume:E ³ ( i)( j) 0 8 < = : (3;3) if i = j 0 if i 6= j: (3.6) : w it, This is a particular case of the variable-coe cient model, as studied by Dor- 14

15 mont (1996). Combining (3.5) and (3.6), one remarks that taking into account the possible in uence of uncertainty on labour demand behaviour leads to additional explanatory variables and heteroskedasticity. This model can therefore be estimated by the GMM estimator. Since ¾ i is computed over the whole estimation period ( ), we have to select the instruments within the preceding available period. Thus, instruments are the logarithms of employment and the logarithms of all explanatory variables (including also real value-added) observed over the years Econometric speci cation similar to (3.5) and (3.6) are used to evaluate the in uence of uncertainty on the ring rate on long-term contracts f l : 4. Results 4.1. Contribution of the various workers ows to labour demand elasticities. To study the contributions of the various workers ows to labour demand elasticities, we use the linear relationship between the employment growth rate and its components. One has: : l = h s + h l x s f l v: h s is the hiring rate on short term contracts, h l, the hiring rate on long term contracts, x s the exit rate on short term contracts, f l the ring rate and v the quit rate. We present in table 2 the estimates of the labour demand (3.1) and the estimates of the equations describing the hiring, ring and quit rates. Instrument validity is tested by the Sargan test of over-identifying restrictions based on the second step estimations. Notice that the estimates of table 2 are obtained with the two-step GMM, which is not a linear estimation procedure. Therefore, the linear relationship between the employment growth rate and its components does not lead to a linear relationship between the static labour demand elasticities and the elasticities of the hiring, ring, and quitting rates. As a bench mark, we thus present the onestep GMM estimates in table 2. Unlike the two-step estimator, the one-step estimator is linear. Therefore, the static labour demand elasticities are exactly equal to the di erences between the elasticities of total entry rate e and total exit rate x 11. In the same way, each total entry rate elasticity equals the sum of the short- and long- term hiring rates elasticities. And each total exit rate elasticity 11 In the case of table 2, we computed the entry rate and the exit rate in order to obtain 15

16 equals the sum of the short-term exit rate, the long-term ring rate and the quit rate elasticities. As noticed in the descriptive analysis, workers ows are much larger than their di erence, the employment growth rate. Thus, in table 2, entry and exit rate elasticities (columns (3) and (6)) are generally much larger than static labour demand elasticities (column (1)). We nd similar results when concentrating on contract types. Short-term contracts are a predominant part of workers ows. Thus, the elasticities of the hiring (respectively, exit) rate on short-term contract account for a large part of the elasticities of the total entry rate (respectively, total exit rate). Elasticities of the hiring rates have the expected signs. Hiring behaviour is, to some extent, comparable on short and long-term contracts. Hiring rates on short and long-term contracts both depend on capital, wage and industry output growth rates and their elasticities have identical signs. The only di erence is that the hiring rate on short-term contracts has much larger elasticities (in absolute value). At rst sight, the signs of most of the elasticities relative to exit behaviour seem rather surprising (columns (6), (7) and (8)).One would expect exit rates to be negatively in uenced by capital and industry output growth rates : during recessions, rms increase the number of terminations. These are reduced during periods of expansion. In the same way, one would expect a positive impact of wage growth on rings. Actually, these results follow mainly from the estimated elasticities of the exit rate on short-term contract. As underlined previously, most of the workers who are hired on a short-term contract leave the rm within the same year. Therefore, on short-term contracts, exit rate elasticities have quite logically the same signs as hiring rate elasticities. Since short-term contracts are the major part of worker ows, this explains the signs of the estimated elasticities on total exit rate. However, the elasticity of f l with respect to wage still has a surprising negative sign (column (8)). Firms reduce the number of costly terminations when the wage growth is faster. In order to understand this negative wage elasticity, one can advance the following interpretation. Firms may react to a rise in wages by increasing their marginal labour productivity through an employment reduction, and through an increase in the share of high seniority workers. Therefore, rms reduce hirings (the wage elasticity of h l equals 0:127) and rings (the wage exact accounting identities. More exactly, we eliminated other entries from the entry rate and other exits from the exit rate. 16

