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7.7.2 Real wage rigidity

Economists have been much better at explaining the consequences of nominal

wage rigidity than they have at providing a generally acceptable

theoretical explanation of the causes of such inertia. Nominal rigidities

allow fluctuations of aggregate demand to have real effects and contribute

to a non-market-clearing explanation of business cycles. However, Keynesian

economists are also concerned to explain the persistently high levels of

unemployment that have been a major feature of the labour markets of the

major industrial countries since the early 1970s and particularly in Europe

during the 1980s (see Table 1.4). In new classical monetary and real business

cycle models all agents are price takers. Perfect and instantaneous

price and wage flexibility ensures that the labour market always clears at a

Walrasian market-clearing real wage. In a new Keynesian world, where

price makers predominate, an equilibrium real wage can emerge which

differs from the market-clearing real wage. Stiglitz (1987) defines a market

equilibrium as ‘a state where no agents have an incentive to change their

behaviour’ and in new Keynesian models of real wage rigidity equilibrium

may not be characterized by market clearing; that is, demand equals supply.

Models involving real wage rigidity are capable of generating involuntary

unemployment in long-run equilibrium, in contrast to new classical models

where, with everyone on their labour supply function, unemployment in

equilibrium is a voluntary phenomenon. Whereas Lucas (1978a) argues for

the abandonment of the idea that a large part of unemployment is involuntary,

Solow (1980) believes that ‘what looks like involuntary unemployment

is involuntary unemployment’ (see also Hahn, 1987; Blinder, 1988a).

New Keynesian explanations of real wage rigidity fall into three main

groups: (i) implicit contract theories; (ii) efficiency wage theories; and (iii)

insider–outsider theories. Since new Keynesian theorists have been mainly

associated with the second and third of these, we will provide only a brief

comment on implicit contract theory. The reader should consult Rosen (1985)

and Timbrell (1989), who provide comprehensive surveys of the implicit

contract literature. It should also be noted that Phelps (1990, 1994) treats

theories of real wage rigidity as a separate category from new Keynesian

theory, belonging instead to what he calls the ‘Structuralist school’.

Implicit contract models The original implicit (non-union) contract models

were provided by Bailey (1974), D.F. Gordon (1974) and Azariadis (1975).

Following the development of the natural rate hypothesis (Friedman, 1968a;

Phelps, 1968), economists devoted more attention to modelling labour market

behaviour as the outcome of maximizing behaviour. The main contribution

of the ‘new’ microeconomics literature (Phelps et al., 1970) was to explain

why the natural rate of unemployment was positive. However, there appears

to be much less turnover in the labour market than search theory implies.

Furthermore, wages frequently diverge from marginal productivities. Implicit

contract theory seeks to understand what it is that forms the ‘economic glue’

that keeps workers and firms together in long-term relationships since such

arrangements, rather than the Walrasian auctioneer, dominate the labour market.

Because firms seek to maintain the loyalty of their workforce they find it

necessary to enter into unwritten (implicit) understandings with their workers.

This ‘invisible handshake’ provides each worker with assurances

concerning the terms of the working relationship under a variety of working

circumstances. The models of Bailey, Gordon and Azariadis examine the

consequences of optimal labour contracts established between risk-neutral

firms and risk-averse workers. In these circumstances the wage rate not only

represents payment for labour services but also serves as an insurance against

the risk of variable income in the face of shocks. A constant real wage

smooths the individual worker’s consumption stream and firms provide this

‘insurance’ since they are in a better position than workers to weather economic

fluctuations, given their better access to capital and insurance markets.

Because firms provide stable wages over time, workers, for their part, accept

a real wage which is lower on average than the highly varying rates that

would be dictated by market forces.

A major problem with this approach is that it predicts work sharing

rather than lay-offs when the economic climate deteriorates. The theory

also fails to explain why the firm does not pay lower wages to new recruits.

