Employment Protection, Bonus Pay and Labor Market Performance

We conduct laboratory experiments where the market rules mimic labor market institutions, and exogenously vary insti- tutions to study the causal impact on subjects’ behaviors. We focus on rules analogous to dismissal barrier institutions, such as employ- ment protection legislation, and on institutions allowing bonus pay. We find that when constrained to fixed wage contracts, dismissal barriers reduce efficiency, but parties react by evolving rising com- pensation profiles. When the option to pay bonuses is introduced this completely offsets the negative effects of dismissal barriers. In the absence of dismissal barriers, bonus pay reduces frequency of repeated interactions, but leaves market efficiency unchanged.