Insider Power, Wage Discrimination and Fairness

Abstract

The exercise of insider power is frequently considered as a major cause of involuntary unemployment. We show that under standard assumptions - insiders are selfish and they need not fear the loss of their job - insider power does not cause unemployment but leads to the introduction of a market clearing two-tier wage system. Yet, while insider power is a common phenomenon two-tier systems are rarely observed. To explain this fact we introduce interdependent preferences. We show that if entrants exhibit a preference for fairness the presence of insider power gives rise to an efficiency wage effect which may prevent the introduction of market clearing two-tier systems. In many OECD-economies employees have the power to bargain collectively with the management over their wages. It is obvious that if wages are not determined by competitive market forces but by collective bargaining at the firm level they will only by chance coincide with the market clearing wage rate. Therefore, it seems rather likely that the exercise of insider power will in general lead to wages which generate unemployment. However, almost the whole literature which deals with insider power as a source of unemployment assumes the absence of two-tier wage systems. In a two-tier system incumbents get paid high wages while entrants' receive lower, possibly market clearing, wages. This paper shows that under 'standard' assumptions, that is, powerful and selfish insiders bargain collectively over wages, both the firm and its incumbents are strictly better off when they implement a market clearing two-tier system. From this follows that a theory of unemployment which is based on the notion of insider power should not merely assume but explain the absence of a market clearing discriminatory wage system. We know only of one model in which unemployment is caused by insider power although it does not rule out a two-tier system by assumption. In Lindbeck and Snower (I988) incumbents have an interest in restricting the employment of additional workers because their wages depend positively on the marginal product of labour which in turn decreases with employment. By harassing entrants insiders are capable of raising the reservation wages and, hence, of reducing the employment of entrants.2 The present model is not based on insiders' capabilities to harass entrants. It