OverviewOverview

OutlineOutline• 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.

Key definitionsKey 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 (fl) and the wage (w)

Source: Tito Boeri and Jan van Ours (2008), The Economics of Imperfect Labor Markets, Princeton University Press.

Labour Market StatesLabour 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.

Labor Market States (cont.)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.

Normalization rulesNormalization 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.

Problems with OECD-ILO Problems with OECD-ILO definitionsdefinitions

• 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.

Source: Tito Boeri and Jan van Ours (2008), The Economics of Imperfect Labor Markets, Princeton University Press.

A framework (generalities)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.

Labor/Leisure choice 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 (l0) 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.

Slope of individual labor Slope of individual labor supplysupply

• 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.

Total effect of a wage riseTotal effect of a wage riseMoney Income

Hours of Leisure

Hours of Work

16

0

0

16

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

The Income EffectThe Income EffectMoney Income

Hours of Leisure

Hours of Work

16

0

0

16

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.

The Substitution EffectThe Substitution EffectMoney Income

Hours of Leisure

Hours of Work

16

0

0

16

5 8

811

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.

The (static) reservation wage The (static) reservation wage • It is the lowest wage at which a jobseeker is

willing to work (slope of IC at l0 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.

Source: Tito Boeri and Jan van Ours (2008), The Economics of Imperfect Labor Markets, Princeton University Press.

From individual to aggregate From individual to aggregate labor supplylabor supply

• Adding up hours worked by each individual• Heterogeneity in non-wage income (or

preferences), hence in reservation wages, wr

• If individuals can only offer fixed number of hours of work, then aggregate labour supply follows distribution of wr (N F(wr) 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.

Participation rateParticipation rateAggregate labour supplyAggregate labour supply

Source: Tito Boeri and Jan van Ours (2008), The Economics of Imperfect Labor Markets, Princeton University Press.

0.2

.4.6

.81

-5 0 5error

cum_ger cum_dnk

cum_bel cum_lux

cum_fra

(Derived) labor demand (Derived) labor demand and equilibriumand equilibrium

• From profit maximisation of individual firms• The optimal employment level equals the

value of the marginal product of labour (fl) to the wage (w): f (l) = w

• As fl 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.

Why Institutions?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.

Institutions and wedgesInstitutions and wedges

Price-Based Institutions and the Wedge Quantity-Based Institutions and the Wedge

L L

U

Wedge

w w

Ld (w)

LS (w)

L

Wedge

L0S (w)

L1S (w)

L

Ld (w)

Source: Tito Boeri and Jan van Ours (2008), The Economics of Imperfect Labor Markets, Princeton University Press.

Institutions and adjustment to shocks

Increasing employment bias Increasing employment bias of LM institutions?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.

Source: Tito Boeri and Jan van Ours (2008), The Economics of Imperfect Labor Markets, Princeton University Press.

More competition in product markets (globalisation) increases the employment

costs of institutions

∆ E

∆ E

w

D0

D1

S

Stronger pressures for Stronger pressures for institutional reformsinstitutional 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.

Source: Tito Boeri and Jan van Ours (2008), The Economics of Imperfect Labor Markets, Princeton University Press.

Acceleration of reformsAcceleration of reforms

1986-1990

1986-1990

1991-1995

1991-1995

1996-2000

1996-2000

2001-2005

2001-2005

0

10

20

30

40

50

60

70

80

90

100EPL NEB

N°

of

Ref

orm

s

Source: Tito Boeri and Jan van Ours (2008), The Economics of Imperfect Labor Markets, Princeton University Press.

Remainder of the courseRemainder 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.