Summary with the 2nd edition of The Economics of Imperfect Labor Markets by Boeri and Van Ours

What are some key definitions related to the labor market? - Chapter 1

The macro-labor literature has developed in between the mid-1990s and the Great Recession. Differences in labor market institutions were seen as the main reason for cross-country differences of unemployment changes resulting from changes in output. The literature focused on transatlantic comparisons of employment and unemployment.

The Organisation for Economic Co-operation and Development (OECD) report attempts to explain employment and unemployment performance of Europe versus the U.S. The main result of this report was that there are institutional rigidities in Europe, which are not in the U.S. Because of these rigidities the labor market does not create as many jobs in the private sector as it does in the U.S.

Especially strict employment protection is responsible for the different shocks in Europe and de U.S. To fully understand these differences one should look further than the cross-country analysis. One should get to know more about the national labor market institutions. Another thing to look at is the nature of the shocks that led to a fall in output in the Great Recession.

From the Great Recession we have learned that labor market institutions are very important. To understand their impact on the labor market one should understand how these institutions work.

Some key definitions

A labor market: a market where a quantity of labor services, L, is offered in exchange for a price or remuneration, called wage w.

According to the OECD-International Labour Organization (ILO) definitions, the entire working population can be divided into three labor market states:

1. An employed individual: someone in the armed forces or who has worked for pay for at least 1 hour during the reference period or has a formal attachment to a job but is currently not at work (because of for instance a holiday).

2. An unemployed individual: someone who satisfies the following criteria:

• Currently not working

• Looked for work in 4 weeks before survey

• Actively looking for a job

• Willing to work

• Immediately available for work

3. An inactive individual: someone who is neither employed nor unemployed. This residual group consists of people who are voluntarily inactive and people who are disabled.

In the field of labour economics we use U for the number of unemployed workers, L for the number of employed workers and O for inactivity. With these variables we can measure several things:

• Labor force (LF) = L + U

• Working-age populations (N) = LF + O

• Unemployment rate (u) = U/LF

• Employment rate (e) = L/N

• Participation rate (p) = LF/N

• Together this leads to the following: e = p(1-u)

The steady state equilibrium is reached when inflows into and outflows from unemployment are equal; the labor force is fixed. This equilibrium can be defined as:

δL = μU

In this formula δ measures the rate at which workers lose their jobs and μ is the rate at which unemployed workers find jobs. From this we can derive that:

u = δ / (μ + δ)

The value of a job, y, is the value of the labor product obtained when a firm and a worker engage in production. It can be seen as the revenue from a job; the quantity and price of the output produced by the job. We often use the marginal product of labor. This is the price of the good multiplied by the increase in output made possible by hiring an additional worker.

The worker’s reservation wage, w^r, is the lowest wage at which the worker is willing to accept a job offer. The worker’s surplus is the difference between the actual wage and the reservation wage. It is given by w – w^r.

The firm’s surplus is the difference between the value of a job and it costs (the wages paid). It is given by y – w.

The total surplus from a job is the sum of the firm’s and worker’s surplus. It is given by:

(y – w) + (w – w^r) = y - w^r

We can distinct between a perfectly competitive market and an imperfect market:

• A perfect labor market is a market where there is no total surplus associated with the marginal job. In other words, in this market y = w and w = w^r. This leads to the fact that y = w^r. Employers and workers are indifferent between continuing or terminating a job relation. This market is a transparent market, both parties are perfectly informed. There are also no frictions or costs involved in matching labor supply and demand.

• An imperfect labor market is a market where there are rents associated with every job. This means that the surplus is positive. These imperfect markets are characterized by labor market institutions. In such a market wage setting is very important. Job destruction is a big deal for at least for one of the parties involved. In this market there are frictions, informational asymmetries and market power.

A labor market institution is a system of laws, norms or conventions resulting from a collective choice and providing constraints or incentives that alter individual choices over labor and pay. These institutions create a wedge between the value of the job for the firm and the worker’s reservation wage. In other words; they can create rents. If y < w^r for all jobs in a market, then the labor market cannot operate.

The reservation wage

For individuals to participate in the labor market their reservation wage must be lower than the wage offered in the market. An individual’s utility function is defined by:

U (c,l) where c stands for consumption and l stands for leisure.

The budget constraint is given by:

c < m + wh

Where m stands for nonlabor income, w stands for the wage and h stands for working hours.

When m=0, the budget constraint is a straight line crossing the horizontal axis.

The utility function can graphically be seen as a set of indifference curves. Each curve represents a combination of leisure and consumption that yield the same utility level. The slope of the indifference curve is given by w^r.

A wage lower than the reservation wage will not be accepted by the worker. When w > w^r the worker is willing to work some hours and devotes the rest of its time to leisure.

When there are no constraints on the choice of hours then the reservation wage is given by:

w^r = (U_l / U_c)

Where U_l and U_c stand for the marginal utility of leisure and consumption respectively. When an individual is free to choose how many hours to work then the following holds:

U (m + w^r_ft h_ft, I₀ – h_ft) = U (m, l₀)

The worker has no choice how many hours to work and can only choose to work h_ft corresponding to the hours of a full-time job. The individual is indifferent between working exactly h_ft hours and not working at all. The reservation wage of an individual with a constraint is higher than for an individual with no constraint. In other words w^r_ft > w_r.

When the wage increases more people will enter the labor market and thus labor supply will increase. The effect of an increase in the wage is ambiguous, it has two opposite effects:

1. The income effect: if the wage goes up then income goes up. With leisure as a normal good, individuals will buy more leisure and thus the amount of working hours will be reduced.

2. The Substitution effect: if the wage goes up, the price of leisure increases. Consumption of leisure will decrease and the amount of working hours will increase.

The substitution effect dominates for people with a low wage and the income effect dominates for people with a high wage. If leisure is an inferior good then the two effects will reinforce each other.

The reservation wage differs across individual workers. Some may need a higher reservation wage because of their private situation. We use G (w) to denote the fraction of individuals or working age with a reservation wage equal to or lower than w. If we multiply G by the number of persons of working age we obtain the aggregate labor supply schedule. G will increase when the wage w increases.

Suppose that capital is fixed in the short run so there is no possibility to substitute labor with capital. From the point of the firm there is only one type of worker. This means that labor is homogeneous. The firm will hire people up to the point where the value of the marginal job is equal to the marginal cost; y = w.

At the equilibrium, all firms will have the same y. The aggregate demand denotes the sum of all jobs at the equilibrium y. We can say that y shows the marginal willingness to pay or the inverse labor demand schedule y (L). We set y (L) = w and then solve for L. This will give us L^d (w). The labor demand declines when the wage increases.

In a perfect labor market the equilibrium is found where demand equals supply. This leads to the wage level w* and to the labor level L*. Workers with a reservation wage below w* will enjoy a positive surplus from participating in the labor market. The sum of all these individual surpluses is the area W_s.

Firms will also benefit. Their profits are reflected in the surplus equal to the area F_s. Workers with a reservation wage above w* will decide not to work. We can say that L* = G (w*) will be the employment rate. The equilibrium nonemployment rate will be equal to 1 – G (w*).

There can also be a labor market with a flat segment. This means that there are workers with w^r = w* that are not willing to work. These workers are unemployed and are shown by the segment U. One can see this in the graph below. All other nonemployed individuals are inactive.

Labor market institutions

Labor market institutions create a wedge between labor supply and labor demand. An example of such an institution is a minimum wage. A minimum wage changes the slope of the labor supply curve. This prevents the firm from hiring workers at a wage below the minimum wage. The labor supply curve will make an upward shift.

The difference between the labor supply and the labor demand reflects unemployed individuals. Thus the minimum wage creates a wedge between supply and demand.

Another institution is a tax on labor. A tax on labor reduces both supply and demand of labor. This means that there is less employment and participation. The revenues of labor taxes are often used to finance retirement plans, family allowances and UBs. All the nonemployment benefits shift the supply curve up resulting in a reduction of the size of the labor market.

Most institutions like minimum wages, taxes and trade unions operate especially on the price of labor. Others operate on the quantity of labor. Such institutions create wedge indirectly because the effective labor supply faced by employers differs from the cumulative distribution of individuals’ reservation wages.

Examples of institutions operating on quantity are working hour regulations and immigration restrictions. They cut away a segment of labor supply to the left of w*. Such restrictions shift the supply curve up. This leads to a new equilibrium with higher wages and with lower employment. This is the same effect as we saw with institutions that act on prices.

Another quantity restriction is employment protection legislation (EPL). This legalization makes it costly for a firm to adjust its number of workers to shocks. It involves taxes and transfers to workers that are only paid in case of dismissal. An EPL reduces firms’ incentives to shed labor. It indirectly affects employment by giving more power to trade unions in wage bargaining. This leads to higher wage and lower aggregate employment. Thus EPL negatively affects employment.

In all OECD countries there are clusters of institutions. Each different cluster involves different labor market outcomes.

Three arguments for the existence of labor market institutions:

1. Efficiency

There are market imperfections that prevent the market from reaching the competitive equilibrium outcome. Labor market institutions may remedy these failures of the market.

2. Equity

In the absence of nondistortionary taxes and transfers, these institutions are best suited to achieve some redistribution that is supported by voters.

3. Policy failures

There are failures in politics that make it possible for a powerful minority to impose institutions on a majority of citizens. Groups organized as a lobby may succeed in influencing political decisions disproportionately.

We consider four indicators of institutions:

1. The index of strictness of EPL.

2. The summary generosity measure of UBs.

3. The ratio of active labor market policy (ALMP).

4. The total tax wedge on low wages.

What is the importance of minimum wages in the labor market? - Chapter 2

The labor market institution minimum wage sets a wage floor for the wage the employer has to pay to the individual worker. Almost all countries in the world have some form of minimum wage. In some countries the minimum wage is set by the government while in other countries it is an agreement between firms and workers.

We can distinguish between three different minimum wages applied in OECD countries:

1. A national, government-legislated minimum wage.

2. A national minimum wage that is the outcome of collective bargaining agreements and is extended to all workers.

3. An industry-level minimum wage that results from industry-level collective bargaining and is extended to all workers in that industry.

Cross-country comparison

Even though it is very hard one can still try to compare minimum wages among different countries. One measure that is often used for this international comparison is the ratio of the minimum wage to the median wage. It may be preferable to use net wages for this measurement because of income taxes. This measure also ignores the setting of minimum wages. So this measure has several drawbacks. The evolution of this ratio differs widely across countries between 1990 and 2010.

A perfect labor market

The minimum wage affects the outcome of a competitive labor market. When the minimum wage is set above the market level employment will reduce and the equilibrium wage level will increase. Workers that were first working below the minimum wage are now replaced by others.

Suppose that in a perfect labor market the minimum wage is set at w. This will lead to the quantities L^d (w) and L^s (w) for demand and supply respectively.

The segment BC, the difference L^s (w) - L^d (w), denotes the number of unemployed individuals. As their reservation wage is lower than w, these individuals are not indifferent between working and not working. Unemployment increases due to the minimum wage; there is a welfare loss.

An imperfect labor market

The effect of a minimum wage in an imperfect labor market is much harder to predict. In some cases, a low minimum wage may lead to an increase in employment.

We will look at the case of a pure monopsony. A pure monopsonist faces an upward-sloping labor supply curve. The marginal cost of hiring a worker is higher than the reservation wage of an additional worker. The profit maximizing choice of the monopsonist is to set the MLC equal to the labor demand. This optimal choice lies at point B.

The monposonist hires less workers than in a competitive economy since L^m < L*. It also pays a lower wage to its workers. The degree of monopsonistic power of a firm is measured by the wedge BC. The steeper the labor supply curve, the larger this wedge. We can calculate the degree of monopsonistic power with the following formula:

ε = (y (L^m) – w^m ) / w^m

When labor supply is infinitely elastic, the employer is a price taker, ε tends to zero and hence monopsonistic power is zero.

The introduction of the minimum wage leads to a new MLC curve equal to the curve DEFG. The new equilibrium is found at point F. The minimum wage set between the monopsony and the competitive economy leads to an increase in employment and in wages.

Introducing a minimum wage in a monopsony model has the following effects:

• If it is set between the monopsony wage and the competitive equilibrium, the labor supply curve determines the relation between employment and the minimum wage.

• If is set above the competitive equilibrium, the labor demand curve determines the relationship between wage and employment. It reduces the total surplus and therefore reduced labor market efficiency.

• If it is set above the MLC, employment is lower than at the monopsony equilibrium.

• If it is set above the wage of the monopsony, profits of the monopsonist are reduced. But it increases labor market efficiency in the range BC.

Serval employers in a labor market can collude to act together as one. This case is similar to the case of a monopsony. Collusion may be favored by bargaining institutions but it reduces the power of employers in setting wages.

Even in a market with many individual employers, employers have some degree of monopsony power. Also in this situation a minimum wage can increase employment if the wage is not too large and workers’ participation decisions respond only to the wage.

In dual markets, the minimum wage may not have negative effects on employment. This may happen when the minimum wage does not apply to the secondary or informal labor market.

Suppose that in equilibrium both the formal and informal sector are at the wage w₀. So we are at point A and C for the formal and informal sector respectively.

If a minimum wage is introduced in the formal sector this will result in a shift along the labor demand curve from point A to point B. This would create unemployment. In the formal sector there is an upward shift of the labor supply curve from L^s₀ to L^s₁. In the informal sector there is a right ward shift of the labor supply curve. This results in a fall in the wage in the informal sector.

The minimum wage reallocates jobs from the formal to the informal sector. The difference between formal and informal wages increases. This mechanism prevents employment losses.

The minimum wage has a positive effect on welfare when the productivity of a job depends on the investment in education and training by the employee. At the minimum wage equilibrium there are more high-productivity jobs. If the minimum wage is set to high then employers may find it too expensive to invest in the training of low-skilled workers.

It is important to remember that not the presence but the level of the minimum wage is that what really matters. Overall the minimum wage reduces employment but in some cases it may have a positive effect on welfare.

Empirical evidence

There are several studies that focus on the effects of the minimum wage. All these studies are based on different data. We will discuss three studies:

1. Studies based on firm-level data

Many studies of the minimum wage are based on firm-level data because the minimum wage is dependent of wage distribution and the actual minimum wage enforcement.

These studies often measure the fraction of people affected by the minimum wage. To measure the enforcement the spike is used. The spike is the proportion of people earning exactly the minimum wage. Especially data from the formal sector in developing countries is used for these studies.

Lighthouse effects: the spillover effects between the formal and the informal sector; the increase in the wage in the informal sector as a result of a signal in the formal sector.

2. Studies based on natural experiments

This study says that the effects of the minimum wage are related to the different characteristics of workers located at varying proportions of the wage distribution.

This methodology uses differences-in-differences estimators. These estimators have been used to measure cross-state variation in setting minimum wages.

3. Studies based on workers’ histories

Two problems of the empirical literature on the minimum wage are:

• It focuses on specific industries while the competitive model focuses on the labor market as a whole.

• It neglects possible effects on working hours.

This problem can be solves by using data from the history of the workers. This empirical research shows that the minimum wage can have a great effect on job-finding and job-loss probabilities.

Policy issues

Some studies argue that a minimum wage has a positive effect on employment while others argue that there is a negative effect. As a result there is a great debate about whether the minimum wage should be increased or decreased.

