This paper analyses the relationship between labour market imperfections and unemployment, with particular reference to European countries. It begins by defining labour market imperfections as failures arising from institutional and regulatory interventions—including employment protection legislation, unemployment insurance, trade unions, payroll taxes, and minimum wage laws—that disrupt market equilibrium and hinder employment creation. Drawing on empirical evidence from OECD Europe, the paper demonstrates how these institutions contributed to rising unemployment from the late 1970s through the 1990s. It also considers the contrasting experiences of Ireland and the Netherlands, where cooperative wage bargaining and active labour market policies successfully reduced unemployment, suggesting that well-designed institutions can produce positive outcomes.
Similar to product markets, labour markets tend to be characterised by imperfections. These imperfections stem from factors such as monopsony, trade unions, wage discrimination, labour immobility, government interventions, and incomplete information on the part of workers (Manning, 2010; Abbritti, Boitami and Damiani, 2012). Indeed, labour markets are persistently imperfectly competitive (Dwivedi, 2010). Imperfections in the labour market often play a significant role in generating unemployment (Baker et al., 2004; Jha and Golder, 2008). They do so by hindering employment creation, determining wages, and creating wage inequalities (Boeri and Ours, 2013). With reference to Europe, this paper analyses the link between labour market imperfections and unemployment. First, a description of labour market imperfections is provided. Then, drawing on empirical evidence from Europe, the role of labour market imperfections in generating unemployment is discussed.
Imperfections generally refer to failures. Labour market imperfections therefore denote failures in the labour market (Abbritti, Boitami and Damiani, 2012). These failures often emanate from efforts aimed at promoting equity and fairness in the labour market (Manning, 2010). For instance, the government may introduce legislation to set a minimum wage floor, or introduce insurance benefits to improve the wellbeing of the unemployed. Additionally, workers may unionise to advocate for better pay and improved working conditions. While these efforts are intended to have a positive effect on the labour market, they may often generate unemployment and other undesirable outcomes (Dwivedi, 2010). They may result in imperfections that are detrimental to investment, economic activity, and efficient resource allocation, consequently obstructing employment growth.
The major labour market factors that generate unemployment relate to labour market institutions and regulations. Labour market institutions and regulations generally denote interventions by the government (Boeri and Ours, 2013). They include elements such as employment legislation, labour market policies, unemployment insurance, unions, and payroll taxes. These elements create unemployment by hindering the free working of labour markets (Baker et al., 2004). They impose rigidities on the labour market and decelerate employment growth. For instance, employment protection policies and unionisation can reduce organisations' demand for labour and harm workplace productivity. Equally, government-imposed labour market policies and labour taxes can increase labour costs and decrease hiring. Furthermore, generous unemployment benefits can increase employees' reservation wages and reduce the incentive to search for work. While these institutional and regulatory elements are important, they can negatively affect employment creation if they are excessively protective and poorly designed.
Labour market regulations may also hinder employment growth by disrupting equilibrium between wages and their marginal product, and by hampering the ability of labour markets to adjust to shifts in the economic environment (Jha and Golder, 2008). This may result in negative outcomes such as resource misallocation (Boeri and Ours, 2013). For instance, regulations that mandate a higher minimum wage may compress the wage structure, leading to the exclusion of less-skilled workers from the labour market and thereby increasing unemployment. Additionally, labour market institutions may prevent employers from adjusting resource quantities in accordance with prevailing economic conditions. During an economic recession, for example, firms may not readily reduce wages owing to existing market regulations. Moreover, collective bargaining systems and other regulations that support the redistribution of economic rents from capital to labour may increase production costs and hinder investment, consequently reducing employment creation opportunities (Jha and Golder, 2008). In essence, labour market institutions and regulations tend to disrupt equilibrium in the labour market. They distort the market because resources are often not allocated at market-clearing prices as dictated by the principles of supply and demand.
Another negative impact of labour market institutions is that they make it harder for outsiders to enter the labour market (Jha and Golder, 2008). In other words, labour market regulations are mainly geared towards protecting the interests of those already employed, undesirably making it more difficult for the unemployed to find work. For instance, an increase in minimum wage and labour taxes due to government intervention may cause firms to reduce hiring, as additional employees would raise operating costs. This would harm the labour market by keeping the unemployed in unemployment for longer. This outcome illustrates how labour market institutions and regulations intended to promote fairness and equity can, paradoxically, perpetuate inequity. Those in employment continue to benefit while the unemployed remain worse off. The negative impacts of economic inequality on economic efficiency are well documented (Boeri and Ours, 2013).
"OECD Europe unemployment trends from 1960s–1990s"
"Successful labour reforms that reduced unemployment"
Boeri, T. and Ours, J. (2013): The Economics of Imperfect Labour Markets, Princeton: Princeton University Press.
Dwivedi, D. (2010): Macroeconomics: Theory and Policy, 3rd ed., New York: McGraw-Hill.
Jha, P. and Golder, S. (2008): Labour market regulation and economic performance: a critical review of arguments and some plausible lessons for India, Economic and Labour Market Papers, International Labour Organisation. [online] Available at: http://www.ilo.org/public/english/employment/download/elm/elm08-1.pdf [Accessed 28 November 2016].
Manning, A. (2010): Imperfect competition in the labour market, CEP Discussion Paper No. 981. [online] Available at: http://cep.lse.ac.uk/pubs/download/dp0981.pdf [Accessed 28 November 2016].
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