# Lecture II: Constructing a theory of equilibrium unemployment - PowerPoint PPT Presentation

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Lecture II: Constructing a theory of equilibrium unemployment. Microeconomic foundations of the wage curve. How are wages set?. Wages can be thought of as the sum of three terms: A compensation for the disutility of labor

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Lecture II: Constructing a theory of equilibrium unemployment

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## Lecture II: Constructing a theory of equilibrium unemployment

Microeconomic foundations of the wage curve

### How are wages set?

• Wages can be thought of as the sum of three terms:

• A compensation for the disutility of labor

• An outside option which determines what the worker would get outsidr the employment relationship (alternative wage = OC of labor)

• A rent which tells us how much he can grab beyond that

### When is unemployment involuntary?

• If the employed are better-off than the unemployed, the latter would prefer to be employed

• Therefore, involuntary unemployment  rent = 0

• Does that mean we are at the Walrasian equilibrium?

### What is a Walrasian equilibrium?

• WE holds if outside option = flow of utility corresponding to a zero wage

• But Unemployment Benefits and Welfare Minima can raise OO above that level

• Unemployment is then voluntary but above the walrasian level

### Do we need rents in the model?

• Assume no rent

• For h(u) to be downward sloping, unemployment must negatively affect the outside option

• This cannot be true if the employed are no better-off than the unemployed

• We thus have a flat h(u) curve and are back to the wage floor model

### Three classes of models:

• Collective bargaining models  rents come from the union’s monopoly on jobs

• Individual barganing models rents come from turnover costs

• Efficiency wage models  rents come from informational issues + incomplete contracting

### Collective bargaining models

• There are three of them:

• Monopoly Union

• Efficient Bargaining

• Right-to-Manage

### What is going on?

• The union maximizes the total expected income of members

• It takes the LD curve as given

• Wages = markup on OC of labor

• Markup inversely related to elasticity

• OC of labor reflects job finding prospects  goes down with u

• If UB indexed on wages, natural rate only depends on replacement ratio and elasticity

### Membership effects

• Note that union membership N has no impact on the outcome

• We can get membershif effects by introducing nonlinearities

• Example: unions maximize the median members’ expected income

• His employment probability is nonlinear in L/N

### Getting membership effects:

• If elasticity of φ falls, then lower membership => higher wages and more unemployment

• If membership depends on past employment => persistence mechanism

• Membership rules matter (encompassing unions vs. Guilds)

### Efficient Bargaining

• Employment is determined at the privately efficient level from the match’s point of view

• Absent institutional rigidities, employment would be at its walrasian level

• Wage bargaining only affects the way the surplus is split  wages are a pure transfer, the true allocative price is the OCL

### Right-to-manage:

• Generalization of monopoly union model

• Generates suboptimal employment

• The rent now depends on the workers’ bargaining power in addition to the elasticity of labor demand

### Individual bargaining

• In collective models, the firms cannot hire workers competitively at the margin

• Nor can other firms in the same sector do so

• Under individual bargaining, the firm could drive the surplus of the match to zero by simply hiring more people

• Turnover costs are needed to create a positive surplus

### The dynamic insider/outsider model

• A representative firm can hire as much as it wants from the pool of unemployed

• Once hired, people negotiate their wage

• The firms incurs a cost F upon separation due to disagreement

### The hold-up problem:

• The intertemporal rent is fixed

• It goes up with the turnover cost

• It goes up with the worker’s bargaining power

• The turnover cost is a specific investment which can be appropriated by the incumbent worker

• F could equivalently be a hiring cost

### Wage pressure goes up with

• Turnover costs

• Insider bargaining power

• Unemployment benefits

• Turnover

• Real interest rates

### The shirking model

• Employee effort e imperfectly observable (flow probability q)

• Penalty upon shirking limited to dismissal

• In equilibrium, employees must be paid rents

• Otherwise, no penalty from dismissal: a job is found instantaneously

• Thus, unemployment duration acts as a discipline device