Steinar Holden, December 2009 Wage setting and unemployment...

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Steinar Holden, December 2009

Wage setting and unemployment Why is there unemployment?

Frictions

• differences between

o workers’ characteristics and preferences, and

o job requirements

• takes time to find appropriate matches

But:

• differences in unemployment across countries and

over time are too large

• Different focus in most of the literature:

o why doesn’t the price clear the market?

o why doesn’t the wage fall?

• Leads to Equilibrium Unemployment Theory

o stock – wage and price curves

o flows – search models

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Why doesn’t the wage fall?

• minimum wages – too low or non-existent in most

countries/for most workers

• efficiency wages – firms profit from high wages

o if motivation is important for efficiency

o if the wage is important for motivation

• wage bargaining

o workers/unions push wages above competitive

wage

Un U

Real wage Wage curve

Equilibrium unemployment

Price curve (labour demand)

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Theoretical framework

Imperfectively competitive firms, facing a downward

sloping demand curve,

Production function firm i (employment N only input)

Yi = F(Ni), F’ > 0, F’’ < 0

Demand (Qi is the producer price, Q the aggregate

output price level, E is the elasticity of demand, Y

aggregate demand)

, 1E

ii

QY Y EQ

−⎛ ⎞

= >⎜ ⎟⎝ ⎠

Profits in firm i (Wi is nominal wage, τ is payroll tax

rate)

πi = QiF(Ni) – Wi(1+τ)Ni

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Right-to-manage assumption:

Firms set prices (and employment) to maximize profits,

for given wages

(1 )1

1 '(.)i iQ WE

Q E F Qτ+

=−

relative price = markup * marginal cost

product market comp. up => E up => markup down

Leads to profit maximising labour demand

1 2(1 ) , , , 0, 0i

iWN N Y E N N

Qτ⎛ ⎞+

= < >⎜ ⎟⎝ ⎠

and indirect profit function

1 2(1 ) , , , 0, 0i

iW Y E N N

Qτπ π

⎛ ⎞+= < >⎜ ⎟

⎝ ⎠

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From firms’ price setting, and aggregating over firms

(Qi = Q for all i)

(1 ) 1 '( )W E F NQ Eτ+ −

=

or

1 2(1 ) , , 0, 0WN N E N NQτ⎛ ⎞+

= < >⎜ ⎟⎝ ⎠

• One-to-one link: employment and real wage,

o no direct effect of aggregate demand, Y, for

given real wage.

• Intuition:

o Y up => N up => marg. cost up => Qi up

=> Q up => W/Q down

(employment only increases if W/Q falls)

• More elastic product demand, E up, (greater

product market competition) leads to higher

employment for given real wage.

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Union utility

1 2, , 0, 0ii i

Wu u N u uP

⎛ ⎞= > >⎜ ⎟⎝ ⎠

P is consumer prices

Wages set in firm-specific bargain,

Nash bargaining solution

0 0(1 )max , , ( , )

i

i iiW

W WY u N u U ZQ P

τπ π⎛ ⎞⎛ ⎞+ ⎛ ⎞⎛ ⎞− −⎜ ⎟⎜ ⎟ ⎜ ⎟⎜ ⎟

⎝ ⎠⎝ ⎠⎝ ⎠⎝ ⎠

• π0 , u0(U, Z) disagreement points, u01 < 0, u02> 0,

o U is unemployment and

o Z is indicator for wage pressure variables, like

unemployment benefits, “union strength”,

industrial conflict legislation, etc.

• π0 , u0: what motivates bargainers to reach

agreement, (costly delay or risk of breakdown)

o increased capital mobility weakens workers

bargaining power

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The solution can be written on the form

(1 ) (1 ), , ,iW PW U Z EQ Q

τ τ+ −−

+

⎛ ⎞+ +⎜ ⎟=⎜ ⎟⎝ ⎠

producer real wage

= W(wedge, U, wage pressure, prod. market comp)

+ - + -

(where the effect of aggregate output Y is subsumed

under U, invoking Okun’s law)

• Lower product market competition leads to

o Larger rents to capture

o Less elastic labour demand

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Empirical evidence for the wage curve:

• aggregate times series

• evidence based on micro data

The Wage Curve (Blanchflower and Oswald)