17 elasticity of f l equals 0:069), but reduce rings less than hirings in order to obtain an employment reduction. This behaviour can be reinforced by the fact that, in France, ring costs are increasing functions of wage and seniority. For the quit rate, the Sargan test led us to reject instrument validity, until we allow for the hypothesis that» it» MA(2): Then, the instrument validity is not rejected at 4% (column (9 ) of table 2). The estimates show that the quit rate depends positively on the capital and industry output growth rates and negatively on the wage growth rate : w. Thus, there is empirical evidence of a pro-cyclical quit behaviour: quits are positively in uenced by the rm s capital growth rate as well as the output growth rate of the industry to which rm i belongs. This later result is underscored by a number of papers (see for instance Hamermesh and Pfann (1992)).We nd that quitting is - quite logically - discouraged by wage growth. This negative and sizeable wage elasticity show that lowering the wage growth is not necessary an optimal strategy for the employer. Indeed, it can induce more quits, a loss of human capital, and therefore possible additional hiring costs to replace the workers who left the rm. As a whole, the negative elasticity of static labour demand (column (1)) with respect to wage growth is very small (-0.066). Examining table 2 carefully,one remarks that this follows from quite sizeable but rather similar wage-elasticities of total entry rate (-0.696) and total exit rate (-0.622), which o set each other 12. But the noteworthy feature of this result is that the negative sign on the wage elasticity stems only from hiring behaviour: exits are not positively in uenced by wage growth The in uence of uncertainty on hiring and ring on long-term contracts We now estimate our variable-coe cient model to test whether uncertainty actually lowers the hiring and ring rates on long term contracts. If this prediction is true, the elasticities of the equations explaining h l and f l should be decreasing functions (in absolute value) of the uncertainty a ecting the rm s revenue. Within the framework speci ed by (3.4), we thus expect opposite signs for the 12 As stated above, in table 2 (one-step GMM estimates), the linear relationship between the employment growth rate and its components leads to a linear relationship between the elasticities of the static labour demand and the elasticities of the total entry and exit rates. As regards the wage elasticity, one has: " w = 0:059 = 0: :613: 17

18 xed and variable parts of the estimated elasticities in the equations explaining h l and f l. Theestimationswereperformedoneachcomponentoflabourdemand. We naturally focus 13 on the results relative to hiring and ring rates on long-term contracts (h l and f l ), which are reported in table 3. The results display clear evidence of a signi cant in uence of uncertainty on the elasticities: all the variable parts of the estimated elasticities are signi cantly di erent from zero. In addition, this in uence is in accordance with our prediction. Indeed, xed and variable parts of elasticities all have opposite signs: a higher uncertainty induces smaller reactions to exogenous shocks of hiring and ring decisions with respect to long-term contracts. More precisely, uncertainty lowers the negative impact of wage growth on hiring rate on long-term contracts (" w;i = 0:498+3:225 ¾ i,seetable2,column2). By the same way, the positive impacts of industry output and capital growth rates on hiring on long-term contracts are to a large extent weakened when uncertainty is higher. Turning now to ring behaviour, one notices that the ring rate on longterm contracts (f l ) depends negatively on the rm s growth rate, as measured by capital growth rate k : (see table 2, column 3). As predicted, this negative in uence is lowered when uncertainty is larger. The f l elasticities with respect to wage and industry output growth rates are also smaller (in absolute values) when uncertainty is larger. One should notice, however, that their xed parts still have the unexpected signs commented above. It is worthwhile to make again some comments about the estimates obtained for the quit rate (see table 3 in appendix 2, column 9). Indeed, quit behaviour may in uence the burden induced by adjustment costs: a high quit rate lowers the ring cost; conversely, many quits require, ceteris paribus, more hirings to replace the exits 14. The estimates reveal that the pro-cyclical quitting behaviour relies crucially on the magnitude of uncertainty. With the xed-coe cients estimates of table 2, we have obtained positive quitting rate elasticities with respect to capital and industry output growth rates ( k : and qs). : The variable-coe cients estimates in table 3 0 show that these elasticities actually have a negative constant part, which is more than o set by the positive strong e ect of uncertainty. In 13 Results of the estimation of the variable-coe cient model for each component of the labour demand are reported in table 3 in appendix Booth et al. (2002 b ) study in a rather di erent theoretical framework the interactions between quits, uncertainty and hiring and ring costs. 18