In attempting to remedy these and other weaknesses of this explanation of

real wage rigidity, new Keynesian economists have developed efficiency

wage and insider–outsider models of wage inertia (see Manning, 1995).

Efficiency wage models Any acceptable account of involuntary unemployment

must explain why unemployed workers are unable to bid down wages to

a level that will generate full employment. Efficiency wage theories suggest

that it is not in a firm’s interest to lower real wages because the productivity

(effort or efficiency) of workers is not independent of the wage, rather real

wages and worker effort are interdependent, at least over some meaningful

range. Efficiency wage theory, described by Gordon (1990) as the ‘rage of the

80s’, is surveyed by Yellen (1984), Akerlof and Yellen (1986), Katz (1986,

1988), Haley (1990), and Weiss (1991); see also Akerlof (1979, 2002), and

Stiglitz (2002).

Solow (1979) provides the basic structure of efficiency wage models. In

Solow’s model, wage stickiness is in the employer’s interest because wage

cutting would lower productivity and raise costs. Because the wage enters a

firm’s short-run production function in a labour-augmenting way, a costminimizing

firm will favour real wage rigidity. This can be demonstrated as

follows (see Yellen, 1984; Katz, 1988). Assume an economy with identical

perfectly competitive firms, each of which has a production function of the

form shown in equation (7.10):

Q AF[e(w)L], e(w) 0 (7.10)

Here Q is the firm’s output, A represents a productivity shift factor, e is effort

per worker, w is the real wage and L is the labour input. Effort is assumed to

be an increasing function of the real wage and all workers are assumed to be

identical. The firm aims to maximize its profits (), which are given by

equation (7.11):

AF[e(w)L]−wL (7.11)

Since effort enters the profit equation as e(w), a cut in the real wage below

that which generates maximum worker effort will lower the firm’s profits. If

the firm can hire all the labour it desires at the wage it offers, it will maximize

its profits by offering an efficiency wage of w* which satisfies two conditions.

The first condition is that the elasticity of effort with respect to the wage is

unity. Restated, this means that the firm should set a wage which will minimize

labour costs per efficiency unit of labour. This is illustrated in Figure

7.5. In panel (a) the effort curve indicated by E shows the relationship

between the effort of workers and the real wage. The higher the real wage,

the greater the effort of workers. Initially there is a region of increasing

returns where increases in the real wage rate elicit a more than proportionate

increase in worker effort (productivity). Effort per pound (dollar) of real

wage is measured by e/w. This ratio is maximized at point M, where 0X is

tangential to the effort function. Since the slope of the effort curve (e/w) is

the inverse of wage costs per efficiency unit (w/e), as the slope of E increases

the wage cost per efficiency unit falls and vice versa. The relationship between

w/e and w is shown in panel (b) of Figure 7.5. Since e/w is maximized

at M with an efficiency wage of w*, the wage cost per efficiency unit also

reaches a minimum at a real wage of w* (see Stiglitz, 1987, p. 5).

The second condition for profit maximization is that the firm should hire

labour up to the point where its marginal product is equal to the efficiency

Figure 7.5 The efficiency wage and the Solow condition

wage. If the aggregate demand for labour at w* is less than the aggregate supply

of labour, then the market equilibrium will entail involuntary unemployment.

Since the optimal wage rate w* does not depend on either the level of employment

or the productivity shift parameter (A), a shock which shifts the aggregate

demand for labour will lead to a change in employment but no change in the

rigid real (efficiency) wage. These points are illustrated in Figure 7.6. Here DL1

shows the marginal product of labour for a given level of effort (e*). If the

efficiency wage exceeds the market-clearing wage (w), then the market equilibrium

is consistent with involuntary unemployment shown by U. If a shock

shifts the labour demand curve to DL2, then involuntary unemployment will

increase, since the efficiency wage remains at w*. Only if the market-clearing

(Walrasian) wage exceeds the efficiency wage will involuntary unemployment

be absent (see Abel and Bernanke, 2001). With w > w* firms would be forced to

pay the market-clearing wage but, for reasons discussed in the following section,

w* is always likely to be greater than the market-clearing wage. If an

increase in unemployment influences the effort of employed workers, then the

effort curve will shift up, which lowers the wage at which e/w is maximized.

