We introduce a minimum wage and severance payments in an equilibrium labor market model with search frictions. We analyze how these policies affect endogenous job creation and destruction decisions and, more generally, the general equilibrium allocation. We structurally estimate the model's parameters using data from Chile, a country where labor market regulations prescribe high severance payments and minimum wage; we build three subsamples corresponding to three different levels of educational attainment. With the resulting sets of estimates we perform a quantitative welfare analysis. We reach three main conclusions. First, when the dispersion in wages found in the subsample is low and the share that workers receive from the surplus their job generates is at an appropriate level, the economy's maximum welfare level is reached in a policy-free environment; on the other hand, if the workers' share is too low, the maximum level of welfare can be attained using any of the following possibilities: severance payments or a minimum wage by themselves or an appropriate combination of these two policies. Second, as dispersion in wages increases, the minimum wage, by itself, can no longer reach the economy's maximum level of welfare. Third, when the dispersion in wages is high enough, no policy in isolation can attain the economy's maximum level of welfare, and a particular combination of labor market policies is required.

At the end of the 1990s, Chilean legislators mandated substantial increases in the minimum wage. We perform an empirical study of the minimum wage welfare effects on the Chilean market using Flinn's (2009) framework, which is a continuous time search model with participation decision, Nash bargaining, and match specific heterogeneity. We use Flinn's strategy to estimate the structural parameters of the model except for the share that workers receive from the surplus generated by the match. Due to inadequate demand side data, we estimate the model fixing the workers' share (α) at different levels in the [0,0.5] interval, and perform the welfare analysis for each set of parameters. A first result is that the optimal minimum wage is decreasing in the workers' share, and for α near 0.13, the actual 2000 level would have been optimal. We then extend Flinn's welfare analysis in two directions. We identify the elements of the equilibrium allocation that are mainly affected by the changes in the minimum wage, and we study the minimum wage as a second-best tool for reaching the constrained efficient allocation. Our second finding is that, for every set of estimates, the change in the participation rate accounts for more than half of the welfare gain induced by the optimal minimum wage. Thirdly, the maximum welfare gain increases with larger values of α. That is, the gap between the planner's welfare and the equilibrium one becomes more significant as the workers' share increases. On the other hand, for larger α's, the optimal minimum wage closes a smaller fraction of the gap, and is therefore less effective. The results of the paper suggest that, at least for larger α's, some labor market policy aimed directly at participation would have been more effective than a mandatory minimum wage.