Uncertainty and Contract Choice in Two‐Tier Labor Markets

ABSTRACT

We develop a search‐and‐matching model in which firms choose between one‐period temporary contracts and open‐ended permanent contracts after observing persistent match quality. Permanent jobs retain valuable matches by lowering effective job‐to‐job turnover, but expose firms to firing costs; temporary jobs permit costless non‐renewal and can be upgraded at a promotion cost. This leads to the coexistence of both contracts and sorting of high‐quality matches into permanent jobs. Our contribution is to characterize how a mean‐preserving increase in idiosyncratic transitory uncertainty changes that assignment. In the full equilibrium, the sign is not mechanical: uncertainty raises the value of flexibility and expected firing‐cost exposure, but can also raise the value of retention. The contract cutoff moves toward temporary hiring when the former forces dominate locally. We derive explicit primitive sufficient conditions respectively in both the additive and the multiplicative benchmarks, and characterize a composition condition under which the observed permanent‐temporary wage ratio falls. Descriptive Canadian evidence and a disciplined quantitative illustration show that higher productivity dispersion can be accompanied by a larger temporary share, a lower wage ratio, and only a modest unemployment response.