The theory underlying the labour market flexibility argument in India is identified and critically examined. A review of the empirical studies reveals that this argument is based on rigid real wages, in turn, explained by hiring and firing costs. Such explanations are provided by the insider–outsider theory of employment and unemployment due to Lindbeck and Snower (1988). A scrutiny of the I–O theory reveals that it could not even explain the existence of involuntary unemployment under reasonable assumptions. Further, it is shown that its policy recommendation necessarily assumes Say’s law. Thus, it is concluded the theoretical foundation underlying the LMF is unsound.
