Abstract
We conducted an experiment to assess the importance of firms’ ability to fire and replace workers in determining both market effciency and the distribution of profits. Worker-firm interaction was modeled as a repeated gift exchange game with random termination to allow for the creation of dynamic incentives. Although the ability to replace has no effect on set of equilibrium outcomes, we find that markets with replacement are more effcient than those where firms are tied to a single worker. Employment protection, preventing firing, lowers effciency further. However, production surplus is split evenly between firms and workers regardless of the replacement option, suggesting fairness norms help select among multiple equilibria in incomplete contract settings. We identify creation of dynamic incentives though the threat of unemployment, sorting through replacement and screening through promotion contracts as important factors contributing to our results.