Alternative Views of the Labor Market and Equilibrium Unemployment
Before proceeding to discuss the model used in this chapter, it is worthwhile to briefly survey alternative approaches to the modeling of unemployment. This will help put the model in its proper context.
There are many alternative approaches to modeling the labor market that differ from the competitive model of the labor market implicit in new classical and some new Keynesian models (e.g., the model of chapter 16). All these approaches offer an alternative explanation as to why, despite unemployment and vacancies, real wages do not adjust sufficiently to induce firms to hire the unemployed and eliminate unemployment.
One approach consists of the so-called efficiency wage theories. In these theories, there is asymmetric information between firms and workers. Firms cannot observe either the productivity or the effort of workers directly. Thus, firms offer wages above the average productivity of low productivity job seekers, or existing employees, in order to attract workers with above-average productivity or to provide incentives to their employees to work more intensively. Therefore they are not prepared to reduce real wages, or to replace workers already in jobs with the unemployed, even if the unemployed offered to work at lower wages.5
A second class of theories are theories of long-term contracts. These contracts prevent firms from undertaking unilateral changes to wages in response to shocks, if such changes are not provided for or allowed in the long-term contract. The contracts can be explicit (such as collective, industry, and individual employment contracts) or informal and implicit.6
Finally, there are theories that highlight the search costs of looking for an appropriate job by unemployed job seekers, and for an appropriate employee by firms with vacancies. In these theories, a costly search process is required for the matching of job seekers with appropriate vacancies to create a new job. These theories are called search or matching theories of the labor market and seek to explain unemployment flows as well as unemployment rates. We examine a key model in this category in chapter 18.
Let us now examine the specific model we use in this chapter.7
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