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Damages or Reinstatement: Incentives and Remedies for Unjust Dismissal

We consider a simple employment contract model to analyze the difference between two remedies for unjust dismissals: damages vs. reinstatement. The bargaining power of workers in the reinstatement case is stronger in severe recessions than it is in the damages case. In contrast, reinstatement worsens the bargaining position of workers in moderately severe recessions than do damages, and hence, the payoff for workers in the reinstatement case is greater in severe recessions and lower in moderately severe recessions than it is in the damages case. A higher payoff in the severe state causes serious damage to workers' incentives because shirking behavior is more attractive under the reinstatement policy. Firms are more likely to fire workers in the reinstatement case than in the damages case. Since there is a transaction cost with employment adjustment, damages are better than reinstatement from the viewpoint of workers’ incentives.