The minimum wage is seen as a tool to reduce the number of working poor. Working poor is defined as individuals who hold a full-time job but nevertheless appear to live close to the poverty line.

It is very hard to determine all the effects of the minimum wage on poverty. Several studies measure the distributional impact among different hoods to get an idea. Many found that the introduction of the minimum wage led to disemployment in the group of unskilled workers.

In some countries the minimum wage also depends on the age of the worker. In such countries there is a difference between the youth and the adult minimum wage. One thing to note is that in these countries youth unemployment rates are always much higher than adult unemployment rates.

A youth minimum wage can have a negative effect. Young people may drop out of school to early because the minimum wage is too attractive to stay in school.

An increase in the youth minimum wage would lead to the fact that hiring old-workers is more attractive to the firm. This reduces the youth employment level and thus increases youth unemployment.

Interactions

Minimum wages have a close relationship with other institutions in the wage distribution. The level of the minimum wage is affected by whether there is a government-legislated minimum wage or a wage floor that is set by a collective agreement.

If a minimum wage is set to high this results in unemployment. This problem can be solved by reducing the statutory minimum wage. The effect can also be mitigated by combining the minimum wage with in-work benefits. This is often seen as an antipoverty device providing wage insurance to workers with low earnings.

The goals of a minimum wage

Minimum wages can achieve two goals in the labor market:

1. Increase efficiency by remedying market failures, like the failures from monopsonistic power.

2. Reduce earnings inequality by supporting incomes of relatively low paid workers, like low-skilled workers.

To achieve both goals the minimum wage has to be set at the right level. To be as efficient as possible governments have to adjust minimum wages over time.

What is the benefit of collective bargaining for the labor market? - Chapter 3

Labor unions: voluntary membership organizations. These unions represent the interests of its members.

The union membership depends on the collective bargaining system. In some countries bargaining takes place at national level while in other countries it takes place on sectoral level.

Everything that the union does affects its members. Unions often do not attract many high-skilled workers and bargain about all kind of aspects of the employment contract. The power of a union depends in the extent of the wage coordination that unions achieve and the coverage of the collective contracts signed by the unions.

Cross-country comparison

The influence of trade unions across countries is something that is not measured often in history. This is because there is not much information about the unions and its members or the information is not reliable. Available data suggests that the influence of unions is very different across countries and has changed over time.

Union presence: the number of active members in the workforce.

Union influence: the fraction of workers involved in agreements negotiated by unions.

The data suggests that there has been an increasing divergence between unions’ presence at the workplace and unions’ influence. The excess coverage is the difference between union influence and union presence and has increased over time.

The union density (or membership) rate is the fraction of workers registered with some trade union. A union also consists of non-working members.

Over the past decades the number of members in unions has decreased significantly. This decline has gone hand in hand with the aging of unions. The medium age of the member has increased while the medium age of the worker has decreased.

Years ago membership meant support, attending meetings, time effort. Nowadays membership may require only voting over the internet and paying contribution. Memberships do not provide exclusive services to their members as they did in history.

Some countries have adopted a voluntary but publicly supported scheme administered by unions or union-dominated funds when unemployment insurance was introduced. This system is called the Ghent system. It is still operating in some countries around the world. One thing to note is that union density is by far the highest in countries with a Ghent system.

Eligible workforce: the employees with bargaining rights.

The coverage of trade unions is the percentage of the eligible workforce whose contract is regulated by the collective agreements assigned by the unions. With this measure one can measure the bargaining power of trade unions. Coverage ratios vary widely across countries.

In most countries the coverage ratio is much larger than the union density. This results from two things:

1. The decline in union density rates

2. The presence in many countries of laws or practices that extend coverage beyond membership.

These rules and practices increase the gap between coverage and membership because the workers have fewer incentives to join a union.

To solve this problem, some unions decided to provide their members with exclusive services to make the membership more attractive.

The level of bargaining refers to the level at which contracts are negotiated. In some countries negotiation occurs mainly on firm level while in other countries it occurs manly on industry level. There are even income policies that are implemented on national level.

Formal centralization: has to do with the actual level at which wage contracts are signed and the existence of parallel union organizations.

Implicit coordination: results from informal (tacit) coordination between independent unions and employers.

In countries with high union density it is easier for unions to organize bargaining in a coordinated way.

Another measure for the unions’ power is the hours of strike or the wage share. The wage share is the ratio of the total wage bill to GDP. Both these measures show trends in Europe that are similar to the trend of union membership.

The strike rate: the number of work days lost per 1,000 workers. This rate can be split up into two components: the average duration of the strike and the incidence of workers involved. Strike durations are often very short.

Bargaining theory

Bargaining models are useful for explaining the effects of union activity on employment and wages. We will first assume a model with identical union members.

The outcomes of collective bargaining, a process between unions and organizations of employers, depend on the bargaining power of the two parties and on the scope of the bargaining. In the collective bargaining process the two parties bargain over wages. It is assumed that all union members are identical and thus all have the same reservation wage and productivity.

This means that when labor is not unionized, labor supply is a flat curve equal to the reservation wage. The union has the goal to maximize the utility of the identical workers while the employer’s goal is to maximize profits. When the bargaining power of a union is higher, the mark-up imposed by unions will be higher. This will result in a lower employment level.

The wage mark-up is equal to:

η = (w^u – w^r) / w^u

where w^u stands for the monopoly union wage and w^r stands for the reservation wage. The more elastic the labor demand, the lower the mark-up obtained by the union.

Employers decide on employment L; they have the right to manage. The collective bargaining outcome lies on the labor demand curve L^d.

The wage cannot be lower than the reservation wage otherwise people are not willing to work. This lower bound of the wage is the competitive equilibrium wage w*.

The upper bound of the wage is the wage that maximizes the surplus of union members, w^u. Wages increase with the strength of the bargaining power of unions. The monopoly union outcome, M, is found where the slope of the labor demand curve is tangent to the slope of the union indifference curve.

Efficient contracts: outcomes of collective bargaining involving both wages and employment.

Bargaining is only efficient if the slope of the union indifference curves, IC, equates the slope of the isoprofit curves, PC. In the following figure it is possible to move from point M to point B. At this point a higher indifference curve is attained while staying on the same isoprofit curve.

The line AB represents the contract curve. The slope of this contract curve is negative. Under a right-to-manage structure only point A can be attained because it represents the competitive equilibrium.

When the contract curve is vertical then bargaining is very efficient. However, the employment outcome is the same as in a perfectly competitive labor market. A vertical contract curve corresponds to a union that is risk-neutral.

So far we assumed that all union members are identical and thus have the same preferences. However, in practice it can be that these preferences differ among individuals. When this is the case, one should do interpersonal comparisons of utility. One can measure this by adding up all individual surpluses or choosing more egalitarian objective functions of a trade union.

Unions are voluntary associations and therefore their objectives depend on their members. The objectives of the member will match with the median union member if members vote sincerely and preferences are single-peaked.

Most part of the members consists of low-skilled individuals and low-skilled individuals are often unemployed. This combined with the fact that the level of high-skilled individuals is very low leads to the fact that the membership will be concentrated around intermediate-skill positions.

Hicks was the first one that developed a model for bargaining. In this model firms and unions only bargained on wages. Unions want a higher wage than firms offer and so they go on strike. However, strikes are very costly for both unions and firms. This is due to foregone earnings and foregone production respectively.

The duration of the strike affects the wage. During a strike, the income of workers is below their normal level and their wage demand will keep falling. This is shown with the union resistance curve UR₁. During the process also firms are willing to give in. This process is shown with the employers’ concession curve EC₁.

The resistance curve and the concession curve intersect at point A. After a strike duration of t_A both parties will come to the agreement of the wage w_A. If unions think that the concession curve is EC₂, then the equilibrium will be found at point B leading to the wage w_B.

If employers think that the resistance curve is UR₂, them the equilibrium will be found at point C leading to the wage w_C.

Unions also face a profit curve. Their profits are maximized where the profit curve is tangent to the union resistance curve.

Empirical evidence

We can distinguish between two streams of research about the effects of unions on the labor market:

1. Estimates of effects of unions on wage gaps and on the entire wage distribution. Union wage gaps: wages of members versus wages of non-members. Uses mainly individual data.

Being a member can be beneficial in some countries. This leads to a gap between wages of union members and wages of nonunion members. The wage gap also reflects the fact whether workers decide to be a member of a trade union; self-selection. Self-selection generates a positive relation between wages and membership.

It is difficult to identify the effect of unions on wages in countries where the coverage of collective bargaining extends far beyond membership. Overall, this research found that unions reduce wage dispersion, notably in countries with higher centralization and coordination of bargaining.

2. Estimates of effects on unions on union density and bargaining coordination on employment, unemployment and inflation. Uses mainly macroeconomic time series.

This study is based on the imperfect measures of the bargaining structure. These measures are limited in time-series variation. One finding of this research is that there is a relationship between the degree of coordination and unemployment when coordination measures are used. When centralization measures are used they found a two sided relationship with low unemployment occurring at low and high levels of centralization.

The overall finding of this research is that an economy performs better on employment when bargaining coordination and unionization are high.

Policy

Many economists point out that unions have a good and a bad side. The good side is that they provide a collective voice but the bad side is their rent-seeking behavior. Without the collective voice, workers with a wage that is too low would see no other option than quitting; the exit option. Unions may help achieve higher efficiency.

Bargaining power on workers allow them to extract rents from their employers. For instance, an employer may have to invest in training in order to be more productive. This investment of the employer is irreversible.

It creates asymmetry between incumbent workers and new workers from outside. After the investment, workers can renegotiate their wage and obtain higher pay. This is called the hold-up problem.

Centralized wage agreements can take into account:

• The effects on inflation associated with the excessive wage claims and internalize the aggregate demand externalities associated with consumer price inflation.

• Fiscal externalities related to the payment of UBs.

However, bargaining systems in OECD countries have recently moved towards decentralization. This is a choice led by the unions and employer associations.

There is a relationship between bargaining coordination and bargaining outcomes. An increase in bargaining coordination has two effects:

1. Negative externalities of bargaining are internalized, which reduces wage pressure.

2. Bargaining power increases, which increases wage pressure.

The effect of increased bargaining power is the dominating effect in the start but later on the effect of internalizing externalities will be dominant. This results in a hump-shaped relationship between bargaining centralization and unemployment and therefore unemployment is highest at intermediate levels of bargaining.

Because of this hump-shaped relationship, countries perform better by pursuing decentralization. Governments are not the ones that make the bargaining decisions, unions are. Governments act as mediators in wage negotiations.

Interactions

Governments and labor unions bargain over the following things:

• Minimum wage

• Labor laws

• Age of retirement

• Family policies

• UBs

• Payroll taxes

Unions continue to have a great influence over wage bargaining in many countries in Europe. The unions’ influence is significantly larger than the presence of the union. The median age of the union member is increasing faster than the medium age of the medium worker.

What are causes en effects of discrimination in the labor market? - Chapter 4

The labor market position of an individual depends on several personal characteristics like education, work experience and training. Sometimes the difference in labor position is related to irrelevant characteristic; characteristics that do not affect the worker’s productivity. Then there is discrimination.

Discrimination: the valuation in the market place of personal characteristics of the worker that are unrelated to worker productivity.

Discrimination can take place on different grounds: age, gender, race, sexual orientation, and ethnicity. It can result from differential market power, lack of information, prejudice and employment barriers.

To deal with the problem of discrimination they developed antidiscrimination legislation. We will focus on discrimination in the labor market itself, not on discrimination of individuals before entering the labor market. The main focus is on gender discrimination.

Cross-country comparison

In all OECD countries there is a system to diminish labor market discrimination on grounds of gender and ethics. In all countries there are different kinds of discrimination. The efficiency of the system depends on how high punishment after violation is.

The incentives of a worker to bring a discrimination case to court:

• Burden of proof

• Limited protection

The incentives of an employer to comply with antidiscrimination legislation:

• Publicity

• Fines

• Prison

Theory

There may exist a gender wage gap if women and men differ in productive characteristics. But research has shown that men and women also differ in psychosocial traits and preferences. Due to these differences, some jobs are more attractive to men and others are more attractive to women. The five most commonly used personal traits are:

1. Extroversion

2. Agreeableness

3. Conscientiousness

4. Neuroticism

5. Openness to experience

There are different theories analyzing the effect of discrimination in the labor market. In the setting of a competitive labor market the most common theory is the taste-based discrimination model. In the setting of a noncompetitive labor market there are three theories:

• Monopsony-based discrimination

• Statistical discrimination

• Discrimination due to occupational crowding

We start with discussing the taste-based discrimination model in a competitive labor market. We assume that labor is homogeneous and that discrimination is against women and in favor of men. Female will receive the wage w_f and men will receive the wage w_m. The wage that females receive is below the wage that men receive.

Prejudiced employers have a preference for male workers over female workers. The utility of employers is calculated with the following formula:

U = π – ω w_f L_f

Where L_f is the number of female workers hired and ω is the employer-specific coefficient of discrimination. ω takes a value between 0 and ω^max. When employers are unprejudiced, ω=0, while for prejudiced employers ω = ω^max.

The wage costs for male workers are w_mL_m and the wage costs for female workers are (1+ω)w_fL_f. Men and women are perfect substitutes and therefore firms hire either men or women. A firm hires only men when w_f< (1+ω)w_f. A firm hires only women when w_f > (1+ω)w_f.

The coefficient of market discrimination, Ω, depends on the wage gap between male and female:

Ω = (w_m – w_f) / w_f

The next graph shows the employer discrimination and the gender wage gap equilibrium.

The curve BCA represents the labor demand curve for women. If male and female have the same wage, only L₀^d jobs are available for women. Point A represents a point with a prejudiced employer. The equilibrium point is found where the labor demand is equal to the labor supply, point E.

If L₀^d > L_f^s, there is no wage effect of discrimination. An increase in the labor supply of female will increase the female wage relative to the male wage and thus increase the equilibrium level.

Firms that will hire females to some extent will earn higher profits than firms that only hire male workers. If ω < Ω, firms will only hire women. Prejudiced firms will have lower profits than unprejudiced firms in the short-run. Therefore, prejudiced firms cannot survive in the long run and are forced to leave the market.

There is another discrimination that can occur: male workers prefer not to work with female co-workers. The utility of the prejudiced male worker is given by:

U_m = w_m (1 – ω I_f)

Where ω is the coefficient of co-worker discrimination and I_f is an indicator of whether this worker has at least one female co-worker. Working with female co-workers will decrease their utility. This model of discrimination has two predictions:

1. In firms where male and female cooperate the male worker will have to earn more to compensate the disutility. Therefore, firms will hire either men or women and the workforce will be segregated.

2. If firms are not prejudiced, the gender gap will not exist even if all men in the firm are prejudiced.

There is also the case that customers do not want to be server by women. When this is the case, the perceived price of a product or service may differ from the actual price. Discrimination occurs if the perceived price p_w depends on the presence of female workers in the production process:

p_w = p (1 + ω I_f)

Where ω is the coefficient of discrimination and p is the actual price. If the price is high, customer will only buy from firms with no female workers. If the price is low, customer will only buy from firms with female workers. This model of discrimination has two predictions:

1. Women will have a lower wage in the case of customer discrimination since firms pay workers according to their marginal product.

