During the 1980s, many European countries introduced fixed-term contracts to fight high
and persistent levels of unemployment. Although these contracts have been widely used,
unemployment remains about the same after fifteen years. This paper builds a theoretical
model to reconcile these facts. I analyze the labor market effect of the introduction of
fixed-term contracts in an efficiency wage model. The form of incentive compatible fixed-
term contracts and the firm’s choice of contracts are studied. Permanent contracts are the
standard way to offer incentives, but fixed-term contracts are cheaper. This generates an
externality, which can make employment higher in the system with only permanent contracts.
As a consequence, from a social point of view, the share of fixed-term contracts is too large.
Increases in the renewal rate of fixed-term contracts into permanent contracts lead to higher
employment levels. The model highlights the interaction between different rigidities in the
labor market. Aggregate employment and the share of temporary contracts are affected in
the same way by firing costs and the flexibility of wages.