This possibility is illustrated in Figure 7.5 by a shift of the effort curve from E

to E1. The e/w ratio is now maximized at M1, with a new efficiency wage of w1


So far we have assumed that effort is positively related to the real wage

rate. Now we must examine the reasons that have been advanced by new

Figure 7.6 Involuntary unemployment in the efficiency wage model

Keynesian theorists to explain this relationship. The idea that worker productivity

and real wages might be positively related over some range was clearly

recognized by Alfred Marshall, who observed that ‘highly paid labour is

generally efficient and therefore not dear labour’ (Marshall, 1920). Much

later, the efficiency wage idea reappeared in the literature relating to developing

economies (Leibenstein, 1957; Bardhan, 1993). In this context higher

wages increase the physical well-being of workers through higher nutrition,

and by reducing malnourishment higher real wages improve labour efficiency.

In the developed-country context, where most workers have adequate

nutrition, a different rationale is needed.

The modern efficiency wage theories which have been put forward relate

in general to the issues of selection and incentives and four categories of

efficiency wage theory can be identified: (i) the adverse selection model (for

example, Weiss, 1980); (ii) the labour turnover model (for example, Salop,

1979); (iii) the shirking model (for example, Shapiro and Stiglitz, 1984); and

(iv) the fairness model (for example, Akerlof, 1982). We will examine each of

these in turn. The reader should note that the papers referred to above (i–iv)

are all collected in Akerlof and Yellen (1986).

The adverse selection model In the adverse selection model, firms that offer

higher wages will attract the best workers. Because the labour market is

populated by heterogeneous individuals, firms have imperfect information

about the productivity characteristics of job applicants; the labour market is

an excellent example of a market where asymmetric information predominates.

When there is asymmetric information one party to a transaction has

more information than the other party. In this case workers have more information

about their own abilities, honesty and commitment than employers

before they are hired and will attempt to send signals to potential employers

that convey information about their qualities, such as educational qualifications,

previous employment record and current wage if employed (see Spence,

1974, for a discussion of job market signalling). Because of the non-trivial

hiring and firing costs firms prefer not to hire workers and then find they need

to fire those with low productivity. The firm may also need to invest considerable

resources in training new employees before it becomes clear that they

are not up to scratch. One way of avoiding this problem is for the firm to send

a signal to the labour market in the form of offers of high wages. In the model

presented by Weiss (1980) the wage offered by a firm influences both the

number and quality of job applicants. If workers’ abilities are closely connected

to their reservation wage, then higher wage offers will attract the most

productive job applicants and any applicant who offers to work for less than

the efficiency wage will be regarded as a potential ‘lemon’. Firms will also be

reluctant to lower wage rates even if faced with an excess supply of labour

wishing to work at the prevailing wage offer because this would in all likelihood

induce the most productive workers to quit voluntarily. As a result of

these influences an underemployment equilibrium is attained. To avoid adverse

selection problems firms will attempt to introduce screening devices,

but these measures involve costs, as will the continuous monitoring of workers

after they have been appointed.

The labour turnover model A second reason why firms may offer an efficiency

wage in excess of the market-clearing wage is to reduce costly labour

turnover. This approach received inspiration from the pioneering work of Phelps

(1968) and Phelps et al. (1970) in the development of explanations of the

natural rate of unemployment and search behaviour. The idea here is that

workers’ willingness to quit a job will be significantly reduced if a firm pays

above the going rate. With quitting rates a decreasing function of the real wage,

firms have an incentive to pay an efficiency wage to reduce costly labour

turnover. In the model developed by Salop (1979), labour market equilibrium

entails involuntary unemployment since all firms need to raise their wages to

deter workers from quitting. In situations where unemployment increases, the

wage premium necessary to deter labour turnover will fall.