2. Firms will be segregated. The product price is low for an all-female firm. This firm cannot afford to hire male workers. The product price is high for an all-male firm. This price falls when one female worker is hired.

In all three cases of taste-based discrimination (employers, co-workers or customers) the workforce will be segregated. Market forces will eventually remove discrimination through competition. However, in an imperfect labor market taste-based discrimination can survive.

We will now discuss the models of discrimination in an imperfect labor market. In an imperfect market employers may have market power over groups of workers. The three models of discrimination:

1. Monopsony and the gender wage gap

Employers may have more market power over women than over men. We assume that the labor market for men is completely competitive while the labor market for women is characterized by monopsony power.

The level of employment for female is found where their upward-sloping marginal labor cost curve intersects the horizontal labor supply curve for men. Total employment is found where the male labor supply curve intersects the labor demand curve. The gender wage gap originates from the labor supply of women being inelastic.

2. Statistical discrimination

This theory is based on the assumption that employers have imperfect information. They do cannot identify fully the productivity of individual workers. Employers use individual test scores but these tests scores are imperfect. The perceived productivity of an individual worker is given by:

q_ij = α_j T_j + (1 – α) T_i

Where q is the perceived productivity of individual I, T is the test score and α is weight attached to information about group activity. The first type of statistical discrimination arises when the employer has a different perception of productivity but attaches no weight to differences in individual test scores; α_j = α. The equation of perceived productivity then becomes:

q_ij = α T_j + (1 – α) T_i

The mean productivities of the two groups will be different. This type of statistical discrimination could be based on stereotyping.

The second type of statistical discrimination arises if employers value the individual; test score of one group more than that of another group, even though the average productivity of the two groups is seen as the same; T_j = T. The equation of perceived productivity then becomes:

q_ij = α_j T + (1 – α) T_i

The mean of the two groups are the same but outside the mean there differences between the groups.

3. Discrimination due to occupational crowding

This theory of discrimination explains how differences in the wage between occupations may occur because some groups of workers are restricted in their entrance to certain occupations. There is wage discrimination between occupations and not within occupations.

The focus lies on the differences in male-female earnings. Women are not allowed to enter some occupations and will look for others. These barriers for women may arise from unions.

The labor market equilibrium changes when such barriers for women to enter male jobs are introduced. This shifts the supply curve for male jobs to the left, reducing employment and increasing wages in male jobs. The women who are banned from male jobs have to find a female job. This shifts the supply curve for female jobs to the right, reducing the wage of female jobs. The difference between the wage of male jobs and the wage of female jobs leads to differences in earnings.

From an economic point of view discrimination is inefficient. It reduces the market surpluses.

Empirical evidence

Unconditional employment and earnings gaps can suggest that there is evidence of potential discrimination.

The gender employment gap is the percentage difference between the employment-population ratios for men and women.

The gender earnings gap is the difference between earnings of men and women relative to earnings of men, usually at the median or mean of the earnings distribution.

Conditional gaps: gaps that measure for specific categories of workers.

The gender employment gap and gender earnings gap are unconditional gaps. When pre-market wage discrimination is important, unconditional wage differentials are probably more informative than conditional wage differentials.

If we look at historical data of the gender employment and earnings gap we find that there are great differences across countries. In some countries the gaps are large while in other countries gaps are relatively low. The data suggests that there is a positive relation between the two gaps.

One can use a regression analysis to examine the difference in male and female wages. In such a model, the differences can be explained through differences in observed characteristics between men and women and through differences in returns to these observed characteristics. If the returns differ than we can speak of discrimination.

There have been recent studies that investigated discrimination along several dimensions:

• Gender: it is not easy for men to enter female jobs as it is also not easy for women to enter male jobs.

• Race: an applicant with a white name for a job has 10 percent chance to be called back while an applicant with an African-American has 6 percent chance to be called back.

• Immigrant status: female recruiters were less likely to discriminate and discrimination is more likely to occur in small firms and occupations with many immigrants.

• Sexual orientation: this type of discrimination was only found in the private sector. The gay applicant was discriminated against in the male-dominated firms while the lesbian applicant was discriminated against in the female-dominated firms.

• Beauty: for men there was a great difference in firm callbacks between attractive man and unattractive man. For women the difference in callback rates between attractive and unattractive applicants was small.

Policy

Female discrimination originates from being protective towards women. In the 1900s there was legislation about how many hours and women could work. People believed that it was bad for the women’s health to work too much.

Equal pay legislation: legislation that implies that men and women in the same jobs should be paid the same wage.

However, such equal pay legislation is thought to be ineffective. Equal pay would lead to a market mechanism that helps women to obtain greater access to jobs. It is also very difficult to implement since equal work is difficult to measure.

Affirmative action policy regulates the allocation of scarce positions in education, employment or business contracting. It tries to increase the representation in those groups. The underutilization of women and minorities in analyzed.

Affirmative action could be in the form of employment quotas but this may be problematic. For firms it may be hard to increase the share of minority groups. It may also lead to discrimination against nonquota groups. Affirmative action affects discriminatory firms but it also affects non-discriminatory firms.

Interactions

Antidiscrimination legislation interacts with several other institutions like:

• Education and training

• Family policies

• Working hours legislation

• EPL

• Unions

There could be pre-market discrimination and therefore intervention at a young age may occur. Individuals can underinvest in education in expectation of discrimination in the future.

The two main reasons for antidiscrimination legislation are equity and efficiency. This legislation improves labor market efficiency through better allocation of workers to jobs and a better use of scarce resources.

In competitive labor markets discriminatory employers will be punished while this is not the case in an imperfect labor market. In an imperfect labor market, market power may be used to sustain discrimination against women or minority groups.

When individuals are aware of the existence of discrimination against their group they may react to it by investing less in human capital.

What are different perspectives on working hours? - Chapter 5

The topic of working hours has been a heated debate between employers and unions for a long time. The optimal length of a working day depends on wages, leisure and productivity. In the last few decades, the working hours per week have been declining but are now at a relatively constant level.

Part-time jobs reduce the average working hours. This part-time work has been increasing in most countries, especially for women. The regulation of working hours has three dimensions:

1. The regulation of standard working hours.

2. The barriers workers and employers face when choosing part-time work instead of a full-time job.

3. Short-time work (STW): the schemes encouraging employers to reduce hours rather than the number of employees when experiencing a negative shock.

The cross-country differences in working hours are very large. These great differences have to do with regulations and with preferences and social customs.

Home production: the time allotted neither to work nor to leisure.

Cross-country comparison

The measure used for cross-country comparison is the average number of working hours per week. One can take this average for all workers or it can be specified for part-time and full-time workers. The average of part-time workers is often roughly half of the average of full-time workers.

In many countries the legal maximum of a normal working week is 40 hours. The maximum number of weekly overtime hours does differ widely across countries. The maximum number of total hours is the normal maximum plus the overtime maximum. This number also varies widely across countries.

Incidence of part-time: the fraction of dependent employment on part-time jobs. The average working hours per employee are affected by this incidence.

In every country part-time work has its own characteristics. Some sectors may better accommodate part-time jobs than other sectors. The choice of employers regarding part-time positions is affected by taxes and social security conditions. A country can introduce fixed costs making part-time more costly on an hourly basis.

Short-time work schemes were activated in most countries during the Great Recession of 2008-2009. This makes the earnings loss of workers due to negative shocks as small as possible. Some countries imposed extra criteria on firms and workers participating in STW schemes. They could for instance impose compulsory training measures or subsidies for participation in training programs.

In other countries they require that the use of STW schemes is supported by a collective agreement or is approved by the unions when white-collar workers are involved. Another condition is that the reduction must exceed a minimum fraction of the standard working hours. This is done so that only firms with a great fall in demand can access STW.

Overall, STW goes with many other conditions and agreements but these differ widely across countries.

STW creates a cost to the employer and thus the firm has to fund the STW schemes. In some countries this is done by general tax revenues while in other countries they are funded by social security contributions.

Replacement rate: the percentage of wages not paid, when under STW, that are replaced by subsidy.

Workers who participate in STW are usually better off than unemployed individuals. Hours reductions can be as high as 100 percent in some countries. This puts the worker in a condition similar to a leave or temporary layoff even though the worker is still on the firm’s payroll.

Theory

We will start with analyzing a perfect labor market with competitive workers and firms. Individuals choose the number of hours based on the hourly wage rate, leisure, income and home production. The individual will supply working hours until the marginal value of nonmarket hours equals the wage rate.

The optimal choice of hours is found where the indifference curve is tangent to the budget constraint. If an employer wants to increase the working hours of an individual it must increase the wage. This amount that the employer has to pay to increase the working hours of the individual is called the overtime premium.

In reality, there are restrictions to working hours. When this is the case workers can no longer maximize their utility as in the unconstrained choice discussed above. They will only work if they can get a higher indifference curve than the curve crossing the zero labor earnings locus.

A nonparticipant is at the endowment point, point E, where utility equals U_np.

This worker can also choose to work full-time and reach point A. At this point utility equals U_ft. If the labor market only offers full-time jobs the worker will prefer not to work since U_np > U_ft.

When a worker can choose between not working, a full-time job and a part-time job the graph will look like:

At point B, the individual receives a higher utility from working part-time than from not working at all. The worker will enter the labor market as soon as it is possible to work part-time. The segment BD measures the extent of the hourly wage reduction that the worker is willing to accept to get a part-time job.

The availability of part-time jobs is associated with higher participation rates. It makes it possible for people with a higher reservation wage to get a convenient combination of work and nonwork.

Working part-time may be an involuntary choice for someone with a relatively low reservation wage. If the worker can only choose to work part-time of not to work at all it would not maximize its utility. The individual is willing to move from a part-time to a full-time job. This situation is called underemployment or involuntary part-time work. Because the worker works less than he is willing to work this leads to a welfare loss.

Employers use labor until the marginal value of an additional hour of work equals the wage costs. They can achieve this level by increasing the number of workers or by increasing the number of hours per worker. We assume the following production function:

y = Lh^α

Where y is the output, L is the amount of workers, h is the hours of work and α takes a value between 0 and 1. The isolabor curve shows the same level of effective labor input.

The isocost of labor curve shows all combinations of hours and workers that are equally costly for the employer. The isocost curve is given by:

C = L (F + wh)

Where w is the hourly wage, h is the number of hours worked and F are fixed costs.

The optimal choice of hours for the firm is independent of the scale of production. Changes in the scale of production change the number of workers but not the hours of work per employee.

The optimal choice is found where the isolabor curve is tangent to the isocost of labor curve. This leads to point A, resulting in h* and L*.

We will now turn to the case of an imperfect labor market. Labor supply and individuals’ preferences matter at the equilibrium. In reality, there are costs of mobility of workers across jobs. This gives employers some monopsonistic power and reduces the size of the labor market. In an imperfect labor market there can be unemployment.

Reductions in working time are encouraged by STW schemes. Workers are subsidized so that they accept a reduction in the amount of hours they work. This is done in such a way that the weekly or monthly wage of the worker is not affected too much. This adjustment is done along the intensive margin.

Employers often react to negative shocks by reducing the number of workers instead of reducing the hours of work per employee. This leads to excessive job losses during recessions or other negative shocks. This employment adjustment is done at the extensive margin.

Another adjustment at the extensive margin is related to fiscal costs of dismissals: in the presence of UB systems, employers lying off their workers exert a negative fiscal externality by imposing a higher expenditure for UBs.

The decision of the firm about working hours is often constrained by regulations of governments. Governments may state a maximum number of weekly hours of work. These regulations also specify the number of normal hours.

Due to these regulations employers have to reduce the number of hours of work they would have asked their employers. The monopsony power is reduced due to the restrictions. Shorter working hours may improve welfare.

Lump of labor: a fixed number of total hours of work demanded by firms, independently of government regulations and of the labor supply response to these changes.

The problem with the idea that shorter working time improves employment is that there is no such thing as a lump of labor. A reduction of the working hours leads to a shift in the isohours curve: it will shift inwards from h₁ L₁ to h₂ L₂.

Overtime hours often pay a higher wage than normal hours. When this is the case, the isocost of labor curve will have a kink corresponding to the standard hours. At the higher wage, there will be a stronger reduction in the number of employees.

Without overtime hours, the isocost curve is ABC. Suppose that h₁ is the standard number of worker hours and that there is overtime work. The new isocost curve will be ABD. A reduction in working hours enforced by regulations of the government will shift B to E leading to the isocost curve AEF.

The reaction of the market can differ. There are three cases considered:

1. If working hours are initially to the right of point E, then the policy change has no effect in the firm’s decision.

2. If employees initially work overtime, so to the left of point B, then the number of workers will fall. This is because the employment of each individual employee becomes more expensive. Firms will reduce their production levels.

3. If all workers initially work exactly point B, then the wage regulation has an effect. The firm may reduce or increase employment depending on whether it moves work to the new kink.

Empirical evidence

Data from several countries points out that there was a substantial decline in annual hours of work between 1950 and 2010. This measure is influenced by the number of hours per week and the number of workweeks per year. In both of these measures there is a wide variation between countries.

Work sharing: reductions in the length of the working weak leading to more jobs.

Work sharing has a significant positive long-run effect on the wage rate and a positive but insignificant long-run effect on employment.

Part-time employment is a negotiation between workers and employees. Part-time jobs can be attractive to workers because these jobs are often also temporary jobs. This creates much flexibility on the workforce. There are three reasons for firms to offer part-time jobs:

1. Makes it easier or firms to match workers to a changing workload because of demand peaks.

2. It gives them cheap and flexible workers. Part-time workers often have a lower wage and less employment protection.

3. Vacancies can be filled with part-time workers.

There is a negative relationship between the share of women who work part-time involuntarily and the incidence of part-time work for women. When there are more part-time workers, working part-time is more attractive.

In many countries we notice an increase in part-time jobs over the last years. This may lead to an increase in employment. It may also lead to higher job satisfaction.

Policy

Working hour regulations may originate from government intervention or through bargaining between unions and employers. Government intervention often takes place when employers have monopsony power. Governments intervene with the idea to increase demand for workers and thus lower unemployment.

During the Great Recession, many countries introduced STW schemes. Data shows that STW levels have climbed among several countries in the world in the period 2007-2009. STW contributes to saving jobs and nowadays almost all OECD countries have adapted some sort of STW scheme. Not the existence but the type of STW scheme is what is relevant.

Interactions

The regulation of working-hours institutions has interactions with several other institutions:

• Collective bargaining institutions. This is because unions often bargain about wages and working hours.

• Family policies. This is because the presence of part-time work allows the combination of work and family responsibilities.

• EPL. This is because EPL makes firms adjust employment.

Researchers found a negative relationship between STW schemes and the generosity of UBs. This is because UBs reduce costs of employers to use the extensive margin of labor adjustment.

What are the requirements for early retirement? - Chapter 6

Early retirement: when the retiring individual is still of the working age. Retirement decisions tend to be irreversible. This permanently reduces the labor force.

In the twentieth century early retirement programs were introduced in many countries. These programs make it possible for workers to retire long before the mandatory retirement age. This means that there is a gap between the statutory and the effective retirement age.

Many studies indicate that there is a strong correspondence between the age at which retirement benefits are available and departure from the labor force. The labor market attachment of older workers is very low in many countries.

Early retirement is not the only exit route for old workers to leave work. Older workers may become disabled or sick or they may have become unemployed. In some countries there are less search requirements for old unemployed workers.

