1

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

2

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)

3

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

4

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

⎛ ⎞+= < >⎜ ⎟

⎝ ⎠

5

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.

6

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

7

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

8

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

9

• 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

10

• 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)

11

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

12

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

13

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)

14

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

15

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

16

• 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

17

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

18

• 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?

19

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)

20

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

21

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)

22

• 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.

23

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

24

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

25

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

26

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

27

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

28

Relationship seems robust

29

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

30

hostile in France, Italy, Spain, Portugal

neutral in Denmark, Norway, Sweden,

Finland, the UK, Ireland

supportive in Germany, Switzerland, the

Netherlands, Austria