Insider Power and Average Labor Demand When Recessions Are Prolonged

This paper examines how insider power in wage negotiations affects average labor demand when recessions are more persistent than booms. It shows that the effect of insider power on average labor demand is more contractionary the greater is the persistence of troughs relative to booms. This analysis is a contribution to the discussion of why the existence of dual labor markets (in which insider power is strong) is negative for employment in the current situation of more prolonged troughs. 1. Introduction The existence of dual labor markets has been pointed out as one of the main problems of some European countries with high unemployment levels. The dual labor market is defined as the division of the workforce into “insiders” and “outsiders,” where insiders are incumbent workers that enjoy protected jobs, so that they receive severance payments in case of dismissal and that can use this power in wage negotiation, while outsiders are both temporary workers and unemployed people (see Lindbeck and Snower [1] for the seminal contribution to this literature). Some authors consider that this kind of divide is especially negative for employment when the economy is suffering a recession (see Bentolila et al. [2, 3]). This paper contributes to the discussion of why the insider/outsider divide is more harmful for employment when recessions are prolonged. In particular, it focuses on the power of insiders to obtain higher wages and on how this affects average labor demand. For this purpose, I use a model in a dynamic stochastic framework with recessions and recoveries. If the economy is in a boom, firms may be experiencing an increase in the demand for its product, so they have an incentive to hire new workers. In the model, new workers (called “entrants”) have no employment protection (i.e., they are not permanent workers) and, after a given period, they may either be fired or transformed into insiders. (I use the term “entrants” as appears in Lindbeck and Snower [1].) When the firm hires the “entrants,” these newly recruited workers receive their reservation wage, that is, the wage at which the present value of their expected utility is equal to the present value of an unemployed person’s expected utility. This implies that a future expected higher insider wage may be compensated for in the current entrant wage. Some authors consider that this behavior makes insider power in wage determination neutral for employment (see, e.g., Bertola [4], Fehr and Kirchsteiger [5], Frank and Malcomson [6], Gottfries and Sj？str？m [7], and Lazear [8]). It is true that firms