This paper constructs a theory of the coexistence of fixed-term and permanent employment contracts in an environment with ex-ante identical workers and employers.Fixed-term workers can be dismissed at no cost while permanent employees enjoy labor protection. In a labor market characterized by search and matching frictions, firms find it optimal to discriminate workers by offering different contracts. We analytically characterize the firm's hiring and firing rules. Using matched employer-employee data from Canada, we estimate the model's parameters. The effects of firing costs on wage inequality vary dramatically depending on whether search externalities are taken or not into account.