Lecture II: Constructing a theory of equilibrium unemployment

1. Lecture II: Constructing a theory of equilibrium unemployment Microeconomic foundations of the wage curve

2. 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

3. 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?

4. 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

5. 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

6. 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

7. Collective bargaining models • There are three of them: • Monopoly Union • Efficient Bargaining • Right-to-Manage

8. Monopoly Union

9. 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

10. 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

11. Getting membership effects:

12. Comments: • 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)

13. Efficient Bargaining

14. Comments: • 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

15. Right-to-manage:

16. Comments • 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

17. 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

18. 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

19. The plumbing:

20. Wage formation

21. 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

22. Deriving the steady state wage schedule

23. Wage pressure goes up with • Turnover costs • Insider bargaining power • Unemployment benefits • Turnover • Real interest rates

24. 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

25. Same plumbing as the insider model

26. Deterring shirking:

27. Comments: • 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