DP2070 | Golden Cages for Showy Birds: Optimal Switching Costs in Labour Markets

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Why do some workers sign contracts with high quitting penalties? Are these restrictions on the workers' mobility perverse for efficiency or workers' welfare? We postulate an answer that hinges on the degree of observability of the worker's performance by alternative employers. When performance is privately observed by the employer, then alternative employers face an adverse selection problem when competing for the worker. In equilibrium separations take the form of layoffs with compensation to the worker with no role for quitting fees. However, if performance is quite public this adverse selection problem is absent and buy-out fees serve to appropriate alternative employer's rents from the reallocation of the worker. In this case, efficiency is not affected. Bargaining power (both before and after signing the contract) determines whether buy-out fees are detrimental or not to the worker's welfare.