Labour Markets
Inside information?

The persistence of involuntary unemployment in market economies poses several important questions for economists. Why do involuntarily unemployed workers not offer to work at a lower wage than their employed counterparts? Why do firms not accept or propose such wage offers? In Discussion Paper No. 134, Assar Lindbeck and Research Fellow Dennis Snower compare two approaches which attempt to explain underbidding: the efficiency-wage and the insider-outsider theories. These alternative explanations have very different implications for the effectiveness of supply- side policies to reduce unemployment.

In the efficiency-wage theory, firms have imperfect information about the productivity of their employees. By offering a higher wage, they hope to attract more productive workers: even though a higher wage raises the firm's marginal labour cost (per unit of time), it also leads to a higher marginal revenue product of labour (net of training costs). When efficiency wages are set at their profit-maximizing levels, aggregate labour demand may fall short of supply, leading to involuntary unemployment. Firms have no incentive to accept underbidding by the unemployed: the productivity of the firm's labour force depends on the wage it pays, so lowering wages would also lower productivity.

Insider-outsider theories emphasize the ability of established employees ('insiders') to exercise influence over their wages without taking full account of the interests of the fledgling employees ('entrants') or the unemployed workers ('outsiders'). The insiders may have 'market power' as a result of the costs to firms of hiring, training and firing workers. Firms have no incentive to hire outsiders or to accept underbidding because they will incur extra costs by doing so: insiders can therefore bid up their wages above the level at which the unemployed would be prepared to work. In other versions of the theory it is assumed that insiders 'harass' outsiders, or cooperate with each other but not with outsiders; this creates a difference in productivity between the two groups. In both cases insiders are able to extract 'economic rent' from their employers, which robs both firms and entrants of any incentive to engage in underbidding. The market power of insiders may thus cause aggregate labour supply to exceed aggregate labour demand.

Lindbeck and Snower contrast the very different foundations of the efficiency-wage and insider-outsider theories of involuntary unemployment. The former explain unemployment through firms' imperfect information about the productivities of their employees; the latter do so through insiders' market power, based on labour turnover costs which can be exploited in negotitation. Efficiency-wage theories generally regard union activity as unimportant in determining the level of unemployment; in the insider-outsider theory, unions may augment unemployment by increasing labour turnover costs. In the efficiency wage theory, the 'involuntariness' of unemployment is traceable to a genuine information cost for firms. In the insider-outsider theory, this 'involuntariness' is mirrored in the more limited opportunities for employment of outsiders relative to insiders - a limitation that may be accentuated by social norms and legislation. In particular, the harassment version of the insider-outsider theory may help explain why outsiders may feel inhibited from underbidding. The versions which emphasize hiring and firing costs may support the notion that 'job security legislation' may at least contribute to unemployment, Lindbeck and Snower suggest. When comparing the realism of the two theories, the vital issue that remains is whether firms' imperfect information or workers' market power is more important in providing microeconomic explanations for the existence of involuntary unemployment in market economies.


Efficiency Wages Versus Insiders and Outsiders
Assar Lindbeck and Dennis Snower

Discussion Paper No. 133, October 1986 (IM/ATE)