Labor Market Rigidities: At the Root of Unemployment in Europe

Horst Siebert
1997 Journal of Economic Perspectives  
This paper analyzes the political support by skilled and unskilled workers for employment protection in a quality-ladder growth model. Creative destruction by innovation of quality-follower firms results in "Schumpeterian" unemployment of unskilled workers. By voting on firing costs, unskilled workers consider a trade-off between the benefit of fewer unemployment spells due to lower labor turnover and the cost of lower quality growth of consumer goods. Skilled workers, although not threatened
more » ... gh not threatened by unemployment, vote for even larger firing costs. Furthermore, alleviating one labor market rigidity by raising the job-finding rate aggravates another rigidity by creating political support for additional firing costs. build a two-country Schumpeterian quality ladder growth model without scale effects that is used to analyze the effects of North-North trade liberalization on wage inequality. More precisely, we apply the PEG ("permanent effects on growth") version of that model, which results in a steady-state innovation and growth rate that can be influenced by public policies. The basic quality-ladder framework traces back to the model of Grossman and Helpman (1991) , where consumers only buy goods with the lowest quality-adjusted price. We restrict the analysis to a closed economy, but introduce labor market frictions. This is done by use of Şener's (2001) matching model of "Schumpeterian unemployment", where the inflow into the pool of unemployed is determined by the endogenous innovation rate that forces technologically-backward firms to shut down and lay off their (unskilled) production workers. In that setting, jobs are created by new innovating firms, where R&D is only performed by skilled workers who do not face the risk of becoming unemployed. However, a successful match between the technology of a new quality leader and an unemployed worker only takes place after a search period of exogenous length, which results in matching unemployment. Contrary to Şener, the exit of old quality leaders overtaken by new innovators is costly in our model, and all workers as well as the unemployed vote on the level of firing costs. Due to the assumption of perfect unemployment insurance, unskilled employed and unemployed workers have the same preferences. Contrary to Saint-Paul (2002) , we do not need anymore the assumption of a productivity differential between employed and unemployed workers that creates the rent for incumbent workers, which in turn provides incentives to vote for employment protection. Here, productivities of employed and unemployed workers are identical. However, the time spent for a successful match with an unemployed worker involves costs for an incumbent firm (forgone profit during search period), which results in an unskilled wage rate strictly above the level of unemployment benefits. The steady-state unemployment rate of unskilled workers is decreasing in the (exogenous) job-finding rate and increasing in the (endogenous) innovation rate. An increase of firing costs is shown to reduce the steadystate innovation rate and to increase the share of unskilled workers. The latter follows from the declining unemployment rate which raises expected wage earnings of unskilled workers, thereby reducing education incentives. This effect is not completely offset by the resulting rise of the skilled wage rate. An increase in firing costs raises the skilled wage rate for four reasons. First, instantaneous (monopoly) profits of quality leaders increase due to more unskilled workers being employed in goods production, which enlarges the market size for the leader's highest quality product. This drives up the reward for innovating that determines skilled labor demand in R&D. Second, the diminution of education incentives causes a shortage of skilled labor supply which, given increased demand for skilled labor, further drives up the skilled wage rate. Third, a declining innovation rate of quality followers reduces the instantaneous probability of firing of unskilled workers at each point in time, thereby somewhat offsetting the negative effect of rising firing costs. Fourth, a lower innovation rate means a longer incumbency period for the current quality leader, which again tends to increase the reward for innovating. When considering the vote for a specific level of firing costs, both worker groups take into account a tradeoff between the benefit of rising per capita consumption quantity (due to a higher expected wage income)
doi:10.1257/jep.11.3.37 fatcat:7dxntgha65b5foa6xftof6fyw4