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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

Lecture II: Constructing a theory of equilibrium unemployment

Microeconomic foundations of the wage curve

how are wages set
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
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
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
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
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
Collective bargaining models
  • There are three of them:
    • Monopoly Union
    • Efficient Bargaining
    • Right-to-Manage
what is going on
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
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
  • 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)
  • 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
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
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 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
Wage pressure goes up with
  • Turnover costs
  • Insider bargaining power
  • Unemployment benefits
  • Turnover
  • Real interest rates
the shirking model
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
  • 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