19 other words, a higher growth induces more quits only when workers feel insecure. On the contrary, the negative wage growth elasticity of the quitting rate is not in uenced by the level of uncertainty The compensating role of exible labour. Are short-term contracts actually used to compensate lower reactions on longterm contracts? To examine this issue, we have estimated a short-term labour demand equation. Suppose that short-term and long-term workers are imperfect substitutes in the production function. Then, if there are no adjustment costs for short-term contracts, the rst order conditions of the rm s pro t maximization program imply, under rather general conditions, that the short-term employment level ajusts continuously as a decreasing function of the optimal level of long-term employment (Dormont and Pauchet (1997)). We estimate a quite simple linear speci cation in rst di erences. Since we have no information about the level of short-term employment, we carry out a minor approximation: the short-term employment growth rate is measured by what we call the relative variation of short-term employment. This indicator is de ned as the di erence between hirings and exits on short-term contracts, divided by the employment level at the beginning of the year. Therefore the relative variation of short-term employment is equal to h s x s.inthesameway, we replace the long-term employment growth rate by the relative variation of long-term employment, equal to h l f l v 15. As underscored before, wage, capital and industry output cannot be treated as exogenous, because they are likely to be measured with errors. Obviously, the relative variation of long-term employment is also a non-exogenous explanatory variable. Therefore, the speci cation is estimated by the generalized method of moments. One should expect a negative sign for the coe cient of (h l f l v) it. The estimation results are presented in table 4. One remarks that the coe cient on the long-term employment variation is signi cantly negative, equal to in the GMM estimate 16. This result suggests that exible labour input and workers 15 Where h l, f l and v denote, respectively, the hiring, ring and quit rates on long-term contracts. 16 Unfortunately, the Sargan test leads to reject validity of the instruments. However, the fact that short- and long-term workers are substitutes seems to be a robust result. Indeed, more simple regressions, where capital, wage and industry output are assumed to be strictly exogenous lead to the same negative elasticity of (h l f l v) it (instrumental variables estimates 19

20 hired on long-term contract are actually substitutes: adjustments on short-term contracts can be used to compensate inaction on long-term contracts. We can also examine whether long-term employment reacts less when the proportion of short-term workers in the rm s total employment is higher. Table 5 in appendix 2 records the estimates of a variable-coe cients model built along the same lines than the model estimated in the sub-section 4.2. Now, we allow the elasticities with respect to capital, wage and industry output to vary according to ex, which is an indicator of the growth of the short-term employment share in the total workforce. The indicator ex can be computed only from To assess the exogeneity of ex, we have carried out the estimations on the cross-section 1992, whereas ex is computed over the period Two noteworthy results are obtained: - Total employment adjusts more rapidly when there are more workers hired on short-term contract (column (2)) The negative wage elasticity of ring rate on long-term contracts that we have found in table 2 can be decomposed into a positive constant elasticity and a negative part linked to the share of short-term employment: " wi =0:304 0:503 flex: We thus obtain the following result: more workers hired on short-term contracts improve total labour exibility, while protecting long-term workers from ring. similar to those in the rst column of table 4, or even ordinary least square on growth rates): 17 This unsurprising result is in accordance with the estimates that Bentolila and Saint-Paul (1992) obtained on Spanish data. 20

21 5. Conclusion According to French law, two kinds of labour contracts can be signed : short-term and long-term. Our results show that this regulation, combined with adjustment costs on long-term contracts, entails the following consequences : (i) higher uncertainty reduces the sensitivity to exogenous shocks of the hiring and ring rates of workers on long-term contracts, (ii) adjustments on short-term contracts are used to compensate for smaller reactions on long-term contracts, (iii) workers on short-term contracts improve total labour exibility, while protecting long-term workers from ring. As summarised by Booth et al. (2002 a ), expanding temporary jobs as a way to improve labour market exibility may have several drawbacks. It can contribute to the creation of bad jobs, which receive less training and have poorer career prospects in the long-term. It can create high turn-over among some workers. And the Spanish case shows that it can result in a dual labour market which can be very hard to reform afterwards. Blanchard and Landier (2002) criticise the very principle of a two-tier reform. They argue that the e ects of such a partial reform may be perverse. They nd evidence of increased turnover and lower welfare for young workers. Finally, they suggest that ring costs should be uniformly reduced for all workers. Our results do not lead to such a pessimistic view of the role of short-term contracts in France. Our data allow us to show between- rm variability as regards production volatility and recourse to short-term contracts 18. Thus, rms face very di erent degrees of uncertainty and make use of short-term contracts with di erent intensities. The French rules governing short-term contracts, with renewal limitation and additional wage cost, limit their use. However, our estimates give empirical support to the idea that rms can use short-term contracts to deal with high uncertainty. Since they do not take this between- rm variability into account, Blanchard and Landier do not modelise the between- rm variability of recourse to short-term workers. One should keep in mind that a major interest of such a two-tier reform is to maintain a high level of welfare for permanent workers (who account for more than 90 % of the employment stock in France), while giving some exibility when necessary. Since uncertainty levels have a high between- rm variability, our results throw into question the relevance of economic policies aimed at uniformly lowering ring costs. 18 See the between- rm variability of h s and x s in table 1 commented at the end of section 2. 21