Cross-country comparison

Early retirement is often financed through a pay-as-you-go system (PAYG); this is a system where current workers are taxed to pay for current retirees. There is an intergenerational transfer from the current workers to the current pensioners. These systems are not well adapted to the future since in many countries the population is aging.

Pension programs are either:

• Defined benefit (DB): the final pension is a function of the length of employment attachment and final earnings. There is no risk concerning the replacement of earnings provided by pension benefits.

• Defined contribution (DC): the contributions to a pension are defined, but the level of retirement benefits depends on lifetime contributions. These systems require that entitlements should be transformed into annual payments. This involves some risk.

DC systems lead to higher retirement ages than DB systems do.

In more recent years other systems were introduced in several countries. Such systems are notionally defined contribution (NDC) systems; a PAYG scheme but with a financial account scheme in which workers contribute during their working lives and draw benefits (defined) after retiring.

Contributions to the NDC system are independent of stock markets or bond returns. The contributions go to the national social security administration. They use the contributions to cover current pension benefits.

When a worker retires, the value of his lifetime contributions is transformed into a real annuity: the pension benefit.

Pension wealth: the present value of the stream of expected pension benefits of the worker.

Benefit accrual: the difference between the pension wealth at the retirement age, a, and at the retirement age, a+1. If the accrual is negative then the ratio of the accrual to the net wage earning is an implicit tax. If it is positive then the ration of the accrual to the net wage earnings is an implicit subsidy.

A negative accrual stimulates retirement while a positive accrual stimulates to continue working.

In most countries the standard age of entitlement to pensions is 65. Across countries there is a wide variation in the incentives to retire. For women there is more variation in the average effective retirement age in the last decade than for men.

Theory

The option value: if an individual works until a certain age it will get a bonus from the pension plan. When he retires before that age then the bonus is lost. Working until the retirement age will give him more value. So he has the option value of work.

The worker will retire when the value of continuing to work falls below the value of retiring. The option value will decrease when the worker comes closer to the optimal retirement age.

The decision whether to retire or not depends on a mix of push and pull factors:

• Push factors: restriction of available job opportunities open to older workers, bad health, lack of incentive to invest in human capital, constraints on changing working hours.

• Pull factors: financial incentives that make it more attractive to retire.

An individual in a DB system that decides to continue working adds to the level of pension benefits in two ways:

1. The length of the labor market attachment increases.

2. If the wage increases with the labor market tenure, the end salary increases.

The pension benefits of an individual in a DC system will also increase when the individual decides to continue working. There is an additional contribution to the pension fund and the annuity rate will increase. Pension wealth reduced under the new regime of NDC.

Empirical evidence

When early retirement programs were introduced there was a reduction in the average age of transition to inactivity. The working lives were getting shorter while life expectancy was getting longer.

Research has found two characteristic facts for prime-aged workers:

• The range in employment rates is much smaller for men than for women.

• In every country employment rates for men are higher than for women.

The early retirement system led to a reduction in employment of older workers and it also reduced the outflows from work due to other things like disability, sickness or unemployment.

In many countries there are low participation rates of older workers. Sometimes this can be the result of a government policy to reduce youth unemployment or as a service to older workers. Some old workers are just too tired to work in the labor market. Older workers can be offered an attractive retirement offer to make place for young workers.

When an older worker has become unemployed it is very hard to find a new job. Therefore, the long-term unemployment rate is higher for older workers. Older workers will also lose their jobs more easily because employers have negative ideas about the adaption to new technologies of these people.

Many firms do want to employ older workers, but few firms hire them. Firms want older workers because these workers have been in the firm for a long time and therefore have experience. This experience and knowledge are important in training functions within the firm. When these workers leave the firm they are relatively expensive as new hires.

Another reason why firms do not hire old workers is because newly hired older workers do not put a lot of effort in the job. This makes them again relatively expensive.

A major part of the trend decline in the labor force participation by older men is explained by implicit tax rates and standard retirement ages.

In the past, there were countries were retirement was prohibited by law. This did not influence the probability of older workers being hired. It did reduce retirement and thus increased the length of the firm-worker relationship.

There is a relationship between aging and the productivity level. Even though older workers are seen as more reliable and more skilled, they have higher health care costs and have lower flexibility in accepting new projects. They may also be less suitable for a new training.

There are wide variations between countries but overall older workers are considered to be more consistent, cautious, slow and conscientious. One can identify a concave relationship between age and productivity. However, this may be caused by the existence of mandatory retirement and not the other way around.

Many employers believe in the fact that the average labor productivity declines after the age between 40 and 50. They believe in this fact and do not even look for evidence to prove it. However, there are economists who do research. Warr found that there is no significant difference between the job performance of older and younger workers.

The wage of older workers moves in the opposite way of the productivity. Many argue that the productivity of older workers declines while other data suggests that older workers are relatively overpaid.

The relationship between age and productivity is hard to establish. But employers have strong opinions about the decline in productivity of older workers. The higher the share of older workers in a firm, the less favorable they are.

Policy

Workers and firms have a long-term relationship. In this relationship the worker is initially underpaid but later on in life he is overpaid. Rising earnings may coexist with declining or constant productivity. But we should note that using the wage as a proxy for productivity may be misleading.

There are three pension-oriented policies to reduce early retirement:

1. Reducing the generosity of early retirement benefits.

2. Improving the reward for delaying retirement.

3. Delaying the minimum age of retirement.

Most OECD countries have used one of these policies to reduce early retirement. They also use a variety of policies to influence the behavior of employers, including large-scale information campaigns. A country can also decide to introduce legislation to minimize age discrimination.

Other countries have introduced wage subsidy systems to retain or hire older workers. However, this goes with deadweight losses and substitution or displacement effects.

Many of the retirement policies were implemented as a short-term policy measure. When circumstances changed these policies did not match anymore. Instead of a reduction in unemployment there was an increase in early retirement of those workers approaching the retirement age.

Interactions

Early retirement programs have interactions with the following other institutions:

• EPL. Early retirement makes it less costly for the firm to lay off workers with relatively long tenures.

• UBs. Are complementary to early retirement.

• Education policies. A longer working life makes the investment in human capital more rewarding.

Retirement policies were, in several countries, imposed to reduce youth unemployment. However, when the policy fails the young worker is the one who pays. The young worker pays for the pensions of individuals retiring earlier.

Which family policies can be considered concerning the labor market? - Chapter 7

Family policies aim at reconciling work of both parents with childcare responsibilities. There are two main types:

1. Parental leave

It provides a period for the mother to recover from giving birth and to bond with the newborn. This policy makes it easier for mothers to stay attached to the labor market when raising children.

2. Subsidized childcare

It affects the choice of the mother with respect to the allocation of time between raising the child and work. This may also affect labor supply decisions of other members of the household.

Family policies differ across countries. Some countries offer great parent support while in other countries governments rely on market solutions. The differences come especially from the following two dimensions:

• The generosity of the leave availability to new mothers

• The degree in which policy designs encourage men’s engagement in caregiving.

Cross-country comparison

Cross-country information shows that there is a large difference in spending for childcare among countries. There is also a large difference in the coverage of formal childcare for children below the age of 3.

Opening hours of childcare facilities may also differ across countries. This may prevent mothers from working full-time. In some countries the demand for childcare is high while in other countries the demand is lower. In many European countries formal childcare use is close to 100 percent in the age group 3 to mandatory school age.

There are also cross-country differences in parental leave. Both the duration and the level of benefits paid in the base (mandatory) period differ. In some countries the parental leave is 3 years (Spain) while in other countries it is 12 weeks (United States).

There are countries where maternity leave is paid. The job position is protected during the entire leave period, independent of whether it is paid or unpaid, mandatory or optional. Employers can voluntary decide to offer paid or nonpaid maternity.

In 2010, an EU directive imposed that employers must grant a minimum of four months of parental leave on the birth or adoption of a child to both women and men. This is done to promote a society with equal family responsibilities within the couple.

Even though there are large differences between countries, all countries give some sort of childcare through paid leave and subsidies. Each country has its own combination of parental and nonparental childcare.

Theory

We will now analyze the effect of the availability of subsidized childcare on the labor supply of women. The mother derives utility from being with her children and from consumption. Taking care of her children can be seen as a leisure activity, a normal good.

There are fixed costs associated with childcare; for instance a fee to preschools. Whether the mother will continue to work and increase hours to compensate the income loss depends on both the costs and nonlabor income. Subsidized childcare reduces the fixed costs and leads to more women continue working but with reduced hours.

There can also be variable cost of childcare. These costs reduce the net wage of the women. Subsidized childcare may in this case also increase hours of work.

Suppose that a woman without a child maximizes utility at the allocation point A. At this point she will work h_A hours.

Suppose that now the mother has a child. This will reduce the set of consumptions because of the fixed costs, F, of childcare shifting the budget line down. The new utility maximizing point will be point B with h_B hours of work. In the case of this graph, the mother will still work after having a child. However, if childcare costs are too high then the mother will prefer not to work at all.

As we mentioned before, there can also be variable costs involved. These costs come at the expense of the net wage of the mother. Variable costs rotate the budget line towards the origin. Subsidized childcare for mothers operating on variable costs increases not only the number of mothers working but also the hours of work.

Parental leave operates at the extension of mandated maternity leave. These arrangements permit both father and mother time to take care of the child. This is a form of subsidized childcare where the parents itself provide the childcare. It has a positive effect on labor supply of mothers but will reduce working hours.

So far we have assumed that the preferences of labor versus leisure are unaffected by the birth of a child. However, suppose now that childbirth changes preferences of the mother. Child birth temporarily increases the opportunity cost of market work. This will increase the reservation wage for women.

In the weeks after childbirth, the reservation wage may be higher than the wage offered by the wage. The reservation wage declines as the child ages. At some age the mother is willing to go back to her initial work position. If the parental leave is not offered or not long enough then the mother will quit her old job.

New jobs obtained immediately after maternity often have a lower wage than the old job. Mothers may spend more time not working without parental leave than with it. A longer maternity leave may reduce the skills of mothers before they return to work. Therefore almost all employers offer parental leave.

The loss of human capital associated with inadequate parental leave is more important for the government than for the firm. Private benefits of parental leave are often lower than social benefits.

Mandatory parental leave increases the value of a job for women. When she accepts the job offer she anticipates that there will be a higher utility gain after childbirth.

Besides formal childcare there is also informal childcare. Parents often trust their relatives more than outside childcare givers. If also informal childcare is subsidized, then a lower transfer would be sufficient for women to resume working soon after childbirth.

Both men and women can take parental leave. However, in practice women are much more likely to take time off under this policy. There are more and more countries that are introducing mandated or incentivized paternity leave.

Maternity policies may also affect fertility plans, the number of children in a family. This effect is important to study because fertility itself has an effect on the labor supply. Fertility is affected by the income and by the price of children. A higher family income leads to an increase in the number of children. An increase in the wage rate of the parent responsible for childcare will make a child more expensive. The relationship between female employment and fertility is negative.

These effects of income and net earnings of women on fertility can be graphically shown.

Empirical evidence

The OECD labor market has been womanized since the wars. The gender employment gap is still present but it has reduced in many countries since then. Low female employment rates can be due to differences in preferences. Women have other preferences related to work and family care.

In the past decades there has been a change in the cross-country correlation between female participation rates and fertility rates. Before the 1980s this correlation was negative while since the late 1980s we observe positive correlations. This means that countries with higher participation rates have higher fertility rates. This change is due to the more generous parental leave.

The employment rate is strongly affected by the presence of children in some but not all countries. In many countries there is almost no difference in employment rates between women without children and women with children. Another thing that can be seen from cross-country data is that the share of part-time among female workers increases with the number of children.

According to Ruhm (1998), parental leave mandates will shift the labor supply curve of women to the right while it moves the demand curve to the left. This will lead to an increase in employment of women and a decline in their wages.

Tanaka (2005) studied the relation between parental leave and child health. The main finding was that job-protected paid parental leave decreases the mortality of the child. However, there is not much support from other studies.

Parental leave policies have a positive and significant effect on the proportion of women giving birth to at least one additional child after the introduction of having a single long leave across two or more relatively close childbirths.

Policy

The most important argument in favor of family policies is that they increase the female labor force participation.

Marketization hypothesis: working women create demand for market substitutes for household production and thus create demand for labor producing these substitutes. This will increase employment.

If there is prove that childcare subsidies are increasing parental employment then the demand for childcare will increase. However, this does not necessarily mean that the quality of childcare will also increase.

One should also take into account cultural and social customs. In many countries people agree with the statement that preschool children suffer when their mothers work. In these countries employment rates of prime-aged women are lower. In countries where the employment rate of female represents cultural and social preferences promoting employment may not be optimal.

Labor force participation of female should go up to deal with an aging society and a shrinking tax base. This is the main argument for subsidizing childcare facilities to encourage mothers to enter the labor market.

Governments can give childcare subsidy to providers or to consumers. Since only providers are eligible for subsidies formal daycare centers and preschools will benefit from the subsidy. This will crowd out informal childcare.

Family as a monolith: everybody in the family has the same preferences and choices are made as if a single decision maker acts for the good of everybody.

A key issue is who in the family should receive the subsidy. One can use two different models to come to an answer:

1. The unitary model of household behavior. According to this model it is immaterial who in the family receives the subsidy.

2. The collective models of household behavior. There is heterogeneity of preferences in the household and hence household bargaining to establish the allocation of incomes, consumption and tasks.

The collective decisions must be Pareto sense. Pareto sense means that it should not be possible to improve the position of one member of the household without making someone else in the same household worse off. The solution depends on the share of nonlabor income across members of the household.

Interactions

Family policies have interactions with the following market institutions:

• Equal opportunity legislation

It reduces the risk that gender asymmetries due to family policies will increase.

• Hours of work

Working-time regulations enable parents to combine work and care.

• ALMPs

• Payroll taxes institution

There are two dimensions along which childcare programs are organized:

1. The employment requirement of the program, with no requirements at the one extreme and with full-time parental employment at the other.

2. The quality of the childcare required to be eligible for a subsidy.

In most European countries there is a strong focus on the quality of childcare while in the United States most of the childcare was focused on parental employment.

Why is it important to invest in education in the endowment of human capita? - Chapter 8

Governments devote their resources to education. They spend their resources as an investment in the endowment of human capital. The degree of economic development can be strongly predicted by the educational attainment of the workforce. More years of education can be related to a higher level of income per capita.

Educational attainment is also important in predicting the labor market performance. A higher education level is related to a higher wage and a higher probability of being employed. So there is a monetary return for the investments in schooling and training by individuals and firms.

The difference between human and physical capital concerns property rights. If a firm wants to use human capital it must make an agreement with workers about the terms of use.

Going to school and on-the-job training are both productive investments because they increase general or firm-specific productive skills of workers. Workers choose their educational level based on the costs and expected benefits.

Training of workers often takes place after entrance into the labor market. Training can be general, useful in many firms, or it can be firm specific. Training and schooling are often complements; training is needed when there is new technology and knowledge needs to be updated.

According to the theory of human capital, general training has to be paid by the worker itself while firm-specific training has to be paid by the firm. There are four market failures related to education and training:

1. Capital markets are incomplete; the individual decision of investment is not optimal.

2. The private rate of return to education and training may differ from the social rate of return.

3. There is a long time lag between educational decision and the outcome of that decision.

4. The presence of the holdup problem; once an investment in training is made by the employer, the worker can leave the firm and negotiate a higher wage somewhere else. Similar, the worker can be fired after his own investment in training.

