High and persistent unemployment in Europe has often been attributed to high real wages that do not respond to employment conditions, on account of excessive power of workers in wage bargaining and institutional arrangements in wage-setting. Real wage moderation since the early 1980s has not led to any significant rise in employment, however, which suggests the presence of another form of labour market rigidity. Many maintain that the greater costs of hiring and firing (relative to the US) may account for employment's slower and weaker response to wage changes. In Discussion Paper No. 893, Research Associate Leonor Modesto notes that the vast empirical literature on wage-setting and the effects of union power on employment has largely neglected the effects of employment protection legislation on unemployment persistence. Burda's assessment of these costs for eight European countries and the US uses a dynamic model of a representative firm facing adjustment costs, but he takes the wage as exogenous. Modesto maintains that his assumption of a competitive labour market is empirically unrealistic, at least for some European economies, since it rules out explanations of persistence based on workers' excessive power in wage-setting ex ante .

Modesto develops a dynamic model of union-firm bargaining that explicitly considers the labour adjustment costs arising from institutional rigidities. He estimates several variants on a set of OECD countries to find that the data validate all versions of the model, but a version with serially uncorrelated shocks performs best for most countries in the sample; precise and robust estimates of the parameters have values consistent with the theoretical model. These results indicate that the costs of legal restrictions on hiring and firing and other unobservable labour costs arising from institutional rigidities vary significantly across the sample, but they are broadly consistent with common priors and available survey evidence. This may improve our understanding of the functioning of different labour markets and therefore guide policy-makers on appropriate legislation for the labour market.

Dynamic Behaviour of Wages and Employment: A Bargaining Model Introducing Adjustment Costs
Leonor Modesto

Discussion Paper No. 893, April 1994 (HR)