• Evidence for many industrialised countries suggest

an “empirical law”, that the elasticity of real wages

wrt unemployment is about -0.1

o If unemployment doubles, real wages fall by

10 percent

• Empirical support for dynamic fluctuations around

a long-run wage curve, rather than a Phillips curve

• Evidence suggest stronger effect of unemployment

in non-union setting

o unions able to resist wage reduction when

unemployment is high

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• Equilibrium unemployment Un given by wage and

price setting behaviour

• Increased wage pressure, Z up,

=>wage curve shifts up => W/Q up and Un up

• More elastic product demand, E up

=> price curve shifts up => W/Q up and Un down

Un U

W(1+τ)/Q real wage W(P(1+τ)/Q,U,Z,E)

wage curve

Equilibrium unemployment

[(E-1)/E] F’(1-U) price curve

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• No direct effect of aggregate demand Y on Un.

o Price level adapts to make aggregate demand

equal to aggregate supply, at eq. U.

• This implies that there is no effect of increased public

demand on Un if the price elasticity for public demand

is the same as for private

o Increase in public demand leads to higher Un if

lower price elasticity than for private demand

Un U

W(1+τ)/Q W(P(1+τ)/Q,U, Z,E)

Equilibrium unemployment

[(E-1)/E] F’(1-U)

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Theory: Wages and prices set in nominal terms, based

on expectations

• U < Un possible if wage and price growth above

expected levels

• Increasing wage and price growth for U < Un

o In reality wage growth may increase even if U

> Un, e.g. due to high profits

• Increase in aggregate demand leads to U > Un (just

like in traditional Keynesian models), and the

model tells what happens to wage and price growth

Un U

real wage wage curve

Increasing inflation

price curve

Decreasing inflation

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Effect of productivity growth

• Higher productivity shifts price curve up

• Higher expected productivity growth leads to higher

wage demands which shifts wage curve up

• Equilibrium unemployment increases if

expected productivity growth > productivity growth

Un U

W(1+τ)/Q real wage

wage curve

price curve

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Effect of immigration for domestic workers

• Wage curve down due to

o more competition for jobs

o less mismatch in labour market

• Price curve (labour demand) down due to

o Can use immigrants instead

• Effect on equilibrium unemployment ambiguous

• Dolado et al (2007): Reduction in Spanish

unemployment due to immigration lowering Un

Un U

W(1+τ)/Q real wage

wage curve

price curve (labour demand)

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Open economy: increased aggregate demand leads to

lower equilibrium unemployment & higher cost level

In open economy:

Y up => Q up => P/Q down

=> wage curve down => Un down

• Domestic prices increase relative to foreign

prices and equilibrium unemployment falls

• Aggregate demand & fiscal policy affect eq. U

Un U

W(1+τ)/Q real wage

wage curve

price curve

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The long run

The price curve becomes flatter, in the limit horizontal,

fixing the producer real wage, due to requirement of

o expected rate of return to capital

o balanced foreign trade

Un U

W(1+τ)/Q

Wages

Equilibrium unemployment

Prices

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• Individually, workers and unions may still gain from

increased bargaining power

• Collectively (nationally) higher wage pressure gives

only rise to higher unemployment, with no long run

impact on real wages

o negative external effects in wage setting

on consumer and input prices,

on unemployment

public budget, and

from envy/status

• Yields strong incentives to incomes policy and

coordinated wage restraint

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Wage setting at

• national or regional level conducive to wage

moderation,

• industry or occupation level lead to increased wage

pressure

• firm level – depends on product market competition

• wage dispersion reduced within wage setting area

A digression on efficiency:

When wages are set by bargaining or efficiency wage

considerations, one should not expect relative wages to

be socially efficient

Wages higher in firms/industries with high productivity

or large rents (weak competition or natural resources)

• leads to lower employment in these firms

• may exacerbate distortions due to weak competition

But local wage setting may improve work incentives

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• Late 1960s and 1970s: increased wage pressure leads

to higher equilibrium unemployment

• Wage setting gradually more moderate since early

1980s

• Why did high unemployment persist?