Cross-country comparison

The organization of education differs highly across countries. There is also a significant difference in the provision of in-company training between countries. Cross-country research suggests that spending levels on education differ widely between countries. Within-country differences are smaller than between-country differences. The relationship between educational spending and educational attainment is positive.

The different education systems across countries lead to differences in quality of education and the teaching curricula. To compare such different systems with each other the International Standard Classification of Education (ISCED) was introduced.

This classification provides six categories defined on the basis of the level and field of education. In this system level 3 corresponds to upper secondary education and level 5 corresponds to first stage of tertiary education. They often look whether there is education at level 3 and or level 5 in a country.

Educational quality can be measured by math scores measured by the Program for International Student Assessment (PISA) survey. There is a positive but mild relationship between this PISA score and educational expenditures.

Some countries use other measures to measure the education quality, like the pupil-tutor ratio, the ratio of average salary of teachers to per capita GDP or the length of the school year.

The participation rates in employer-provided training also differ widely across countries. It ranges from a very low percentage of 12, in Hungary, to a very high percentage of 61, in Sweden.

Theory

In a perfect labor market employers have full information about the productivity of workers. Wages can adjust the differences in productivity and individuals invest in their human capital. The investment in human capital is costly: it involves also opportunity costs as the time devoted to schooling is not allocated to a remunerated activity.

There are three basic assumptions of the human capital model of educations satisfied in a perfect labor market:

1. More education leads to higher productivity.

2. Higher productivity leads to a higher wage.

3. Individuals choose their level of education based on financial considerations.

The optimal level of schooling depends on the expected benefits and costs of schooling. Expected benefits are determined by wages, employment probability and the time over which the returns to education will be received.

The initial situation, which represents primary education, is normal at the level zero.

The individual faces two options:

• Start working immediately and have annual earnings equal to w₀. We assume that these annual earnings will remain constant until the year of retirement T.

• Attend s years of schooling and pay the education costs during these years. After s years of education the wage increases to w_s. The total direct costs of schooling are equal to C_s. The monetary benefits are the higher earnings over the period s to T.

The individual will choose option two, s years of schooling, if the present value of school is larger than the present value of not doing so.

The option of additional schooling is more attractive when the expected payout period is longer. Therefore, especially young people go to school. If the market rate of return to investment (external rate) > the rate of return to schooling (internal rate), then the individual should reduce the number of years of schooling.

The level of human capital may differ across individuals before getting education. Their innate ability level differs. The innate ability is the productivity of the worker without any investment. There may also be differences in the physical costs of acquiring education, motivation, interest and drive to succeed. This leads to differences in rates of return to schooling across individuals.

After education individuals can invest in human capital by on-the-job training. Whether the employee will take training depends on who pays for the training. General training increases productivity for the firm but also leads to the problem of property rights. Workers pay for this by getting a lower wage during training.

The optimal amount of general training can be illustrated in a graph:

• τ is the amount of general training and increases productivity

• v (τ) is the output per worker and increases when the amount of general training increases

• w (τ) is the wage and increases when the amount of general training increases with diminishing returns.

• c (τ) are the training costs and also increase with the amount of training, increasingly.

In perfect markets v (τ) = w (τ); the firm does not benefit from general training. Therefore, the firm will not pay for training and the worker has to bear the costs.

A worker will choose the optimal level of training such that the difference between revenues and costs is at its maximum. So where marginal costs equal marginal revenues. This is found where τ = τ*. If workers are not credit constrained, they will invest up to the private net benefits from training.

However, if there are credit constraints then the worker may not be able to make the investment. In that case there is a market failure since the employer can also not make the investment.

In an imperfect labor market employers may not be able to identify the ability of the workers. In this imperfect market the investment made in education by each individual worker can be used by the employer to make inferences about the productivity of the worker that he plans to hire.

Educational attainment is in this case used as a signaling device of a worker’s ability. This leads to a positive correlation between educational attainments and the wage. This is only possible when there is a separating equilibrium: more productive workers invest more in education than less productive workers.

People with a higher level of innate ability find it less expensive to acquire a particular level of education compared to people with a lower level of innate ability.

In an imperfect labor market private returns to schooling are the same but social rates of return to education are much lower than in a perfect market. This means that education does not increase productivity.

The asymmetric information thus leads to overeducation from a social standpoint. In this case there may be cross-subsidies from high-educated to low-educated individuals limiting the investment in schooling.

Some researchers suggest that wages and productivity at any educational level are also affected by noncognitive skills and not only by cognitive skills (investment in education). Such noncognitive skills are motivation, perseverance and self-esteem. These skills create large ability gaps between individuals at young ages. The family and social environment are important in determining these noncognitive skills.

We have discussed the case of overinvestment but in general market imperfections lead to underinvestment in human capital rather than overinvestment. This is because it can be difficult for those undertaking the investment to obtain the full returns from the investment.

A firm has paid costs for the workers that are already in the firm, the insiders. It has to pay another cost when it wants to hire unemployed workers willing to supply labor, the outsider. These costs have to be made to make the work of the new workers at least as productive as the work of the insiders. This creates a wedge between insiders and outsiders.

These things reduce the incentive of the employer to invest in human capital. This will result in underinvestment of education.

One may think that firms will only pay training when it is firm-specific. However, data suggests that a major part of general training programs are financed by the firm.

In an imperfect monopsony labor market a firm is willing to pay for general training of its workers because it is profitable to do so.

Empirical evidence

Data suggests that there is a strong relationship between labor market status and educational attainment. It also shows that earnings are much higher when the education level is higher.

The differences in employment and wages have increased due to scholarization in the postwar period. Even though there was this large increase in labor supply for educated workers, it was not high enough to match with the large increase in the demand for educated workers.

The increase in the demand is due to the skill-based technology change. This change was that routinized jobs were replaced with machines and the demand for abstract tasks requiring a higher level of education increased.

In some countries we see job polarization; higher employment at the two extreme skill levels, an increase in high-skill jobs, large decline in medium-skill jobs and a small decline in low-skill jobs.

The relationship between education returns can be shown with the Mincerian wage equation:

Log (w) = α + β s + γ₀ x + γ₁ x² + ε

Where s is the years of education, x is the years of work experience and ε is an error term. The parameter β measures the return to education.

However, there are two problems with this approach:

• Individuals are not identical before investing in human capital

• Higher levels of education generally lead to higher levels of innate ability

Each individual chooses the amount of schooling that equates the marginal return of an extra year of schooling to its marginal costs. Differences in the marginal costs lead to different optimal amounts of schooling.

The ability bias: a more able person will get more from an additional year of education and pays less for those years in terms of effort. Therefore he will invest more in schooling.

To measure the returns to education we have to take potential selectivity into account. Selectivity is the fact that individuals with different characteristics, potentially affecting wages, have different levels of education.

Often these different levels of education are used to identify the effect of education on earnings. These levels are not related to the individual choices. Research has taken into account other exogenous variables like an increase in compulsory school age, differences in distance to school and compelled leave of education due to military obligations.

Another approach is to identify the different levels of innate ability across individuals before entering education. Often twins are used for such studies because they have the same family and background and are assumed to have the same innate ability. When doing this one can identify the importance of educational attainments on returns to education.

As stated before the distance to school affects the level of education. Children who live closer to school are more likely to stay in school and thus achieve a higher educational level. This will provide us with an estimate of the rate or return to schooling.

When these estimates of the rate of return to schooling do not control for ability bias then the value is often lower than the value obtained when accounting for selectivity.

The wage of a worker is positively related to the past investments in training. A large part of the training costs is paid by the employers even though it is general training. Research has shown that only employer-financed training has a positive effect on wages. Training financed by the worker itself will have no/a small effect on the wage.

The amount of training sponsored by the firm is affected by the labor market imperfections. When a labor market becomes more flexible then this reduces the incentives for the firm to invest in training.

Policy issues

In all the OECD countries there is a compulsory schooling age that forces individuals to go to school until a certain age. Such a compulsory age may we improving the welfare of a country because it may lead to an increase in future revenues. This compulsory age prevents individuals from dropping out of school too early.

An increase in the compulsory schooling age may have a significant positive effect on the quality of schooling. The quality of schooling differs widely across and within countries.

School vouchers: certificates issued by the government, which parents can apply toward tuition at a private school rather than at the state school to which their child is assigned. These vouchers increase the competition between schools leading to incentives for improvements in school quality.

A government can decide to subsidize firms to stimulate the training in the firms. This typically happens when the social returns to training are larger than the private returns to training.

Interactions

Schooling and training laws have interactions with several other labor market institutions:

• Payroll taxes

Education decisions are based on net gains, which are affected by taxes.

• Unions

Wage compressions induced by the unions make investment in human capital less profitable.

• EPL

EPL may stimulate on-the-job training investments.

• Retirement programs

A longer working life increases the lifetime returns from education.

The main reason for governments to intervene in education and training is the presence of market imperfections and the fact that a more highly educated workforce leads to positive externalities.

What are the causes en effects of migration on the labor market? - Chapter 9

International migration is something that we do not see in the time of globalization. Capital mobility has increased and barriers to entry have been removed while cross-border worker lows are still tightly restricted.

Until a few decades ago, there was a large migration outflow out European countries. The migration policies in Europe are becoming stricter and stricter. However, there is a large inflow of illegal immigrants. Around 40 percent of migration to Europe is illegal.

Migration policies introduce restrictions on the movement of persons across jurisdictions. It is often found is the form of a quota. The quota sets a maximum number of work and residence permits to be issued to foreigners in a given year. Quotas are based on the first-come, first-served basis. Migration policies can also be found in a direct form: admission criteria that limit access.

Points system: each applicant is attributed a score based on explicit criteria that typically reward educational attainment, experience and language abilities. This system is adopted by an increasing amount of countries.

An indicator of the stance of migration policies is the number of bureaucracies involved in admission procedures.

Length of stay: the maximum duration of the residence to work permit.

There is a positive relationship between migration and efficiency because migration lowers the differences in productivity and unemployment between countries. However, migration also has negative effects, on wages and unemployment.

Migration tends to happen in waves. Migration policies are used to minimize the negative shocks of such a wave. They try to control the magnitude of migration.

Besides that, migration policies can also effect the composition of migration. The debate about migration policies is a heated topic in many countries. Some people find that we should host more immigrants while others are afraid that those immigrants will steal their jobs.

Cross-country comparison

In the first decades of the twentieth century migration flows were very high in the United States. This increase has not continued into the era of globalization. Currently they experience much lower migration inflows than in the past.

In Europe there were very large migration flows after World War II. In the 1950s migration was encouraged in European countries. Countries opened their labor markets because of labor shortages.

This labor standard was abandoned at the beginning of the 1970s. This was a result of the increase in the unemployment. Since then migration policies have become stricter and stricter.

The migration policies differ widely across countries. In Europe we can roughly distinguish between four types of policy:

• Labor mobility

• Family reunion

• Long-term residence

• Access to citizenship

Theory

Migration has a negative effect on wages of natives in a competitive labor market. This is because there is a downward sloping demand curve. Migration may also reduce employment among natives. The magnitude of these effects depends on the elasticity of labor supply.

We will first discuss the case of a perfect labor market. The equilibrium is found where labor demand equals labor supply. The graph below has an inelastic labor supply and the equilibrium is found at point C.

Migration will shift the labor supply curve to the right. When the labor supply is rigid then there is no decline in the employment among natives. The new equilibrium is found at point D.

Workers experience a loss in welfare equal to area A while employers gain area A + B. This means that there is an aggregate welfare increase.

The immigration surplus is given by the triangle B and equals 0.5 (w₀ – w₁) (L₁ – L₀).

Suppose now that the labor supply curve is elastic, see the graph on the next page. Migration shifts the equilibrium from point C to point D.

The welfare loss to workers is equal to area A1 and the gain to employers is equal to area A1 + A2 + B. This means again that there is an aggregate welfare increase.

The immigration surplus is given by the triangle B. In this case of elastic labor supply the labor supply employment of native workers goes down from L₀ to L₂. The amount of immigrant workers is equal to L₁ – L₂.

Migration typically happens in countries where there is some sort of wage rigidity present. Suppose that we are in an economy with a minimum wage. This means that there is initially no unemployment.

Migration leads to many job losses. The more immigrants who come in and find a job, the higher the unemployment among natives will be. This leads to a decline in the total income of natives.

Migration is a rational choice that involves two decisions:

1. Whether to migrate.

2. Where to relocate.

These two decisions are interdependent. We will first analyze the first decision: whether to migrate or not. Such a decision is based on a cost-benefit analysis. Most costs of migration are paid at the moment of moving. These costs are often very large.

The benefits from migration come from the earnings difference between the destination country and the original country. Migration occurs when the present value of the benefits exceed the costs. Migration is more likely to occur:

1. The larger the earnings difference between original and destination country.

2. The lower the migration costs.

3. The longer the expected length of working life, because this leads to a longer period over which the individual experiences the earnings differential benefits.

4. The lower the discount rate, because this leads to a higher value of materialization of future benefits.

From point 3 and 4 we can conclude than young people are more likely to migrate. Their time horizon is longer.

The second decision is where to relocate. We assume that initial mobility costs are independent of the final destination. The decision then only depends on the earnings differential in the destinations.

Suppose that the only thing that affects the earnings of the migrant is skill. The choice that the immigrant faces is graphically shown in the graph on the next page.

Workers with a high-skilled level, higher than s*, will choose to go to country 1 since their wages are higher there. Low-skilled immigrants, lower than s*, will choose to go to country 2 since their wages are higher there.

Suppose now that country 1 introduces an income floor, b, to protect natives and immigrants. The new curve of country 1 will be kinked:

In this case people with skills lower than s** will also choose to move to country 1. The amount of people going to country 1 has increased. Instead of only high-skilled immigrants there will now also be low-skilled immigrants in country 1. So a welfare system affects the skill composition of migration.

The composition of migration also affects the distribution of income. We will explain this by using a model with the following assumption:

• There are two types of labor: skilled and unskilled.

• Migrants and natives are perfect substitutes.

• There is only one good produced.

• Labor is fixed.

• Skilled and unskilled labor are complements

If migration does not change the skill composition of the native population then it will not affect the wages and income distribution.

However, when migration does change the skill composition of the native population then there will be changes. Suppose that all immigrants are unskilled, while in the native country there are also skilled workers. Unskilled wages decline resulting from the migration. The unemployment of unskilled workers may increase.

Labor demand for skilled workers will increase leading to an increase in the wage for skilled workers. As a result, the wage differentials between skilled and unskilled workers will increase. Hence, the earnings inequality increases.

When the immigrants are all skilled than the opposite happens: the earnings inequality will be reduced by migration.

Empirical evidence

Studies of migration compare employment and unemployment rates of foreign born and native born men and women. The cross-country differences in the share of labor force that is foreign born are very large.

Some research has shown that there is a negative cross-country correlation between the share of foreign born workers and the unemployment rate of native born men. However, this relationship could not be found in all countries.

In most countries in Europe the unemployment rate of foreign born workers is higher than the unemployment rate for native born workers. Overall, native men are more attractive than foreign men due to specific market characteristics.