22 6. Appendix 1: Sample and variables The sample used for this study was obtained by combining 3 INSEE sources : - The survey Enquête structure des emplois (ESE) gives information about the employment level and employment structure by skills, for each establishment with more than 20 workers. - The Monthly Worker s Movement Declaration ( Déclaration des mouvements de main-d oeuvre (DMMO)) is an administrative record of workers ows in establishments of more than 50 workers. Each establishment gives a monthly report of its employment level and the number of workers entering and exiting by type of contract. This information is available for all France since The BIC( Béné ces industriels et commerciaux ) data bank corresponds to the Survey for Corporate Tax Return. It gives information, at the rm level, on balance sheet variables for each rm of more than 20 workers. This information is available for the period To construct our panel, we used a sample of 14,907 establishments balanced over the period , which was set up by Lagarde, Maurin and Torelli (1995). This sample contained information from the DMMO (aggregated at an annual level) matched with information from the ESE. We then selected establishments according to 3 criteria. First, we kept the plants which completed the questionnaire of DMMO every month of each year. Second, we retained plants for which, each year of the period, the declared net ows of workers (arrivals minus separations) were approximately equal to declared employment variation. Third, we eliminated plants whose employment levels declared in ESE and DMMO were too di erent. We also restricted our sample to the manufacturing sector. In the BIC datasets, about 7000 rms are present each year for the manufacuring sector. The matching of this dataset with the ESE-DMMO panel led to a sample of about 2,200 rms. To combine the ESE-DMMO panel with the BIC source, we had to aggregate the establishment information of the ESE-DMMO panel at the rm level. Therefore, it was necessary to avoid large discrepancies between the employment level of the ESE-DMMO source and the employment level of the BIC source. Indeed, a rm of less than 50 employees, which appears in the BIC data set, does not appear in the ESE-DMMO source, which contains only establishments of more than 50 employees. Moreover, the total employment of a rm with several establishments, some of them with less than 50 workers, appears to be lower in the ESE-DMMO source than in the BIC source. We eliminated all rms which had a relative dif- 22

23 ference of 10% between the employment stock observed in the BIC source and the one obtained by aggregating at rm level the ESE-DMMO information. We choose to aggregate establishment data up to the rm level in order to merge information about worker ows and information about the rm s economic performances. It is possible for a long-term worker to move from one establishment to another one within the same rm. However, this kind of movement is not costly and rather scarce: in our database, it represents less than 0.7 % of total employment; using another representative sample of French establishments, Abowd et al. (1999) show that transfers in and out rms represent less than 0.8 % of employment. In addition, we do not have many multiple-establishment rms in our sample. We thus considered this phenomenon as negligible and didn t model it. One selection criterion limited our sample most signi cantly: the choice for manufacturing industry led to an elimination of 78 % rms in the BIC database. We have selected rms belonging to the manufacturing industry in order to specify a labour demand function under the assumption of monopolistically competition with a realistic measure of capital stock. The results may be a ected by the use of a balanced sample of large manufacturing rms: we do not observe worker ows linked to rms creations and destructions. One should be cautious about generalizing our results. Anyway, we wanted to test whether uncertainty led to rigidity in hirings and rings on long term contracts with a sizeable sample. And currently, it is impossible to get microeconomic information about rm s performances, uncertainty and worker ows in a representative sample. We nally obtained a sample of 915 French manufacturing rms observed over the period The BIC source provides information, at the rm level, on balance sheet variables. Capital stock is taken as the gross book value of xed assets adjusted for in ation by using an estimate of the average age of capital. This estimate takes into account that scal lengths of life underestimate actual service lives of the capital stock and so enables us to obtain a correct de ator of capital. The wage is computed as the labour cost (total wage bill plus social contributions) per employee. Industry output and price are taken from aggregate output series with 18 levels for the manufacturing sector. 23