The Economics of Imperfect Labor Markets Second Edition

The novelty of our book is that from the start the focus is on labor market institutions operating in imperfect labor markets, that is, markets that depart from perfect competition. Unlike competitive markets, imperfect labor markets allow employers and employees to enjoy rents, and hence a job is a big deal. Losing a job for a worker or having to replace an employee leaving the firm is costly in such markets, while employees and employers involved in this type of events would not suffer any loss in competitive labor markets. Imperfect markets are also characterized by the presence of many labor market institutions, that is, systems of laws and programs that shape the behavior of individual workers and employers. Institutions result from a political process aimed at (1) increasing economic efficiency and (2) achieving some redistributive goal. Efficiency is achieved by remedying market imperfections, such as excessive monopsonistic power, informational asymmetries that give rise to moral hazard and adverse selection problems, and externalities associated with social customs or the job-matching process, as well as transaction costs and frictions that restrict the size of markets. Redistribution provides a rationale for these institutions even when there are no market imperfections. In imperfect markets redistribution sometimes can be achieved while pursuing efficiency, as in the case of institutions, such as minimum wages or employment subsidies, that counteract excessive monopsonistic power. In most cases, however, the traditional trade-off between efficiency and equity arises. Actually, the redistribution operated by these institutions may well not promote a more egalitarian society or represent the interests of the median voter. There are frequent policy failures in the design of labor market institutions that give disproportionate representation to some pressure group pursuing very specific interests. This book also takes into account that institutions rarely operate in isolation. Hence, from a positive standpoint, the effects of each institution on the labor market are investigated by considering not only its direct effects on employment, unemployment, and wages, but also its indirect effects, mediated by the presence of other institutions. For example, a change in the generosity of the unemployment benefit system affects unemployment directly by reducing search intensity and increasing the reservation wage of job seekers and indirectly by increasing the bargaining power of unions and the level of the efficiency wage. This, incidentally, provides a third rationale for the presence of some institutions: they are created to counteract or complement the effects of other institutions. Policy failures may arise also in this context because the institutions that are responsible for the distortions are rarely reformed. Often the political process creates chains of distortions and clusters of institutions whereby institutions are used to compensate for undesirable effects of other institutions.