Redundancy Payments and Firm-Specific Training

This paper attempts to provide an economic rationale for the existence and pattern of redundancy payments. A model of firm-specific training with uncertain returns to training and uncertainty about the outside options of workers is constructed for this purpose. The central result is that an optimal contract will involve the firm in bearing only a part of the training costs because workers may quit. Since workers bear part of the cost of training, they will have to be compensated by a redundancy payment if dismissed. Furthermore, the optimum level of this redundancy payment will vary across firms, with large payments being offered by firms where the returns to training are highly variable. These insights into the nature of redundancy payments differ from those of other models, where they are viewed either as a transfer fee or as representing the difference between inside and outside wages for contracted workers.