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

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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

Monopoly Union

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



  • 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 plumbing:

Wage formation

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

Deriving the steady state wage schedule

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

Same plumbing as the insider model

Deterring shirking:


  • The model is equivalent to I-O model

  • Just replace rent by e/q

  • Rent now depends on effort levels and on the monitoring probability

  • Effects of s and r are the same

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