Several studies have come to the following two conclusions:

1. Immigration has a negative effect on the wages of less-skilled workers and earlier immigrants.

2. There may be a small increase in unemployment in the short run and zero in the long run.

American studies focus on the effect of migration on wages while most European studies focus on the effect of migration on employment. Immigration has a negative effect on native wages or employment.

Economic theory takes three factors into account relating to migration:

1. Self-selection if immigrants into high-wage regions.

Regions with high wages and low unemployment are likely to attract more migrants.

2. Relocation of native workers.

When the amount of migrants in an area rises, natives may respond by moving their labor or capital to other regions.

3. Changes in the regional output mix.

Open economies adjust to migration by changing the composition of the output mix or production technologies to reap the benefits from the increased labor supply.

The best way to investigate the effect of migration on labor market outcomes is to use the national level.

A few studies have used differences-in-differences techniques for the effects of migration on wages and employment of natives. Most use a treatment group and a control groups for this study. However, it is not obvious how these groups should be defined in the case of immigration.

Other studies have tried to evaluate the effects of migration on the labor market that come via labor taxes. They looked at the net contribution of immigrants to fiscal balances in the destination country.

The age structure and the ethnic composition of immigrants are very important in determining the fiscal impact of migration. Family structures differ between natives and immigrants: immigrants have more dependent children who use publicly funded schools and are in general more poor which results in a lower pay of taxes.

The income convergence in a country is mainly determined by the human capital characteristics of the migrants. The migrants move to the most productive region, arbitraging away differences in labor productivity.

There is a wide variation in unemployment rates between countries. When looking at the unemployment rates of the children of natives and children of immigrants there are two types of countries:

1. Countries where there are substantial differences between unemployment rates of native children of immigrant children. The unemployment rate of immigrant children is substantially higher.

2. Countries where the differences in unemployment of the children are small.

Policy

Migration of unskilled workers can lead to wage and income inequality. These things can reduce economic gains of migration and are political unfavorable.

Political restrictions on migration may lead to more illegal and unskilled migration. This strengthens the political position against migrants leading to an even stricter policy. There are two strategies to stop this vicious circle:

1. Closing the welfare door to migrants.

2. Introducing a points system that rewards skilled migration

The concern about migration is growing in Europe. People fear that it will lead to negative fiscal and benefit externalities on the native population. Closing the welfare door to migrants would lead to a reduction in the proportion of unskilled workers in migration inflows.

Closing the welfare door is also used in the political economy. People are concerned about welfare abuse by immigrants and closing the door gives them some confidence in the policy.

However, closing the door is not favorable in countries with very large numbers of immigrants.

The point system is a method to rank applications for residence and work permits. Each application gets a score based on educational attainment, experience and language abilities.

This system is very useful and effective in selecting migrants. The introduction of this system reduces the skill differences between natives and migrants.

The point system could also be used to discriminate against certain countries of origin instead on focusing on skill levels of the migrants.

An important drawback of the point system is that it has a negative effect on growth in the sending country through the brain-drain effect: the assertion that migration tends to strip the sending nation of all its best workers.

High skilled immigrants have access to higher rewards. This enables them to send generous transfers back home, supporting growth in the home country.

Interactions

Migration flows have interactions with the following other labor market institutions:

• Wage compression

Low wage compression attracts high-skilled immigrants

• Income floors

Income floors attract immigrants, especially low-skilled immigrants

• Minimum wage legislation

• Unions

• Family policies

• UBs

Why is employment protection of the workforce important? - Chapter 10

Employment protection legislation (EPL) consists of the norms and procedures to be followed in case of dismissals of redundant workers. It imposes restrictions on the hiring of workers under temporary contracts and on dismissals. It also sets compensations to be paid by former employers to the worker in case of early termination of a contract.

In a firing decision are not only worker and employer involved, but there can also be a third party to assess the legal validity of the layoff.

EPL has two components:

• A transfer: monetary transfer from the employer to the worker. Consists of severance payments and the advance notice period.

• A tax: a payment to a third party, external to the worker-employer relationship. Consists of trial costs and all other costs related to administrative procedures.

Severance payments: a monetary transfer from the firm to the worker to be paid in the case of firm-initiated separation.

Advance notice: a specific period of time to be given to the worker before firing can actually be implemented.

Legal minima: statutory payments and mandatory rules that apply to all employment relationships, regardless of what is established by specific labor contracts. The severance payment and advance notice are a part of these legal minima.

Trial costs: the payments for lawyers and the like.

In most countries there is a separation between individual and collective dismissals. Individual dismissals can be further distinguished between economic and disciplinary dismissals. Disciplinary dismissals do not include a monetary transfer.

Cross-country comparison

In order to do a cross-country comparison one should be able to measure the strictness of EPL.

The OECD uses the following three indicators:

1. Strictness of firing regulation for individual workers under a permanent contract.

2. Strictness of collective dismissals.

3. Regulations to hire workers under temporary contracts.

The weighted average of these three measures provides the overall EPL indicator of a country. There are several remarks about the interpretation of this OECD EPL index:

• It averages several subindicators about employment contracts, temporary contracts and collective dismissals. Therefore, the index can change.

• Changes in the EPL subindicators are not independent of each other. It is best to weight the OECD index for regular workers by the share of workers subjected to regulations.

• One should obtain the two components of EPL, transfer and tax. However, disentangling the tax from the transfer is a difficult task.

There are large cross-country differences in the strictness of the EPL. These differences vary between the main components of the EPL.

In OECD countries in the period 1998-2008, EPL for regular workers almost did not change while the regulation of temporary contracts was eased. The EPL for collective dismissals did also not change much over this period. We can conclude that the overall EPL did not change a lot over the period 1998-2008.

Dual-track reform strategy: includes reforms only at the margin on a flow basis for new hires while the employment security of entitlements of the incumbent workers remained unchanged.

The share of temporary workers differs between European countries. In most countries this share increased over the period 1998-2008 for both men and women.

There is a strong positive relationship between restrictions on layoffs from permanent jobs and the share of temporary workers. There is also a relationship found between the EPL indicator for temporary layoffs and the share of temporary workers. However, this relationship is much less strong.

Theory

The EPL imposes costs in firms because the firm has to adjust the levels of the workforce. Employers could avoid paying severance payments by not changing employment levels after a shock.

EPL has no effect on employment, welfare of workers and profits if the three following conditions are met:

1. Workers are risk-neutral.

2. Wages are flexible; there is no wage floor.

3. EPL consists only of the transfer component, the severance payment. The tax component is zero.

Under these circumstances the net discount value of a job is unchanged. This is because the EPL only affects the intertemporal structure of wages. The severance payment is inserted in the wage contract.

Employers pay a lower wage which forces the workers to buy a sort of bond from the employer. This bond or insurance gives the worker the right to receive a compensation at the time of separation.

The employee receives the same payment in discounted terms from offering labor with or without EPL. Therefore, the worker will be indifferent to the presence of the EPL. This means that the effects of EPL are undone.

Boeri and Jimeno (2005) argue that there is a negative relationship between employment protection and both economic layoff and disciplinary layoff probabilities. The costs of disciplinary dismissals are interrelated with the costs of economic dismissals.

The impact of an EPL on a firm depends on the monitoring technology of the firm. The better the technology, the stronger the impact of EPL on disciplinary versus economic layoffs.

The efficiency wage model is useful for explaining the effects of EPL on wages. We assume that employers have only imperfect information about the effort of their employees the workers can either put in effort, providing them disutility, or shirk and face the probability of being detected and fired.

The flow value of a job for a person who does not shrink is:

ρV_e^N = w – e + δ (V_u – V_e^N)

where w is the wage, e is the effort, δ is the exogenous job separation rate and V_u is the asset value of being unemployed.

For shirkers, the flow value of a job is:

ρV_e^S = w + (δ + Φ)(V_u – V_e^S)

Where Φ is the rate at which shirkers are detected and fired; the probability of a disciplinary layoff. In this model we assume that V_e^S< V_e^N.

If we combine this with the two formulas above we can obtain the efficiency wage:

w^e > ρV_u + e ((Φ + ρ + δ) / Φ)

If workers are risk-averse instead of risk-neutral, they will suffer a welfare loss when EPL is introduced. They will experience fluctuations in their earnings.

Suppose now that condition two of EPL neutrality is not satisfied: wages are rigid instead of flexible. An EPL with fixed wages:

• Has no effect on average employment or unemployment.

• Lowers the volatility of employment over the business cycle.

• Reduces profits

In each period of time, the employment level without EPL is the only level that maximizes profits. Profits are thus always higher without EPL.

Finally, if condition three of EPL neutrality is not satisfied there is a tax instead of a transfer. This EPL tax can be avoided by a firm by not reducing employment levels over time. Thus the EPL tax is included in the employer’s decision to hire another worker. Therefore the EPL tax reduces the creation of jobs.

But an EPL tax also leads to lower job destruction because it is more costly to the firm to lay off workers. So the effects of EPL on employment and unemployment are ambiguous.

An EPL will increase the bargaining power of those people who have a job, insiders, and are more protected from those people who seek for a job, outsiders. This leads to an increase in the equilibrium wage compared to the situation of no EPL.

Insiders are better off with the presence of an EPL tax because it reduces the risk of a job loss.

Boeri and Garibaldi (2006) suggest a two-tier scheme of transitory job creation. Employment is fixed between employment in bad times, L_b, and employment in good times, L_g.

From period T₀ onward the firm can enjoy flexibility; it can hire workers on a temporarily basis. The firm will hire workers up to the level L_g, leading to an employment increase of A to B. In bad times employment will decrease from B to C. In the next cycle, there is an employment increase for C to D followed by a decrease in employment from D to E.

This cycle continues until the stock of permanent workers reaches the level L_b. The firm has built up a buffer of workers with flexible contracts so they can adjust employment to business conditions starting from point T₁.

Empirical evidence

There are many studies that measure the cross-country differences of EPL strictness. A few studies have found a significant effect of employment protection on employment and unemployment stocks. This study shows that EPL negatively affects unemployment inflows and outflows. This is consistent with economic theory.

EPL also affects the composition of employment and unemployment in OECD countries. Stricter EPL leads to higher youth unemployment and lower unemployment among prime-aged groups. This is also consistent with economic theory since young individuals are typically outsiders and prime-aged individuals are typically insiders.

Other studies only examine how EPL affects stocks of employment and unemployment. Some economists found a negative effect of EPL in employment flows while others found a positive effect.

Labor turnover: the sum of hirings and separations.

Job turnover: the sum of job creation and destruction.

Economic theory suggests that the strictness of EPL has a negative effect on labor market flows, labor turnover and job turnover.

Several empirical studies use within-country variation in EPL and policy change. Research in Europe has exploited the exemption of small units from the strictest EPL provisions. Combining this with dual-track strategies makes it possible to carry out difference-in-differences policy studies.

Others base their study on age-specific EPL. When older workers are better protected than younger workers then the changes in EPL can be used to measure the effects of EPL on the labor market. The hiring behavior of a firm is almost not influenced by hiring subsidies, which led to deadweight effects.

Employment protection affects the behavior of those who are protected. Those protected workers may have an incentive to put less effort in their work leading to a reduction in productivity.

Although there is no one-to-one relationship we can still say that reduced absenteeism will lead to an increase in labor productivity. The level of absenteeism increases significantly when employment protection is granted at the end of the probation period of the worker. Researchers also found that EPL has a negative effect on absence rates.

Within-country studies found that EPL has a negative effect on dismissal rates. Another finding was that the presence of thresholds on firm size increases the persistence of the firm.

The role played by the court is also important in the empirical research about the effects of EPL. Judges may find that workers should be more heavily protected against dismissals.

The long-term unemployment has a positive relationship with the number of cases brought before courts, across OECD countries with available EPL data. Whether courts are favorable to employees plays an important role in the worker’s decision whether to bring the case to court or not.

Policy

In general, workers are risk-averse and have no/limited access to capital markets. Employers are instead risk-neutral and have better access to capital markets. A firm can invest in capital markets to insure itself against negative shocks.

Workers cannot adjust via the capital market and therefore it is optimal that the employer provides some insurance to their workers. In this way they can smooth out some income fluctuations. EPL is most commonly used for such insurance. An alternative is UBs.

The provision of such insurance, the EPL, has two effects on wages:

• EPL strengthens the bargaining power of insiders leading to an increase in wages.

• EPL reduces the fallback option of workers leading to a moderate effect on wages.

When workers are completely insured against job loss, then the second effect nog longer exists. Firms that offer full insurance to their workers will be able to recover the insurance through lower wages.

Workers need incentives to withhold them from shirking. They need a penalty associated with the possibility of being fired. Therefore full insurance is not optimal. The optimal level of employment protection provides some, but not full, insurance.

Another important issue of EPL concerns the third part involved. This third party is very unpredictable but sometimes it is unavoidable to involve them. The unavoidable costs to the third party make the costs of layoffs for employers and workers very uncertain. A way to reduce this uncertainty is to restrict the duration of the judicial involvement.

Every country has permanent and temporary contracts. In some dual markets there could be workers that are better protected than other workers in the market. It is often the case that is segmentation in the market; there is small probability to move from a temporary job to a permanent one.

Countries with large differences between temporary and permanent contracts experienced large increases in unemployment during the Great Recession.

To reduce the segmentation single contracts can be introduced in which employment protection increases with tenure.

Interactions

EPL has interactions with the following other labor market institutions:

• UB systems

EPL provides insurance against unemployment risk. The trade-off between EPL and UBs depends on the distribution of skills in the labor force. A large fraction of skilled workers in a country there is often low employment protection and there are high UBs. We expect that EPL becomes less important over time as countries improve the coverage of their UB systems.

• Unions

A stronger influence of the union leads to a reduction in downward wage adjustment and wage differentials across workers in the same firm. Unions and EPL are complementary institutions.

• Retirement programs

Older workers have a strong market position because they are not very likely to lose their jobs. However, when they do lose their jobs it is very difficult to find a new one. This leads to long unemployment. The solution to this long-term unemployment is to increase employment protection.

What are benefits from unemployment? - Chapter 11

Unemployment benefits (UBs) protect individuals against uninsurable labor market risk. UBs offer a replacement income to workers who have lost their job and are now unemployed.

When the first UB system was introduced many people were against the idea of paying people who do not work. UBs consist of several key dimensions:

• Eligibility conditions: the norms determining access to the benefit.

• Entitlement conditions: the rules concerning the duration of the payment.

• The level of payments.

Income replacement systems of people with a recent job loss are often proportional to their past contributions. This is generally channeled through an unemployment insurance (UI) fund that collects compulsory payroll taxes. This UI component of UBs is a transfer that is proportional to the last wage earned and the duration increases with the length of the contribution record.

A worker can also enjoy unemployment assistance. This is often offered at a flat rate and for a maximum duration that depends on the length of the contribution period.

There is also general social assistance. This assistance is offered for an unlimited time and is only given to unemployed individuals who have income and family assets below a certain poverty level.

Cross-country comparison

Unemployment benefits differ across countries in several dimensions. Sometimes people have to wait after the job loss before they are entitled to the benefits. They made a waiting time so that people will have a disincentive to apply for unemployment benefits.

Some countries have a waiting period while others do not. The longest waiting period, of 14 days, can be found in Canada. The maximum duration of UBs also varies widely between countries. In some countries it is even infinite.

