Copyright SDA Bocconi MBA34 Managerial Excellence – 1° Term Labor market policies and the labor market Class 20 The firm and its environment - Francesco Giavazzi

Copyright SDA Bocconi The importance of the labor market Labor market functioning determines:  Level of employment and number of hours worked (thus per-capita GDP) And also:  Unemployment  Extent of labor market participation of different segments of working-age population  Wages of different types of workers In a nutshell, the importance of the labor market for welfare of people cannot be missed

Copyright SDA Bocconi In Oecd countries unemployment rates vary from 2 to 12% of labor force – Why? Need to understand effects of labor market institutions (unemployment subsidies, taxes on labor, employment protection legislation)

Copyright SDA Bocconi Two types of unemployment In actual labor markets, supply and demand fail to adjust and unemployment shows up. In two guises: Frictional (or search) unemployment is due to the time needed to match workers with jobs. Seen as largely voluntary Structural (or wait) unemployment arises because the number of jobs available in some labor markets is insufficient to provide a job for everyone who wants one. Typically involuntary and may have different causes

Copyright SDA Bocconi Job search unemployment Job search is process thru which workers find “appropriate” jobs (=commensurate to their tastes and skills) Job search unemployment originates for it takes time for individuals to find appropriate job This unemployment is not caused by a high wage rate inflexible downwards, but by the time spent searching for the “right” job Some search unemployment is inevitable, because the economy is always evolving (sector shifts). So do vacancies posted by firms and workers’ skills

Copyright SDA Bocconi Labor market flows Unemployment Pool (U) Some employed lose their job Some unemployed find jobs The Employed (L)

Copyright SDA Bocconi The “flows of workers” model Flows from employment to unemployment (layoffs) Happen when companies scale down, close down, or when a particular employee under-performs a fixed fraction “p” of the employed is laid off flow from employment L to unemployment U is (p ∙ L) Flows from unemployment to employment A fraction “s” of the unemployed receives a job offer every period. In turn, only a fraction “f” of these job offers are accepted – only those above the individual reservation wage (wage at which each unemployed is willing to work) The flow from U to L is (s ∙f∙U )

Copyright SDA Bocconi Equilibrium flows in and out Unemployment Pool (U) Total number = p ∙ L Total number = s ∙ U The Employed (L) The level in the tub is constant (i.e. U doesn’t change) if flows balance p ∙ (W-U) = s ∙ f ∙ U, W = L + U

Copyright SDA Bocconi The natural rate of U Natural Rate of Unemployment: The rate of unemployment at which flows in and out of employment balance out: U/W = NRU = p / (p + f ∙s) If p is high, turnover is high, and NRU is high as well If s is low (few jobs created), NRU is high If the unemployed are very choosy (i.e. their reservation wage is high), f is low and NRU is high Longer duration of U in countries where the process of matching unemployed workers to jobs is slow and unemployed are very choosy

Copyright SDA Bocconi What makes the unemployed choosier? Current job offer less appealing with labor market slack and high taxes on labor income Continuing searching for a better job more appealing with high and long-lasting unemployment benefits High labor taxes and generous unemployment benefits   f, i.e. make workers choosier, and raise NRU The combination of both high taxes and generous benefits makes unemployment a TRAP, particularly as the economy slows down after a period of boom (’80s-’90s vs. ’50s-’60s in OECD countries)

Copyright SDA Bocconi Another type of U: Wait unemployment Motivated by the presence of a wage floor Labor supply Labor demand Labor Wage Wage floor set above competitive wage U L A

Copyright SDA Bocconi Mechanics of wait unemployment Suppose (real) wages are not allowed to adjust downwards below the wage floor  “real” wages. This is what matters for workers & firms As a result: L + U willing to work at the wage floor, but only L are offered jobs by firms Job rationing arises, U is wait unemployment Remark: wait unemployment is ALWAYS BAD. But then: if wait unemployment bad, why is there the floor?

Copyright SDA Bocconi Why wage floors? Three reasons for wage floors (in the economists’ jargon: “downward rigidity of real wages”) 1. Minimum wage laws 2. Monopoly power of unions 3. Efficiency wages

Copyright SDA Bocconi Minimum wage laws In most industrial countries, Govts enacted laws setting lower bound for wages Pros  Raise some people out of poverty  Prevent early dismissal of unskilled adults (vis-à-vis skilled youngsters) Cons  If wage floor binding, unskilled and young workers stay unemployed. Also lower on-the-job learning  Other ways of fighting poverty without raising labor costs (e.g. Earned Income Tax Credit)

Copyright SDA Bocconi Monopoly power of unions In most industrial countries, wages of unionized workers set by sequential union-firm bargaining Bargaining often in two stages  First, union and firm negotiate over wages (and working time), at the state, industry or company level, depending on countries  Then, firm has right to manage on how many to hire at negotiated wage

Copyright SDA Bocconi Monopoly power of unions: implications  Negotiated wage typically higher than competitive wage (wage floor for unionized workers)  Employment set by firms at lower level than in competitive labor market, wait U arises  Even wage of non-unionized often higher if unions are powerful. Wage floor effectively for everybody  Two types of workers: Insiders (those who benefit from higher wages) and Outsiders (those left out of the labor market). Outsiders would like to work at current wage level but can’t

Copyright SDA Bocconi Efficiency wages Firms may freely choose to pay efficiency wages, i.e. wages higher than in competitive markets  To reduce labor turnover  To motivate workers to work harder  To make workers well fed and healthier (only relevant in poor countries) Same consequences as above  Wage floor, wait unemployment, two groups of workers  This comes from company decisions, not from govt regulation or bargaining

Copyright SDA Bocconi Summing up: How to lower the natural rate of U Active labor market policies –assist job search of the unemployed agencies for information dissemination. Public? Is the Internet enough? –retraining Do training programs really work? –more active measures: subsidies to job search or job creation Coordinated wage bargaining –Union coordination may moderate wage claims compared to alternative with many (industry-wide) unions independently setting wages

Copyright SDA Bocconi Summing up: How to lower the natural rate of U Employment Protection Legislation (EPL): another oft-discussed tool of labor market policy EPL includes all measures geared to protect jobs –Severance pay requirements –Notice requirements –Government approval for layoffs Higher EPL has ambiguous effect on U figfig –Reduces probability of being fired for those holding a job –Reduces probability of finding a job for those who haven’t one or for those who look for another one –Lengthens job tenure but also unemployment duration (fig) (fig)

Copyright SDA Bocconi Conclusions: Europe versus US % points 2007 (projection) Participation rate Unemployment rate Employment rate Euro area (“Lisbon goal”: 70, by 2010) USA But, in the US, also less job stability and more wage inequality. Which labor market is best? Answer from Class Discussion?

Copyright SDA Bocconi EPL and unemployment: no relation ##

Copyright SDA Bocconi EPL and duration of U: positive – but rather noisy - relation))