1. Overview

2. Outline Some key definitions – institutions, markets and wedges – labor market states A simple static framework and the wedge Why institutions? Learning from reforms: difference-in- differences. Pressures coming from globalisation. Source: Tito Boeri and Jan van Ours (2008), The Economics of Imperfect Labor Markets, Princeton University Press.

3. Key definitions An institution is a system of laws, norms or conventions resulting from a collective choice, and providing constraints or incentives which alter individual choices over labor and pay. A labor market is a market where labor services (specified in a vacant job) are sold for a remuneration called wage Institutions create a wedge between the value of the marginal job for the firm (f l ) and the wage (w) Source: Tito Boeri and Jan van Ours (2008), The Economics of Imperfect Labor Markets, Princeton University Press.

4. Labour Market States Employed, L (OECD-ILO convention) People in working age who, during the reference week (or day), have made for at least one hour: –paid work (also paid in nature) or –self-employed work Paid work includes : –People who are not temporarily working but who have formally a paid work (e.g. they have a salary, maternity leave, etc.) Source: Tito Boeri and Jan van Ours (2008), The Economics of Imperfect Labor Markets, Princeton University Press.

5. Labor Market States (cont.) Unemployed, U People in working age who, during the reference week (or day), were : –without either paid or self-employed work, –willing to work and –looking for a job. Inactive O People in working age neither employed nor unemployed Source: Tito Boeri and Jan van Ours (2008), The Economics of Imperfect Labor Markets, Princeton University Press.

6. Normalization rules –Labour Force (LF): L+ U –Working Age Population (N): L+U+O Unemployment rate: (U/LF) Employment rate: (L/N) Activity rate (or labor force participation rate) (LF/N) Source: Tito Boeri and Jan van Ours (2008), The Economics of Imperfect Labor Markets, Princeton University Press.

7. Problems with OECD-ILO definitions Porous participation borders: potential labor force excluded Relaxing job search requirement, less inactive (about 15% less inactive in the EU countries) Some discouraged workers (without work and willing, but not searching) are undistinguishable from the unemployed in terms of labor market transitions (Box 1.3) Source: Tito Boeri and Jan van Ours (2008), The Economics of Imperfect Labor Markets, Princeton University Press.

9. A framework (generalities) Labor supply derived from labor-leisure (plus home production) choice Aggregation assuming that workers do not choose hours, just participation Heterogeneity in reservation wages (Derived) labor demand with markups Institutions implement a wedge between labor supply and demand Source: Tito Boeri and Jan van Ours (2008), The Economics of Imperfect Labor Markets, Princeton University Press.

10. Labor/Leisure choice Preferences: indifference curves are negatively sloped in c and l (negative MRS), do not interesect (no incoherence) and convex (MRS declining with l) Constraints (assuming away non-labor income) –Hourly wage (w) as slope of the budget constraint –Maximum amount of hours (l 0 ) to be allocated to labor (h)/leisure (l) Source: Tito Boeri and Jan van Ours (2008), The Economics of Imperfect Labor Markets, Princeton University Press.

11. Slope of individual labor supply Depends on relative magnitude of income/substitution effects. With leisure as normal good, income effect negatively affects labor supply Substitution effects always positive on hours worked Generally substitution effects dominates for low- wage earners while income effect for high wage earners Income effect irrelevant at participation margins Source: Tito Boeri and Jan van Ours (2008), The Economics of Imperfect Labor Markets, Princeton University Press.

12. Total effect of a wage rise Money Income Hours of Leisure Hours of Work 16 0 0 5 8 811 B C A 64 128 192 Observed Change U2 U1 N2 N1 Source: Tito Boeri and Jan van Ours (2008), The Economics of Imperfect Labor Markets, Princeton University Press. N3

13. The Income Effect Money Income Hours of Leisure Hours of Work 16 0 0 8 9 78 B A 64 128 192 Income effect U2 U1 N3 N1 Source: Tito Boeri and Jan van Ours (2008), The Economics of Imperfect Labor Markets, Princeton University Press.

