In this paper we conduct an analysis of the effects of firing costs in models that consider
simultaneously worker heterogeneity, imperfect information on their productivity and union
power. We consider an OLG model where heterogeneous workers participate in the labour
market both when young and old. Each generation of workers is represented by its own
union. Unions set wages unilaterally taking into account firm behavior. Firms are atomistic
and choose employment treating wages parametrically. There is imperfect information about
worker productivity.
We find that at given wages firing costs increase youth unemployment and decrease old age
unemployment. However, once we take the wage response into account, we find that firing
costs increase both youth and old age unemployment. This happens because unions react
strategically, and respond to higher firing costs. Indeed, when firing costs increase, firms
refrain from hiring youths since, if a young worker turns out to be inadequate, it will be more
costly to fire him. The union, knowing this, reduces the wage of young workers in order to
attempt to increase their employment prospects. However, despite this cut youth
unemployment still increases with firing costs. In the second period, on the contrary, higher
firing costs give the union more power. In fact, knowing that firms will be less likely to cut their
labour force when firing costs are high, the union increases the wage of old workers, and,
therefore, old age unemployment increases.