Two important labour market developments of the last two decades have attracted much attention in recent literature: increasing and persistent unemployment in Europe, and widening wage differentials across US workers. In Discussion Paper No. 1186, Research Fellow Giuseppe Bertola and Andrea Ichino offer a comparative analysis of these phenomena and of different labour market institutions across the Atlantic. Their possible determinants are discussed in the light of a simple dynamic model of employment and wages.

In a `flexible' dynamic equilibrium, wage differentials across standardized units of labour are consistent with equilibrium at a point in time: if mobility is costly for workers, in fact, it occurs in equilibrium only when retraining and relocation costs are compensated by higher (expected) wages in the receiving sector, region, or firm. This dynamic insight may help interpret the portion of wage inequality which remains unexplained by static models of wage determination in the US, where workers do move across firms, occupations, and regions in response to productivity and demand shocks. In a `rigid' European environment, conversely, institutional rigidities reduce wage dispersion and employment fluctuations: hence, mobility offers limited gains to individual workers, and occurs at a much lower speed. Productivity and demand fluctuations have more important effects on firms' profits if they cannot induce employment and wage changes, and expectations of future downturns induce employers to exercise caution when hiring in upturns. Job security restrictions and wage compression reduce or eliminate frictional unemployment, but generate persistent or even permanent unemployment if wages are set above the full employment level, in the aggregate and in each different region or other labour market segments.

Wage Inequality and Unemployment: US vs Europe
Giuseppe Bertola and Andrea Ichino

Discussion Paper No. 1186, May 1995 (HR/IM)