14. The Substitution Effect Money Income Hours of Leisure Hours of Work 16 0 0 58 8 11 C A 64 128 192 Substitution efffect U2 N2 N1 Source: Tito Boeri and Jan van Ours (2008), The Economics of Imperfect Labor Markets, Princeton University Press.

15. The (static) reservation wage It is the lowest wage at which a jobseeker is willing to work (slope of IC at l 0 and non- labor income level) At that level elasticity of individual labor supply is always positive (substitution effect dominates) Reservation wage is increasing in non-wage income and separates employment from non-employment Source: Tito Boeri and Jan van Ours (2008), The Economics of Imperfect Labor Markets, Princeton University Press.

18. From individual to aggregate labor supply Adding up hours worked by each individual Heterogeneity in non-wage income (or preferences), hence in reservation wages, w r If individuals can only offer fixed number of hours of work, then aggregate labour supply follows distribution of w r (N F(w r ) where N is working age population) and is always increasing in wages Source: Tito Boeri and Jan van Ours (2008), The Economics of Imperfect Labor Markets, Princeton University Press.

19. Participation rate Aggregate labour supply Source: Tito Boeri and Jan van Ours (2008), The Economics of Imperfect Labor Markets, Princeton University Press. 0.2.4.6.8 1 -505 error cum_gercum_dnk cum_belcum_lux cum_fra

20. (Derived) labor demand and equilibrium From profit maximisation of individual firms The optimal employment level equals the value of the marginal product of labour (f l ) to the wage (w): f (l) = w As f l l < 0, labour demand is decreasing in wages Role of competition in product markets Source: Tito Boeri and Jan van Ours (2008), The Economics of Imperfect Labor Markets, Princeton University Press.

21. Why Institutions? Three arguments for their existence: 1.Efficiency: a competitive LM does not exist 2.Equity: as no lump-sum transfer is available, redistribution is distortionary 3.Policy failure: heterogeneity and powerful minority interest groups; inertia of institutions Source: Tito Boeri and Jan van Ours (2008), The Economics of Imperfect Labor Markets, Princeton University Press.

22. Institutions and wedges Price-Based Institutions and the WedgeQuantity-Based Institutions and the Wedge LL U Wedge w w L d (w) L S (w) L Wedge L 0 S (w) L 1 S (w) L L d (w) Source: Tito Boeri and Jan van Ours (2008), The Economics of Imperfect Labor Markets, Princeton University Press.

23. Institutions and adjustment to shocks

25. Increasing employment bias of LM institutions? In the 1950s and 1960s US enviously looking at European institutions. In the 1980s and 1990s the other way round. Interactions between shocks and institutions (e.g., shocks create U, EPL or UBs make it longlasting) Under stronger competitive pressures, LM institutions may have higher costs in terms of foregone employment Source: Tito Boeri and Jan van Ours (2008), The Economics of Imperfect Labor Markets, Princeton University Press.

27. More competition in product markets (globalisation) increases the employment costs of institutions ∆ E w D0D0 D1D1 S

28. Stronger pressures for institutional reforms fRDB inventory of labor market and social policy reforms Classified by area (e.g. EPL, UBs, RET, MIG, WT), direction (increasing / reducing the wedge) and scope (structural / marginal) Source: Tito Boeri and Jan van Ours (2008), The Economics of Imperfect Labor Markets, Princeton University Press.

30. Acceleration of reforms 1986-1990 1991-1995 1996-2000 2001-2005 0 10 20 30 40 50 60 70 80 90 100 EPL NEB N° of Reforms Source: Tito Boeri and Jan van Ours (2008), The Economics of Imperfect Labor Markets, Princeton University Press.

31. Remainder of the course Institutions by institution Outline of each lecture – description of the institution (measurement) – theory (does it implement the wedge? how? effects on employment and wages) – evidence (possibly difference-in-differences) – policy issues Source: Tito Boeri and Jan van Ours (2008), The Economics of Imperfect Labor Markets, Princeton University Press.