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# Lecture 5: Labour Economics and Wage-Setting Theory

Spring 2016

Lars Calmfors

## Literature: Chapter 7 Cahuc-Carcillo-Zylberberg: 435-445

Topics
Weakly efficient bargaining
Strongly efficient bargaining
Wage dispersion
Co-ordination of wage bargaining
,QVLGHUVDQGRXWVLGHUV

Efficient contracts
Bargaining over the wage only and letting employers determine
employment (right to manage) is not efficient.
An efficient solution can be found by bargaining over both the
wage and employment.

Max [ R ( L ) wL ] [ ( w) ( w ) ] L
1

w, L

0 L N and w w

s.t.

Interior solution

(1 )

R '( L ) w

R ( L ) wL

(1 )

= 0

(I)

L
R ( L ) wL

'( w)
( w) ( w )

= 0

(II)

w R '( L ) =

( w) ( w )
'( w)

(III)

## This is the equation of a contract curve (Pareto-efficient combinations

of w, L) connecting tangency points of indifference and isoprofit
curves.
The same equation would be obtained by maximising

L [ ( w) ( w ) ]

s.t.

## Differentiation of the contract curve equation gives:

dw
dL

R "( L )
"( w) [ w R '( L ) ]

## = 0 R '( L ) = w according to (I)

R '( L ) = w ( w) = ( w ) and w = w according to (III)
Hence the contract curve starts on the labour demand schedule at w = w
If w > R '( L ) and workers are risk averse, i.e.

## = 0 gives the competitive level of employment L = L ( w )

With > 0 , the union uses its bargaining power to raise both the wage and
employment over the competitive levels.
If workers are risk-neutral, then " = 0 and

dw
dL

## Strongly efficient contracts

Efficiency gain for union if utility of employed and unemployed are
equated
Incentive to bargain with firm over unemployment benefit paid by the firm
Union objective

L ( w) + ( N L ) (b + w )
Firm profit

= R ( L ) wL ( N L )b

Max L ( w) + ( N L ) (b + w )
w, b

s.t. = 0
Max L ( w) + ( N L ) (b + w ) + [ R ( L ) wL ( N L )b 0 ]
w, b

FOC

L '( w) L = 0
( N L ) '(b + w ) ( N L ) = 0

'( w) =
'(b + w ) =

Hence:
'( w) = '(b + w )
w =b + w
Pareto efficiency requires a wage for the employed that is equal to
the income as unemployed.
The firm pays a benefit b to all unemployed.
It pays a wage

w + b to the employed.

Employment does not matter to the union, since members are insured
against unemployment.
The bargaining problem

Max

[ R ( L*) wL * bN ] [ ( w + b ) ( w ) ]
1

FOC:
( w + b) ( w )
'( w + b )
with

[ R ( L*) wL * bN ]

w = w +b
R '( L*) = w

## Employment equals the competitive level

Union members appropriate a share of the firms profit without
this having negative effects on employment

Diagrammatical illustration
Indifference curves:

= ( w)

1 dw = 0
1 dw

= 0

dL
dw

= 0

dL
The indifference curves are horizontal lines.
Isoprofit curve

= R ( L ) wL bN = R ( L ) wL N ( w w )
d = 0 = R '( L ) dL wdL Ndw
dw
dL

R '( L ) w
N

## Tangency points between isoprofit curves and indifference curves

give a vertical contract curve (at the competitive level of employment)
Bargaining over wages, employment and unemployment benefits
from firms is strongly efficient.

## Collective bargaining and wage dispersion

Heterogeneous workers
Collective bargaining reduces wage dispersion

## Two types of workers, indexed by i = 1, 2

Revenue of the firm = R(L1, L2)
Type -1 workers are more productive with a higher reservation
wage w1 > w2
Ni workers of type i in the firms labour pool
The union utility function

= Li ( wi ) + ( N i Li ) ( wi + bi )

Li N i

i=1

## Strongly efficient bargaining over employment, wages and

unemployment benefits
Optimal contract implies wi = wi + bi

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Bargaining problem

Max R ( L , L ) ( w L
b ,b , L , L

i =1

0 Li N i

s.t.

b N ) N { ( w

1

i =1

b ) ( w )}

i = 1, 2

FOCs

(11)

R (L1 , L2 )
L1

= wi

N [ ( w ) + b ) ( w ) ]

R ( L , L ) ( w L + b N )

(12) '(w i + bi ) =

i=1

i =1

## Equation (11): Productive efficiency, i.e. the marginal productivity

of each type of worker equals the reservation wage. This implies the
competitive level of employment.