The shirking model In most occupations labour contracts are incomplete,

which allows workers to exercise discretion with respect to their effort levels.

Because contracts cannot specify every aspect of a worker’s performance and

duties there is ‘effort discretion’ (see Leibenstein, 1979, for a similar approach).

Since the collection of information relating to the productivity of

individual workers and the continual monitoring of workers is very costly to

the firm, the payment of an efficiency wage in excess of the market-clearing

equilibrium wage can act as an incentive which will deter the worker from

shirking. Such behaviour may be particularly difficult to detect and monitor

when teamwork characterizes the workplace.

The possibility that workers may vary their effort is a further example of

the type of problem that can arise when there is an informational asymmetry

present. Workers know more about their effort levels than do their employers.

This asymmetry creates a ‘principal–agent’ problem. An agency relationship

develops whenever there is a relationship between economic actors and the

welfare of one person depends on the actions of the other party; that is, when

the welfare of the principal is influenced by the action (or inaction) of the

agent. In the labour market case the principal is the owner of an enterprise

and the managers and other workers are the agents. One way of reducing the

problem of shirking in this context is to pay an efficiency wage.

The threat of dismissal is not an effective deterrent in a labour market

where workers can quickly find a new job at the same wage rate. However, if

a firm pays a wage in excess of that available elsewhere, or if there is

unemployment, workers have an incentive not to shirk, since there is now a

real cost to being fired and shirking becomes more risky for each worker. In

the Shapiro–Stiglitz (1984) model, the payment of an efficiency wage acts as

a disincentive to shirking, and involuntary unemployment in equilibrium is

an outcome of the problems firms face when monitoring is imperfect: ‘With

imperfect monitoring and full employment workers will choose to shirk.’ By

being paid more than the going rate, workers now face a real penalty if they

are caught shirking. But, as Shapiro and Stiglitz (1984) note, ‘if it pays one

firm to raise its wage it will pay all firms to raise their wages’. Since a rise in

the general level of real wages raises unemployment, even if all firms pay the

same efficiency wage, workers again have an incentive not to shirk because if

caught they will now face the possibility of prolonged unemployment. The

‘reserve army’ of the unemployed act as a disincentive device. Hence the

effort (productivity) of the worker hired by the ith firm, ei, is a function of the

wage it pays, wi, the wage paid by all other firms, w–i, and the rate of

unemployment, u. This is shown in equation (7.12):

ei ei (wi ,w−i ,u) (7.12)

When all firms pay the same wages (wi = w–i) shirking depends positively on

the level of employment. The no-shirking constraint (NSC) indicates the

minimum wage at each level of employment below which shirking will

occur, and is shown in Figure 7.7. In Figure 7.7 the market-clearing wage is

w. However, as is evident from the diagram, no shirking is inconsistent with

full employment. As an incentive not to shirk, a firm must offer an efficiency

wage greater than w. With all firms offering a wage of w*, workers are

deterred from shirking by the risk of becoming unemployed. The diagram

also shows that the need to pay a wage greater than w decreases as unemployment

increases and that the efficiency wage w* and level of employment L0

are associated with an equilibrium level of involuntary unemployment indicated

by LF – L0. As the NSC will always lie above and to the left of the

labour supply curve, there will always be some involuntary unemployment in


The NSC will shift to the left if the firm reduces its monitoring intensity

and/or the government increases unemployment benefit. In each case the

wage necessary to deter shirking at each level of employment is higher. A

change in the NSC brought about by either of the above reasons is shown in

Figure 7.7 as a shift of NSC from NSC0 to NSC1. The equilibrium following

this shift is indicated by E1, showing that the model predicts an increase in

the efficiency wage and an increase in the equilibrium rate of involuntary

unemployment as a result of these changes.