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Sources of persistence

• Equilibrium unemployment may increase when

unemployment is high

• Low output and lower profitability lead to lower

investment and lower capital stock

o Labour demand shifts

• Long term unemployment

o Loss of skills

o Loss of motivation

o Sorting

• Insider wage setting

o Wage setters neglect the unemployed

o More likely under decentralised wage setting

(national unions cannot neglect the

unemployed)

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European unemployment – the aggregate evidence

Large variation over time and across countries

Econometric evidence based on panel data

• Interaction of stable institutions and shocks/baseline

variables which shift over time

o Layard et al (1991) (increased wage pressure, the

replacement ratio, real import price, etc)

o Ball (NBER, 1996) (monetary policy, institutions

and hysteresis)

o Blanchard and Wolfers (EJ, 2000) (TFP growth,

the real interest rate, labour demand shifts, etc)

• Changing institutions

o Belot and van Ours (JJIE, 2001) (interaction

between institutions)

o Nickell, Nunziata and Ochel (EJ, 2005)

Studies agree that institutions are important, but vary on

additional variables and interactions

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Nickell, Nunziata and Ochel (EJ, 2005)

20 OECD countries, 1961 - 1995

• Higher unemployment in country-years with

o strict EPL (not significant)

o high benefit replacement ratio

o long benefit duration

o interaction of benefit duration with repl. ratio

o increased union density

o low coordination in wage setting

o low interaction of coordination and union density

o high total employment tax rate

o low interaction of coordination and empl. tax rate

o high owner occupied housing (not significant)

o labour demand shock

o TFP shock

o money supply shock (not significant)

o real interest rate (not significant)

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• Based on dynamic simulations, Nickell et al find that

changing institutions can explain 55% of the 6.8

percentage point increase in European unemployment

from 1960s to 1990-95.

o changing benefits can explain 39%,

o increased labour taxes 26%,

o shift in union variables 19%, and

o movements in EPL 16%

• Nickell et al argue that model with institutions and

shocks make no real contribution to understanding the

change in unemployment as compared to the model

with changing institutions.

• Bassinini and Duval (OECD, 2006): Find results

along lines of Nickell et al, data 1982-2003:

o changes in institutions explain almost two-thirds

of non-cyclical unemployment changes

o replacement rate, tax wedge, product market

regulation lead to higher eq. unemployment

o corporatism and ALMP lead to lower eq U.

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Critique of the institutional explanation

Baker, Glyn, Howell and Schmidt (2004),

Freeman (2007)

Evidence based on institutional variables fragile due to

• uncertain classification of institutional variables

• “economic Darwinism”, where measures are

constructed ex-post of researchers who were not

unaware of unemployment developments

• coefficient estimates unstable, often insignificant or

with “wrong” sign

• no apparent bilateral relationships (consistent with

evidence in OECD, 2004)

o bilateral relationships in one decade often

disappear or are reversed in the next

Sparrman (2009) – Nickell et al – explanation behaves

poorly post-sample

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Summing up – my reading of the evidence

Some institutions are undoubtly of importance

• High unemployment benefits reduce job finding

rate for unemployed

o may increase labour force participation,

o may lead to better jobs

o effective control of job search

• Strict EPL reduces job flows

o Unclear effect on aggregate U

o Effect on subgroups

o Bad combinations exist

Must be possible to lay off employees if

there is no profitable jobs

• Large tax wedge for low income workers a problem

• Some labour market measures work, others don’t

o suitable education, training & job-search good

• Wage moderation is important, but measures of

coordination/centralisation are difficult

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Equilibrium unemployment:

• depend on institutions and mismatch

• sets lower bound to actual unemployment rate

• but actual unemployment also affected by shocks,

and effects may persist

• monetary policy key equilibriating mechanism

o other equilibrating mechanisms are weak

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Recent macro-unemployment research

• Reduction in unemployment during the mid 2000s

led to less interest in OECD unemployment

• More reseach on calibrated search models

o Ljungqvist and Sargent, others

• Some research on endogenous institutions

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Algan and Cahuc AEJ-Macro, 1/2009

• Better to protect workers than jobs

o Inspired by Danish flexicurity idea: generous

unemployment benefits reduce “political

need” for strict EPL

• In countries with weak civic attitudes, workers will

cheat making it less costly to insure workers by

strict EPL, in spite of adverse efficiency effects

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Relationship seems robust

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Blanchard and Phillipon (2006):

• Institutions are endogenous, it is the quality of the

labor relations that is the true underlying force

o “labor/employer relations are generally

cooperative”

• Relationship holds when quality is instrumented by

o strike activity in the 1960s

o attitude towards early unions in 19th century

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hostile in France, Italy, Spain, Portugal

neutral in Denmark, Norway, Sweden,

Finland, the UK, Ireland

supportive in Germany, Switzerland, the

Netherlands, Austria