Equation (12): RHS is independent of i. Hence the same wage for the
two types of labour.

## Wage equality follows from the assumption of a utilitarian union and

identical preferences.

11

N1
N1 + N 2

( w1 ) +

N2
N1 + N 2

( w2 )

N1
+ N2
1

w1 +

N2
N1 + N 2

N1
N1 + N 2

w1 +

N2
N1 + N 2

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## Two-stage bargaining over employment (Manning 1987)

Stage 1: Bargaining over the wage
Stage 2: Bargaining over employment
Different bargaining strengths in the two negotiations
Bargaining over employment (given the wage)

Max [ R ( L ) wL ]

1 L

[ ( w) ( w ) ] L L L

s.t. 0 L N

## The solution gives L = L ( L , w , w)

Bargaining over the wage (takes the outcome of second-stage
bargaining over employment into account)

Max

[ R ( L ) wL ] [ ( w) ( w ) ] L
1

L ( L , w , w) and w w
s.t. L = 
Different cases
L = 0 and > 0 gives the right-to-manage model
L = gives (weakly) efficient bargain model
Otherwise solution on neither labour-demand schedule nor
contract curve

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Motivations
Efficient bargaining is complex
Wage bargaining precedes employment bargaining
Wage bargaining is often at more centralised level
Strongly efficient bargaining is improbable because of
moral hazard problems: unemployed being fully insured
will not search effectively for jobs
- argument for partial insurance
- individual firm (sector) offering full insurance would be
swamped by labour inflow
One does not find many examples of contracts with
unemployment benefits paid by firms
Unclear empirical results on right-to-manage model and
(weakly efficient) bargaining

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## Employment is determined by the product real wage wp

wp =
W = Nominal wage
P = Output price
L = L (wp),
where L = Employment
The union maximises expected utility for a representitive
member:
U=

wc + (1 ) b,

wc =

## = Consumption real wage

Pc = CPI
b = Real unemployment benefit

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## Conclusions on co-ordination and real wages

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The degree of co-ordination and the real wage in a closed economy (the
Calmfors-Driffill curve)

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## The degree of co-ordination and the real wage in an open economy

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An extended model

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## Insiders and outsiders

Unions negotiate on behalf of insiders (the already employed
those with a strong affiliation to the labour market)
Unions do not negotiate on behalf of outsiders (the unemployed
in general or the long-term unemployed)
An insider-outsider model
LO insiders
The firm decides on how many insiders LI LO it wants to
retain.
It also decides on how many outsiders LE it wants to hire.
Revenue function R(LI + LE)
The firms profit: = R(LI + LE) - w(LI + LE)
Employment of insiders, LI, and of outsiders, LE, is found by
maximising profits s. t. LI LO and LE > 0.
Define wO by R(LO) = wO.

##  as the employment level such that R( L ) = w, where

Define L
w is the current wage.

Labour demand

LI = L and LE = 0 if w wO
LI = LO and LE = L LO if w wO
If w wO we have LI = L < LO , so some insiders are fired.

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Wage bargaining

## VI = expected utility of an insider

VI = A ( w) + (1 A ) ( w )

A = Min (1, L / LO )

## w = the reservation wage

Max

[ ( w) ] {A [ ( w) ( w ) ]}
1

## with ( w) = R ( L) wL

 / L (interior solution
Let w1 be the solution when A = L
O
with some unemployed insiders).
The solution is the same as in the standard right-to-manage
model but with LO = N.

( w1 ) ( w )
w '(w1 )

w + (1 ) w
L

(10)

Solution with A = 1
Set w = 0 in (10); employment of insiders cannot increase
L

( w2 ) ( w )

w2 '(w2 )

(1 ) w

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Different solutions

## B1 = Nash bargaining product when L > L0,

i.e. some employed outsiders
B2 = Nash bargaining product when L < L0,
i.e. some unemployed insiders
We have:

B1
B2
>
w
w

Larger gain from wage increase if only outsiders lose their jobs
than if also insiders do.
Second-order conditions for a maximum

2 B1
(B1 / w)
=
< 0
w
w2
2 B2
(B2 / w)
=
< 0
2

w
w

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(1)

B1
>0
w
(2)

(3)

B2
>0
w

## Corner solution with

B1
>0
w

w > w0 and L L0

w = w0 and L = L0

B2
<0
w

## Interior solution with

B1
>0
w

w < w0

B2
<0
w

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Conclusion
A fall in the number of insiders results in an unchanged wage
or in an increase in the wage
Explanation of the persistence of unemployment
No incentive to reduce the wage as the union does not care