The replacement rate: the ratio of the UB to previous earnings.

The replacement rate differs significantly between countries. In countries where there is no relation between UBs and previous earnings, the replacement rate is very low. In countries where the UB is paid as a flat rate, the replacement rate is low, like 10 percent. But there are also countries where we find very high replacement rates of 90 percent.

The net replacement rate: the ratio of the UB to previous earnings at different earnings levels, both measured after taxes.

The net replacement rate tends to be higher than the replacement rate. Several studies look at the effects of previous earnings, family situation, duration of employment and social assistance ‘’top-ups’’ or cash housing benefits on the net replacement rate. Some findings of these studies are:

• Net replacement rates differ when the baseline family changes.

• Previous earnings have a negative effect on the net replacement rate.

• In some countries we obtain a higher net replacement rate for two-earner families while in other countries we obtain a lower rate for those families.

• In almost every country one could see that the absence of children decreases the net replacement rate.

• There could be a relationship between the net replacement rate and the unemployment duration but this is only found in a few countries.

• In some countries social assistance ‘’top-ups’’ or cash housing benefits affect the net replacement rate.

Putting all these components into one dimension is a very difficult task. Because of the great differences in net replacement rates it is very hard to make cross-country comparisons about UBs.

The OECD makes a summary measure of benefit generosity. This is the average of the replacement rates in the first five years of unemployment for an average worker.

In this summary is assumed that the average length of unemployment is shorter than 2 years and that after 4 years jobless people loss the attachment to the labor market. A drawback of this summary is that it neglects the eligibility and entitlement conditions.

The coverage of UBs: the fraction of unemployed workers receiving the benefits.

One should keep in mind that replacement rates and coverage rates of UBs are not independent of each other. There is a positive correlation between generous benefits and the benefit take up. A more generous benefit encourages more people to apply for UBs.

There is a negative correlation between replacement rates and benefit overage. In many middle-income countries UBs offer a relatively high nominal replacement rate but only for a short time and for only a small part of the workforce.

UBs are multidimensional institutions and therefore one should always use a variety of measures to characterize UBs. UBs can be reformed along various dimensions.

Theory

In competitive labor markets, UBs affect market outcomes through two main channels:

1. Participation effect: UBs increase the (static) reservation wage of individuals, inducing more people not to support labor at any given market wage.

2. Taxation effect: UBs affect labor market outcomes through the increased taxation, generally payroll taxes, required to finance UBs.

The generosity of UBs needs to be financed and this is often done through statutory payroll contributions. More generous UBs go on line with an increase in proportional taxation of earnings. If UBs are funded through taxation then the UB systems are more progressive.

Suppose that nonlabor income of an individual is equal to m. As long as m is positive, this will lead to a kink in the budget constraint of the individual. At zero hours of work, the individual will get m. The welfare of the individual is maximized where the budged constraint is tangent to indifference curve. The static reservation wage is equal to the slope of this indifference curve.

Suppose now that a UB b is introduced. This increases nonlabor income to m + b. In the presence of UBs the reservation wage is given by:

U (m + b, l₀) = U (m + w^r h_B, l₀ – h_B)

Where h is the hours of work, and l the level of leisure. The larger b, the stronger will be the increase of the reservation wage after the introduction of the UB system. The reservation wage increases when UBs are introduced.

The increase of the nonlabor income resulting from the introduction of the UB leads to the fact that the individual can attain a higher indifference curve than without the UB. The value of the nonparticipation option has increased.

If w < w^r, the marginal value of leisure exceeds the opportunity costs. The individual is then better off when it does not work at all. For the individual to supply labor the hourly wage has to increase.

There will be differences in reservation wages among individuals as long as workers have different preferences for leisure and work. When the market wage increases there are more people of working age willing to supply labor.

The labor market equilibrium with UBs has a higher wage and lower employment than the wedge-free equilibrium without UBs. In this system UBs reduce the size of the labor market but does not lead to unemployment.

In imperfect labor markets with imperfections UBs affect labor market outcomes through three main channels:

• The job search effect: UBs increase the reservation wage of recipients leading to workers who are choosier about job offers. This results in workers reducing their search intensity and thus increase the duration of their unemployment. In this longer process they will find a better job. Longer search leads to a higher quality of the job.

• The wage effect: UBs improve the fall back option of the workers. It puts a higher wage floor and increases wage claims.

• The entitlement effect: UBs lead to more people participating in the labor market. This increases the value of employment and unemployment over the value of inactivity.

Another effect that is present in an imperfect labor market is the taxation effect that is also present in competitive markets.

To characterize the effects of UBs we use the framework provided by the job search theory. This theory focuses on the time and costs involved in looking for a job. The individual searches in the market and does not need to accept the first offer. He can choose how many effort he wants to put in the job search.

A person who decides not to search at all is called inactive. The ones that are actively searching are the unemployed. During the search the individuals earn a UB. An increase in generosity of UBs increases the reservation wage and reduces the search intensity. This is because the opportunity costs of having a job increase.

Besides workers, also employers are searching. They post vacancies to find a match with a jobseeker. The search of the employer is costly. At a given time the job is destroyed. The job search is easier when there are more vacancies. Similar, it is easier to fill a vacancy when there are more unemployed workers seeking for a job.

The job search involves some costs and is time consuming. When a vacancy is filled this generates positive rents for the employer and the worker involved. The rents are split between the worker and employer. The wage will increase with the fall back option of workers and thus with the unemployment income and the job-finding probability for any given level of search intensity.

UBs thus increase the equilibrium wage via the Nash bargaining rule. The stronger the effect of the UB on the fall back option, the stronger the effect on the equilibrium wage.

UBs are financed through payroll taxes and therefore the tax fund must be equal to the UB multiplied by the total number of unemployed people divided by the total wage bill:

t = bU / wL

One can also detect a relationship between UBs and efficiency wages. The efficiency wage is equal to:

w^e> ρV_u + e ((Φ + ρ + δ) / Φ)

where ρ is the discount rate, e is the effort, Φ is the rate at which shirkers are detected and fired, δ is the exogenous job separation rate and V_uis the asset value of being unemployed.

If the job-finding rate, μ, is constant and V_e is the asset value of being employed, then the flow value of unemployment is given by:

ρV_u = b + μ (V_e – V_u)

In the equilibrium inflows into unemployment are equal to outflows from unemployment:

μU = δL

The costs of effort are equal to the expected cost of shirking. This is shown in the following equation:

e = Φ (V_e – V_u)

With all this information we can rewrite the equation for the efficiency wage into:

w^e > b + e ((Φ + ρ + δ/u) / Φ)

So the efficiency wage increases with the level of UBs and decreases with the unemployment rate. A higher unemployment wage makes the loss of a job more costly and therefore encourages workers to shirk. UBs decrease the penalty of being detected shirking.

When an individual decides not to participate in the labor market then he is inactive. UBs are only given to people that are seeking for a job. This encourages inactive individuals to move to unemployment, increasing the labor force participation. Thus UBs may increase the labor force participation.

Sometimes UBs are only offered at people with previous work experience. This divides the unemployed into two groups:

• First-time job seekers

• Job seekers with previous experience

The first group will not receive UBs while the second group does receive the UBs. The first group will increase their search intensity after the introduction of UBs. This is because the value of holding a job has increased. The second group however, will decrease their search intensity after the introduction of UBs.

Empirical evidence

There are many studies on the relationship between UB generosity and the level of unemployment. Cross-country data on OECD countries shows that a higher UB replacement rate and longer benefit durations are related to higher unemployment rates.

Some estimates are that a 10 percent increase in the replacement rate corresponds to a 1.7 percent increase in the unemployment rate. A common finding that is found in almost all studies is a sharp increase in the exit rate close to benefit expiration.

Some studies of Europe and the United States have detected that policy changes affect the benefit levels. These studies examine how UI recipients react to incentives using a quasi-experimental identification of the treatment effect. A control group and a treatment group are just for these studies. The difference-in-differences gives the treatment effect of the policy change.

Card and Levine (2000) examine the UI benefits in the state New Jersey. They found that 13 weeks of extra benefits would raise the average duration of regular UI claims by about 1 week. Carling et al. (2001) found that a cut in UI benefits increased the outflow from unemployment.

Studies show that a change in policy regarding UI benefits affects various unemployed workers in different ways. Some groups of workers experience an increase in the replacement rate while others experience an extension of the PBD. In other groups one found a combination of those two effects.

The main conclusion of all these studies on UI benefits is that there are substantial effects on unemployment duration if the replacement rate or the PBD changes. The magnitude of these effects differs across countries.

One note is that it is important to know whether one of the two main components of the benefit system, benefit level and benefit duration, matters more than the other. This should be kept in mind when examining the effect of UI on unemployed workers.

Findings suggest that the change in benefit duration has a stronger effect than changes in benefit levels. This means that benefit duration is a more effective tool to examine influences.

The effects of UBs on post-unemployment outcomes are mixed. Some old studies argue that there is a positive but weak effect. But there are several other studies that found no effects at all.

Most recent studies found that more generous UI hardly increases re-employment wages. However, evidence of the effect of UI on employment duration is mixed.

Thus evidence of a relationship between UI and post-unemployment is very weak according to many studies. But these studies do point out evidence of a relationship between replacement rates and PBD affecting the job-finding rate.

Policy

The effect of UI may depend on the business cycle. During a recession UI effects will become lower while during booms the effects will be higher.

During a recession unemployment duration is longer, which may call for more generous benefits. In the U.S. they have a system that provides longer UI durations during recessions. This system of cyclical variations in UI generosity is not often seen in OECD countries.

The study of Kroft and Notowidigdo (2010), shows that in the United States the elasticity of unemployment duration with respect to UI levels varies with the unemployment rate. They detected a positive correlation between the duration elasticity and the unemployment rate.

During a recession, the extension of UI duration can improve the welfare of the country. There are several studies that try to determine the optimal UI over the business cycle.

One can distinguish between two sources of unemployment:

1. Unemployment that stems from matching frictions (in booms)

2. Unemployment that stems from job rationing (in recessions)

Cyclically adjusted UBs are favorable because moral hazard is not really an issue in a recession compared to a boom. More generous benefits would not harm the functioning of the labor market.

However, an argument against a cyclically UB is that more generous UBs encourage more people to enter unemployment during recessions.

When there are more generous benefits workers will be longer unemployed. This may be due to moral hazard or due to liquidity constraints. The liquidity constraint arises when imperfect credit and insurance markets prevent individuals from smoothing consumption. A UB can correct for the market imperfection in this case.

Chetty (2008), studied the effects of liquidity constraints. He found that 60 percent of the increase in unemployment durations caused by UI is a result of the liquidity effect.

He found two pieces of evidence for this:

1. Increases in benefits have a much larger effect on the duration of liquidity-constrained households than for unconstrained households.

2. Lump-sum severance payments increase durations substantially among constrained households.

Card et al. (2007a) used many more observations than Chetty (2008). They found that the lump-sum severance payment has a significant effect on the duration of joblessness. A large part of the behavior resulting from longer UBs is explained by the liquidity effect rather than the moral hazard.

Interactions

UBs interact with several other labor market institutions. Some of these are:

• Collective bargaining institutions

• Active labor market policies

• Taxes on labor

• Employment protection

• ALMPs

We will take a closer look the employment protection. UBs and employment protection are similar labor market institutions. They protect the workers against labor market risk.

There are two key differences between EPL and UBs:

1. EPL protects only individuals who already have a job while UBs protect the working-age population at large.

2. EPL does not impose any tax burden on workers while UBs are financed by a payroll tax levied on the individuals who have jobs.

Unemployed individuals prefer UBs over EPL while employees would prefer EPL over UBs. UBs and EPL are imperfect substitutes and therefore it is unlikely that we see a country with only one of the institutions.

It is useful to have both institutions in a country because of the moral hazard problem; neither UBs nor EPL can give full insurance against job loss. Providing both institutions leads to a better insurance against job loss.

Active labor market policies - Chapter 12

Active labor market policies (ALMPs) have been present in many countries for many years. ALMPs in OECD countries aim at improving the functioning of the labor market by enhancing the labor market mobility and adjustment. They facilitate the redeployment of workers and their investment in human capital. ALMPs are used to overcome the market failures of UBs.

There are four main types of ALMPs:

1. Labor market training: training for unemployed adults, those at risk of losing their jobs, and employed adults.

2. Subsidized employment: targeted measures to promote or provide employment for the unemployed and other priority groups.

3. Public employment services: placement, counseling and vocational guidance, job search courses and administration of UBs.

4. Activation: provides incentives for the unemployed to increase job finding either directly through benefit sanctions or through mandatory participation in training or subsidized employment.

If unemployed workers are unwilling to participate in activation programs then they may lose their benefits temporarily or permanently. Some activation programs are workfare: they do not deliver further services except keeping the unemployed busy. Workfare makes it possible to distinguish between voluntarily and involuntarily unemployed individuals.

In other words, workfare allows the administration to enforce a work test: a test that assesses the actual willingness to work of an individual.

Most activation programs of OECD countries do not use workfare; all programs are intended to function as employment services. ALMPs promote individuals to search actively for a job.

Cross-country comparison

Often ALMPs are expensive. To determine the level of ALMPs in a country, two measures can be used:

1. The number of workers participating in ALMPs as a share of the labor force.

2. The amount of money spent on ALMPs as a percentage of GDP.

The cross-country differences of both these measures are large. One can also detect a great difference between cross-country expenditures in subsidized jobs.

Some studies of ALMPs also study sanction rates. These rates refer to behavior during benefit periods. The rates range from very low to quite large in OECD countries. There are two reasons why sanction rates of a country may be low:

• It can be that sanctions are seldom imposed because the system is lax and not credible.

• Low sanction rates can be a result of a reaction by workers to comply with the search guidelines.

Theory

The effect AMPLs may have on the labor market is illustrated in the next graph. The graph shows a Beveridge curve that shows the empirical relationship between unemployment rates and vacancy rates.

The unemployment-vacancy combination moves up and down the curve BC₁ during cyclical fluctuations. At a specific time point there is a combination in the labor market of unemployment rate u₁ and vacancy rate v_1.

The introduction of ALMPs shifts the Beveridge curve inward to BC₂. When this is the case, conditional on the vacancy rate v₁, the unemployment rate will fall from u₁ to u₂.

There is a mismatch between vacancies and the unemployed leading to an inverse relationship between unemployment rates and vacancy rates.

Through the process vacancies are filled and unemployed workers find jobs. This process is described in an aggregate matching function:

m = A (U)^1-α V^α

Where m is the number of matches per time period, U is the number of unemployed workers, V is the number of vacancies and A represents the efficiency of the matching process. α is usually assumed to be 0.5.

If the stock of unemployed or the stock of vacancies is zero the m=0. Unemployment outflows increase with U and V, although at a decreasing rate.

Boone and van Ours (2009) show that there is a relation between UBs and training. Training would be more effective if UBs are more generous and would lead to a reduction in unemployment.

They also found a relationship between benefit sanctions and unemployment duration.

The benefit sanctions affect unemployment duration through two channels:

1. Ex post effect: an actual reduction in benefits stimulates the search efforts of a worker.

2. Ex ante effect: the risk of being sanctioned influences the search behavior of unemployed workers who have not been sanctioned.

