Heterogeneity in the effects of uncertainty shocks on labor market dynamics and extensive vs. intensive margins of adjustment

Abstract

The real option value theory posits that non-convex adjustment costs pertaining to a firm's input are central to comprehending the consequences of increased uncertainty. This paper leverages the diversity observed at both sectoral and country levels in the degree of irreversibility associated with hiring and firing, a critical factor generating what is commonly referred to as “wait-and-see” behavior in times of heightened uncertainty. Our empirical findings reveal two key insights. First, in alignment with the concept of second-moment shocks, uncertainty shocks predominantly influence the labor market through the extensive margin rather than the intensive margin. Second, the effects of uncertainty shocks exhibit pronounced heterogeneity across countries and industries, and the adverse employment effects (extensive margin) are amplified in a country with strict employment protection or in an industry characterized by a higher natural layoff rate, consistent with the real option theory.