Figure 7.7 The shirking model

The fairness model In recent years several economists have examined the

adverse effects of ‘unfair wages’ and wage cuts on worker effort via the impact

such cuts will have on the morale of the workforce. Sociological models stress

such factors as the importance of wage relativities, status, relative deprivation,

loyalty, trust and equity. In a series of papers, Akerlof (1982, 1984) and Akerlof

and Yellen (1987, 1988, 1990) responded to Solow’s (1979, 1980) ‘piece of

home-made sociology’ and developed models where feelings about equity and

fairness act as a deterrent to firms to offer too low wages in the labour market.

Thurow (1983), Blinder (1988a) and Solow (1990) have also indicated that this

socioeconomic line of enquiry could prove fruitful as an explanation of persistent

unemployment. Recently, in his Nobel Memorial Lecture, George Akerlof

(2002) presented a strong case for strengthening macroeconomic theory by

incorporating assumptions that take account of behaviour such as ‘cognitive

bias, reciprocity, fairness, herding and social status’. By doing so Akerlof

argues that macroeconomics will ‘no longer suffer from the “ad hockery” of the

neoclassical synthesis which had overridden the emphasis in the General Theory

on the role of psychological and sociological factors’. Since in Akerlof’s view

Keynes’s General Theory ‘was the greatest contribution to behavioural economics

before the present era’, it would seem that economists need to rediscover

the ‘wild side’ of macroeconomic behaviour in order to begin the construction

of ‘a not too rational macroeconomics’ (Leijonhufvud, 1993).

Many economists share Akerlof’s concerns and are critical of models

where the labour market is modelled in much the same way as a commodity

or financial market. The flexible price–auction model employed by new classical

economists does not seem to resemble observed labour market behaviour.

There are fundamental differences between labour inputs and other nonhuman

inputs into the production process:

1. Workers have preferences and feelings; machines and raw materials do


2. Workers need to be motivated; machines do not.

3. The productivity of a machine is reasonably well known before purchase,

so that problems of asymmetric information relating to quality are

much less significant.

4. Workers can strike and ‘break down’ because of ill health (stress and so

on); machines can break down but never strike for higher pay or more


5. The human capital assets of a firm are more illiquid and risky than its

capital assets.

6. Workers normally require training; machines do not.

7. Human capital cannot be separated from its owner; non-human capital


8. Workers’ utility functions are interdependent, not independent.

Because of these crucial differences, worker productivity is a discretionary

variable; the effort or output of a worker is not given in advance and fixed for

the future, irrespective of changes which take place in working conditions

(see also Leibenstein, 1979). A machine does not get angry when its price

fluctuates, nor does it feel upset if it is switched off. In contrast, workers are

not indifferent to their price, nor are they unmoved by becoming unemployed

against their will. For these and other reasons, the notion of fairness would

seem to be an important factor in determining outcomes in the labour market.

As Solow (1990) has argued, ‘The most elementary reason for thinking that

the concept of fairness, and beliefs about what is fair and what is not, play an

important part in labour market behaviour is that we talk about them all the

time.’ The words ‘fair’ and ‘unfair’ have even been used by neoclassical

economists at university departmental meetings!

The first formal model to bring in sociological elements as an explanation

of efficiency wages was the seminal paper by Akerlof (1982), where issues

relating to fairness lie at the centre of the argument. According to Akerlof, the

willing cooperation of workers is something that must usually be obtained by

the firm because labour contracts are incomplete and teamwork is frequently

the norm. The essence of Akerlof’s gift exchange model is neatly summed up

in the phrase ‘A fair day’s work for a fair day’s pay’. Everyday observation

suggests that people have an innate psychological need to feel fairly treated,

otherwise their morale is adversely affected. In Akerlof’s model, workers’

effort is a positive function of their morale and a major influence on their

morale is the remuneration they receive for a given work standard which is

regarded as the norm. If a firm pays its workers a wage above the going

market rate, workers will respond by raising their group work norms, providing

the firm with a gift of higher productivity in exchange for the higher


In subsequent work Akerlof and Yellen (1990) have developed what they

call the ‘fair wage–effort hypothesis’, which is derived from equity theory. In

the workplace personal contact and potentially conflicting relationships within

a team of workers are unavoidable. As a result issues relating to fairness are

never far away. Since there is no absolute measure of fairness, people measure

their treatment by reference to other individuals within their own group.

