In Discussion Paper No. 1143, Martin Rama and Research Fellow Guido Tabellini use the common agency approach to study the interaction of product and labour market distortions. On the positive side, it is their intention to explain observed trade and labour market policies in developing countries. On the normative side, they want to study how best to structure conditionality clauses relating to these policies in the aid or loan programmes of multilateral organizations.

Between the two extreme views of labour market deregulation and encouraging guarantees of workers' rights is located the idea of a 'social pact' between capital and labour, cooperative behaviour to influence government's decisions. The authors extend the standard common agency model by simultaneously taking labour markets and trade unions explicitly into account. Positively, they establish that, in equilibrium, labour and product market distortions always move in the same direction in response to exogenous changes of relevant parameters. While cooperation between capital and labour does not modify the equilibrium levels of distortions, it may reduce the amount of resources wasted in lobbying. Normatively, with regard to conditionality clause policies, the authors recommend that labour market distortions ought not to be targeted because they are likely to move in the desired direction once trade distortions are removed or diminished. This result follows from the assumption that economic agents not organized in a political lobby are not harmed by labour market policy, but rather by trade policy. If this feature of the model is removed, the optimal conditionality clause should target both product and labour market distortions.

Endogenous Distortions in Product and Labour Markets
Martin Rama and Guido Tabellini

Discussion Paper No. 1143, February 1995 (HR/IM)