Empirical evidence

Many studies investigate the relationship between unemployment and vacancies, and outflows from unemployment. This relationship underpins the Beveridge curve. The literature of these studies confirms that the stock of unemployment and vacancies is positively related to the outflow from unemployment.

Boeri and Burda (1996) found that the efficiency of the matching process depends on the scale of ALMPs. However, it is very difficult to draw efficiency conclusions from shifts in the Beveridge curve.

There are four indirect effects of ALMPs:

1. Displacement effects: jobs created by one program can replace other jobs.

2. Deadweight effects: labor market programs subsidize hiring what would have occurred anyway in absence of the program.

3. Substitution effect: jobs created for a certain category of workers replace jobs for other categories as relative wages change.

4. Fiscal substitution effect: there are taxes required to finance the programs.

There are reforms that are improving the effectiveness of formal job intermediation. These reforms increase the premium of formal versus personal job-finding channels. In some countries wage premiums are obtained via formal channels while in other countries penalties are displayed.

There are many experiments in the area of ALMPs. The problem with these experiments is that their validity is uncertain. One does not know whether the conclusions hold in general or only in the experiment. However, these experiments do highlight some issues that are useful in understanding how ALMPs work.

An issue that is highlighted is the effects of intensive counseling and monitoring. The experiment used a treatment and a control group. In the treatment group unemployed workers were exposed to more intensive counseling and monitoring than the ones in the other, control, group.

The result of this experiment was that intensive counseling and monitoring stimulated unemployed workers to make more applications for jobs. This led to an increase of the job-finding rate.

Other studies investigated the effect of compulsory interviews every six months for unemployed workers. Unemployed people were randomly placed in the control or treatment group. People in the control group received benefits but did not have to participate and interview. In the treatment group, benefits reduced if the unemployed did not attend the interview.

Exits to a job were significantly different for the treatment and control group. The introduction of the compulsory interviews reduced male employment with 6 percentage points after 5 years.

Profiling: involvement in employment and training services of claimants with long predicted unemployment spells or high predicted probabilities of UB exhaustion at relatively early stages of their unemployment spells.

Profiling is effective for specific groups of workers, like women re-entering the labor force.

Van den Berg and van der Klauw (2006) distinguish between two types of job search:

1. Formal job search: this is conducted through personnel advertisements and public employment offices.

2. Informal job search: direct contacts with employers and search through friends, relatives or employed workers.

According to them, counseling and monitoring only affects the formal job search. Monitoring leads less informal job search because it is substituted by formal job search. This reduces the effectiveness of monitoring.

The conclusion of their research was that counseling and monitoring did not improve the effectives of the job search. Unemployed individuals participating in counseling and monitoring do not find a job more quickly.

They did find a relationship between counseling and monitoring, and the type of research. Unemployed individuals who participated in counseling and monitoring shifted their search from informal to formal channels.

Graven and Ours (2008) show with their studies that mandatory programs help unemployed workers to find a job more quickly.

There are also studies that do not rely on experiments. Such studies are nonexperimental studies and are based on cross-country comparisons. Nonexperimental evaluations are not necessarily biased over experimental studies.

The most recent evaluation studies are not very optimistic about the benefits of ALMPs. These studies argue that ALMPs have at most a modest impact on the prospects of labor market participants.

Martin and Grubb (2001) did research about whether ALMPs work in OECD countries. They concluded that subsidies to employment and direct job creation have not been effective in helping the unemployed to get permanent jobs.

Studies based on micro data conclude that the effects of ALMPs on job-finding are small. A drawback of ALMPs is that unemployed workers reduce their job search effort. This is called the locking-in effect.

Another conclusion from micro studies is that activation measures are more effective than training programs or employment subsidies.

According to the UB law in the Netherlands, an unemployed worker has three obligations that must be met to be entitled to UBs:

1. The worker has to prevent unnecessary job loss.

2. The worker has to take actions to prevent staying unemployed.

3. The worker has to keep the administrative organization informed about everything that is relevant to the payment of the UB.

Related to these three obligations are four categories of infringements:

1. Blameworthy unemployment after dismissal.

2. Lack of effort to find a job.

3. Administrative infringements (searching too late)

4. Other infringements (fraud, inaccurate information)

The imposition of a sanction will lead to a significantly higher re-employment rate. A benefit sanction raises the job-finding rate.

Policy

OECD jobs study of 1994 recommended that governments should strengthen the emphasis on ALMPs and improve their effectiveness.

This study also stated that there is enough evidence that ALMPs can reduce unemployment by improving the efficiency of the job-matching process.

Most employment services are provided by government agencies but sometimes they are also provided by private employment services.

The OECD argues that to implement a quasi-market, public employment services have to separate the public authority and multiple employment service providers.

Local employment service providers can choose which strategy they want to use to bring unemployed individuals back to work. Strategies will persist through the idea of the survival of the fittest. Only successful strategies will persist, even if one cannot identify why the strategy is successful.

Profiling is an important issue in local employment service providers. To reallocate resource optimally, unemployed individuals with longer expected durations of benefit receipt should receive more or different employment service.

Activation policies set requirements and put obligations on the recipients of UBs. They obligate them to attend interviews with employment counselors, search actively for a job and accept job offers.

The difference between activation policies and public employment service providers is that with activation policies participation is compulsory to remain entitled to UBs. Activation policies make collecting benefits less attractive for unemployed workers.

Overall, there is strong evidence in favor of activation programs.

Interactions

ALMPs are used to help unemployed or inactive people with trainings to get a job. ALMPs have strong interactions with the following other labor market institutions:

• Payroll taxes

• UBs

• In-work benefits

ALMPs reduce moral hazard associated with UBs. By reducing the efficiency costs of UI the trade-off between insurance and unemployment duration improves.

The expenditure on ALMPs as a fraction of GDP and the summary measure of UB generosity are positively correlated across countries.

UBs lead to disincentives for unemployed workers to search for a job. This leads in a number of traps:

• The unemployment trap: benefits paid to unemployed workers are high relative to net income from work. This discourages job search.

• The inactivity trap: concerns the people that are inactive and do not receive UBs.

• The poverty trap or low-wage trap: UBs discourages those already in low-paid work from increasing working hours or moving into higher paid employment.

When and why are payroll taxes applied? - Chapter 13

Payroll taxes are levied on the wage bill and consist of two things:

• Income taxes

• Security contributions

The income taxes are levied on both labor and nonlabor income.

Payroll taxes create a wedge between the cost of labor to the firm and the net wage of the worker. It reduces the size of the labor market. The tax makes workers supply less hours of work and employers will create fewer jobs.

Many labor market institutions are financed by payroll taxes; STW, retirement plans, education, UBs and ALMPs.

Cross-country comparison

Payroll taxes are usually levied as a percentage of the gross wage, called the tax rate.

The average tax rate: the total tax paid divided by the total amount the tax is levied on.

The marginal tax rate: the percentage tax paid on the next amount of money earned. The marginal effective tax rate may differ from the marginal tax rate.

In a progressive tax system: the average tax rate increases with income. In this system the marginal tax rate is higher than the average tax rate.

To be eligible for social programs one has to pass an income and asset test. Tax systems are very complex and therefore tax levels are often calculated in many different situations to get a good view of them.

There is a great cross-country difference in the overall tax burden. Also average payroll taxes range widely across countries. We find countries with very low, New Zealand, and with very high, Germany, payroll taxes.

Social security contributions are relatively large in most countries. The cross-country differences in social security contributions are mainly due to differences in private pension arrangements.

Also the marginal tax rate differs greatly among countries. We find a very low rate of 18.7 percent in Mexico and a very high rate of 66.3 percent in Belgium. The marginal tax rate is in almost every country higher than the average tax rate. However, the magnitude of this difference differs between countries.

Sometimes one uses value-added taxes (VATs) in the calculation of the overall tax burden. VATs also differ greatly across countries.

Households with children and a single parent or just one earner have a lower family tax wedge than single workers. Households with children and two earners often benefit from small tax concessions compared to single individuals without children.

In a family with children and two unemployed parents the disincentives for one of them to accept a job are quite substantial. If one of the parents already has a job than the disincentives for the other parent to search for a job are smaller.

In households with one working person and one unemployed it is more attractive to let the nonworking partner move into employment than letting the working person work more hours. This is the case in almost all countries except Denmark, Japan and the Netherlands.

Theory

Theory suggests that the structure of the tax system is more important than the level of the taxes in affecting labor market outcomes. We will start with analyzing the effects in a perfect labor market.

The budget constraint of the individual is nonlinear; it is a line composed of different segments of a line. The taxes affect the decision about how many hours to work. The graph below shows a typical progressive tax system in which individuals are not taxed below the level y₀.

Above that level income is taxed at τ₀ and above y₁ income is taxed at τ₁. The budget constrain consists of three lines and can be described as:

wh if h < h₀

wh₀ + w (1 - τ₀) (h – h₀) if h₀ < h < h₁

wh₀ + w (1 - τ₀) (h – h₀) + w (1 – τ₁) (h – h₁) if h > h₁

A purely proportional tax system may induce an individual with stronger preferences for leisure to work less than in the progressive tax system.

A progressive tax system affects the intensive margin more than the extensive margin. The tax can be reduced by reducing the working hours.

In the presence of a minimum guaranteed income scheme (MGI), the budget constraint contains a flat segment. An MGI is a scheme topping up income to guarantee to individuals at least a given subsistence level of income. Suppose that this level of income is y_min.

The income cannot fall below y_min so the budget constraint will be a flat line from that point onwards. The optimal allocation will shift from point A to point B.

Taxes generally lead to lower participation. Payroll taxes may not only affect labor supply but also labor demand. The tax burden depends on the elasticities of labor supply and demand.

The payroll taxes in a competitive labor market are shown by the graph below. The equilibrium is found where supply and demand are equal leading to the combination of wage and employment; w₀, L_0, point A.

When a tax is introduced employment declines to L₁. The wage costs for the firm are equal to w^d and the net wages to workers are equal to w^s.

The tax wedge is equal to w^d – w^s. The part paid by the employer is w^d – w⁰ and the part paid by the worker is w⁰ – w^s.

The steeper the supply curve of labor, the higher the tax share paid by the workers. The steeper the demand curve of labor, the higher the tax share paid by the firm.

The after tax equilibrium is inefficient because employment is not at the level that maximizes total gains from labor services trade. The deadweight loss is equal to the triangle ABC.

We will now discuss the effect of a tax in an imperfect labor market. The effect depends on the relationship between the tax and UBs. Suppose that UBs are indexed to net wages.

A higher proportional payroll tax implies an equivalent reduction in the reservation wage for job seekers and of the actual wage. Both wages are reduced by the same amount and therefore the labor supply curve will not change. This means that there is no effect on employment and unemployment.

Now we will look at a change of the structure of the tax system. This does affect unemployment. A revenue neutral increase in the progressiveness of the tax system increases employment and reduces unemployment.

The increased labor supply reduces wages and this leads to an increase in labor demand. Progressive taxes affect the sharing of the total rent split between workers and employers.

When no UBs are indexed into net wages then also a proportional tax will affect the employment and unemployment.

The effect of the tax on employment and the wage depends on the slope of the wage-setting function. If this function is flat, a tax leads to a large reduction in employment. If the function is relatively steep than employment will not change much.

An increase in taxes will shift the demand curve inwards leading to a decrease in employment and wages.

If wage bargaining is organized by unions then a tax affects the wage platform of the unions. Progressive taxation leads to lower unemployment while regressive taxation leads to higher unemployment.

The effect of tax structure changes on employment depends on the nature of the labor market. The structure is irrelevant in a competitive market or in an efficiency model of wage setting. In such models the only thing that matters is the level of the taxes. However, in a labor market with imperfections the structure of taxes is very important.

Empirical evidence

Many literatures have studied the behavioral responses to taxes and transfers. These studies found that the tax rate does not really affect the labor supply of men but it does affect the labor supply of women. The labor supply of women increases significantly when net wages increase.

Eissa (1995) found that the labor supply of high-income married women is affected by a tax reform. This labor supply increases when the tax rates decreased.

There are several studies that found evidence of a relationship between tax reductions and the participation of single parents.

Gruber (1997) examines the incidence of payroll taxation. A reduction in costs of payroll taxation of the firm was fully induced on workers in the form of higher wages.

Disney (2000) concluded from his research that the labor supply of regular full-time workers is probably inelastic to changes in the tax. He found four groups that are affected by high tax rates:

1. Those with high-income work

2. Those with low-income work, eligible for in-work benefits

3. Those nearing retirement

4. Those considering the labor force

High tax rate have led to workers to retire early. For young prospective workers the high marginal tax rate is discouraging them to work. This problem is solved by in-work benefits.

Policy

A tax system makes the incentives for low-income unemployed workers to find jobs lower. Policies try to make working pay off.

In a means-tested welfare system individuals without income receive an MGI. The MGI is reduced when the individual starts making money. Individuals are only willing to enter the labor market if they can earn at least the amount of the MGI.

Earning disregards are often allowed to reduce the disincentive effects of an MGI. Benefits are withdrawn only as a percentage of the increase in earned income to preserve financial incentives to work.

In-work benefits are only paid to those people who work. In-work benefits are used to reduce the poverty of working people. The benefits depend on the gross income of the worker.

In the phase-in region OA benefits increase to the maximum amount D. At the flat region AB in-work benefits are constant. In the phase-out region BC the benefits are slowly reduced.

In-work benefits increase the incentives to work. Studies show that long-term subsidies have a positive effect on employment rates. However, temporary wage subsidies do not have a permanent effect.

In almost every country we find some sort of in-work benefits. The first in-work benefit scheme was the Earned Income Tax credit (EITC) introduced in the United States in 1975.

The benefit levels between countries vary widely. There are also large differences in entitlement criteria. In some countries only people who experience long-term employment are entitled while in other countries all workers who find a job are entitled.

In-work benefits may reduce the incentive to work in the phase-region. When income increases the in-work benefits will decline. So in-work benefits do push a person to find a job but it reduces the incentive to work longer, thus earn more.

An MGI scheme and an in-work benefit schema can be combined if there are enough resources available to fund them. If the behavioral response is along the extensive margin of labor supply, then an in-work benefit scheme is the optimal program. If the response is along the intensive margin, then a MGI scheme is the optimal program.

Tax credits are sometimes provided to firms to hire a specific category of workers. When the labor costs of a specific type of workers are reduced then the employer will hire more of these workers.

Some governments provide wage subsidies to employees with very low wages or employment subsidies to employers. These subsidies increase the employment level. There are several studies that have evidence for this relation.

Some tax and benefit systems are based on individual incomes. This raises concerns regarding the family income of those receiving the tax credit. Income targeted tax credits are better but they may discourage other family members to work.

If the tax credit is targeted on individual income then there is no problem of a decreased incentive of the other family members to work. But a drawback from this is that part of the benefits will go to high-income families.

Interactions

Payroll taxes interact with the following other labor market institutions:

• Education

• Retirement programs

High tax rates induce workers to retire early.

• UBs

There is positive relationship between the total tax wedge on labor and the coverage of UBs.

• Minimum wages

The minimum wage prevents the tax credit from being entirely transferred to the employer.

• Unions

Union bargaining affects the structure of taxation and the incidence of payroll taxation

• ALMPs

Taxes change the incentives of unemployed workers to search for jobs.