Fairness is measured by making comparisons with workers similarly situated

(inside and outside the firm). Thus an individual worker’s utility function can

be summarized as equation (7.13):

U = U(w/ω,e,u) (7.13)

The utility of this worker (U) is dependent on the real wage (w) relative to the

perceived ‘fair’ wage (ω), the worker’s effort (e) and the unemployment rate

(u). Assuming the worker wishes to maximize this function, the effort expended

will depend on the relationship between w and ω for a given level of

unemployment. Workers who feel unfairly treated (w < ω) will adjust their

effort accordingly. ‘The ability of workers to exercise control over their

effort, and their willingness to do so in response to grievances, underlies the

fair wage–effort hypothesis’ (Akerlof and Yellen, 1990, p. 262). Just as firms

face a no-shirking constraint in the Shapiro–Stiglitz model, they face a ‘fair

wage constraint’ in the fairness version of the efficiency wage model. Since

the fair wage exceeds the market-clearing wage, this framework generates an

equilibrium with involuntary unemployment.

The essence of this innovative approach to explaining real wage rigidity is

that the morale of a firm’s human capital can easily be damaged if workers

perceive that they are being unfairly treated. Firms that attach importance to

their reputation as an employer and that wish to generate high morale and

loyalty from their workforce will tend to pay efficiency wages which are

perceived as fair.

It appears that American entrepreneur Henry Ford shared Marshall’s insight

that ‘highly paid labour is generally efficient and therefore not dear

labour’. In the autumn of 1908, Henry Ford launched the production of the

famous Model T Ford. During the period 1908–14, he pioneered the introduction

of mass production techniques that characterized the ‘American System

of Manufactures’ (Rosenberg, 1994). The assembly line production methods

introduced by Ford required relatively unskilled workers rather than the

skilled craftsmen he had previously needed to assemble automobiles one by

one. The first moving assembly lines began operation in April 1913 but

unfortunately for Ford, the introduction of these mass production techniques

drastically changed the working environment and led to a massive and costly

increase in absenteeism and the turnover of workers. In 1913 the annual

turnover of workers at Ford was 370 per cent and daily absenteeism was 10

per cent. In January 1914 Ford responded to this problem by introducing a

payment system of $5 for an eight-hour day for male workers over the age of

22 who had been with the company for at least six months. Previously these

same workers had been working a nine-hour day for $2.34. For a given level

of worker productivity an increase in the wage paid was certain to increase

unit labour costs and, to contemporary observers, Ford’s policy seemed to

imply a certain reduction in the firm’s profits. However, the result of Ford’s

new wage policy was a dramatic reduction in absenteeism (down 75 per

cent), reduced turnover (down 87 per cent), a massive improvement in productivity

(30 per cent), a reduction in the price of the Model T Ford, and an

increase in profits. It appears that Ford was one of the first entrepreneurs to

apply efficiency wage theory. Later, Henry Ford described the decision to pay

his workers $5 per day as ‘one of the finest cost cutting moves we ever made’

(see Meyer, 1981; Raff and Summers, 1987). There is no evidence that Ford

was experiencing trouble recruiting workers before 1914 or that the new

wage policy was introduced to attract more highly skilled workers. The most

plausible rationale for the policy is the favourable impact that it was expected

to have on workers’ effort, turnover and absenteeism rates, and worker morale.

Raff and Summers (1987) conclude that the introduction by Ford of

‘supracompetitive’ wages did yield ‘substantial productivity benefits and

profits’ and that this case study ‘strongly supports’ the relevance of several

efficiency wage theories.

Insider–outsider models Why don’t unemployed workers offer to work for

lower wages than those currently paid to employed workers? If they did so,

wages would be bid down and employment would increase. There appears to

be an unwritten eleventh commandment: ‘Thou shalt not permit job theft by

underbidding and stealing the jobs of thy comrades.’ The insider–outsider

theory also attempts to explain why wage rigidity persists in the face of

involuntary unemployment (see Ball, 1990, and Sanfey, 1995 for reviews).

The insider–outsider approach to real wage rigidity was developed during

the 1980s in a series of contributions by Lindbeck and Snower (1985, 1986,

1988a, 1988b). In this model the insiders are the incumbent employees and

the outsiders are the unemployed workers. Whereas in efficiency wage models

it is firms that decide to pay a wage higher than the market-clearing wage,

in the insider–outsider approach the focus shifts to the power of the insiders

who at least partially determine wage and employment decisions. No direct

effects of wages on productivity are assumed.

Where does the insider power come from? According to Lindbeck and

Snower, insider power arises as a result of turnover costs (Vetter and Andersen,

1994). These include hiring and firing costs such as those associated with

costs of searching the labour market, advertising and screening, negotiating

conditions of employment, mandatory severance pay and litigation costs.

Other important costs are production-related and arise from the need to train

new employees. In addition to these well-known turnover costs, Lindbeck

and Snower (1988a) also emphasize a more novel form of cost – the insider’s

ability and incentive to cooperate with or harass new workers coming from

the ranks of the outsiders. If insiders feel that their position is threatened by

outsiders, they can refuse to cooperate with and train new workers, as well as

make life at work thoroughly unpleasant. By raising the disutility of work,

this causes the outsiders’ reservation wage to rise, making it less attractive for

the firm to employ them. To the extent that cooperation and harassment

activities lie within the control of workers, they can have a significant influence

on turnover costs by their own behaviour.

Because firms with high rates of turnover offer both a lack of job security

and few opportunities for advancement, workers have little or no incentive to

build reputations with their employers. Low motivation damages productivity

and this represents yet another cost of high labour turnover.

Because it is costly to exchange a firm’s current employees for unemployed

outsiders, the insiders have leverage which they can use to extract a

share of the economic rent generated by turnover costs (the firm has an

incentive to pay something to avoid costly turnover). Lindbeck and Snower

assume that workers have sufficient bargaining power to extract some of this

rent during wage negotiations. Although unions are not necessary for insider

power, they enhance it with their ability to threaten strikes and work-to-rule

forms of non-cooperation (For a discussion of union bargaining models and

unemployment, see McDonald and Solow, 1981; Nickell, 1990; Layard et al.,


Although the insider–outsider theory was originally put forward as an

explanation of involuntary unemployment, it also generates some other important

predictions (see Lindbeck and Snower, 1988b). First, insider–outsider

theory implies that pronounced aggregate shocks which shift the demand for

labour may have persistent effects on wages, employment and unemployment.

In countries with large labour turnover costs and powerful unions, this

 ‘effect persistence’ will be significant. Second, in cases where the shocks are

mild, firms with high turnover costs have an incentive to hoard labour, and

this reduces employment variability. Third, the insider–outsider model can

provide a rationale for many features associated with ‘dual labour markets’.

Fourth, this model has implications for the composition of unemployment.

Lindbeck and Snower (1988b) argue that ‘unemployment rates will be comparatively

high for people with comparatively little stability in their work

records’. This offers an explanation for the relatively high unemployment

rates which are frequently typical among the young, the female population

and various minority groups.

While the insider–outsider theory and efficiency wage theories provide different

explanations of involuntary unemployment, they are not incompatible

but complementary models, since the amount of involuntary unemployment

‘may depend on what firms are willing to give and what workers are able to get’

(Lindbeck and Snower, 1985).