Market power, Growth and Unemployment

Transcription

1 Markt powr, Growth and Unmploymnt Pitro F Prtto Dpartmnt of Economics, Duk Univrsity Jun 13, 2011 Abstract I prsnt a modl whr firms and workrs st wags abov th markt-claring lvl Unmploymnt is thus gnratd by thir xrcis of markt powr Bcaus both th labor and product markts ar imprfctly comptitiv, markt powr in th labor markt intracts with markt powr in th product markt This intraction shds nw light on th ffcts of policy intrvntions on unmploymnt and growth For xampl, labor markt rforms that rduc labor costs rduc unmploymnt and boost growth bcaus thy xpand th scal of th conomy and gnrat mor comptition in th product markt Kywords: Markt Powr, Markt Structur, Endognous Growth, Unmploymnt JEL Classification umbrs: E10, L16, O31, O40 1 Introduction Traditional xplanations of unmploymnt focus on labor markt rigiditis and ignor th charactristics of th product markt This lavs out important factors that should b includd in th analysis of th ffcts of institutions and policis In this papr, I xploit this argumnt, and rcnt dvlopmnts in ndognous growth thory, to argu that unmploymnt and productivity growth ar rlatd bcaus thy both dpnd on th structur of th product markt Th sourc of th rlation is th pricing bhavior of agnts with markt powr Workrs and firms hav control ovr wags and prics; th xrcis Addrss: Dpartmnt of Economics, Duk Univrsity, Durham, C Phon: (919) Fax: (919) prtto@condukdu I thank Ptr Arcidiacono, Michll Connolly, Enriqu Mndoza, Rob Rd, Jonathan Tmpl and John Satr for usful commnts 1

2 of markt powr in th product markt intracts with its xrcis in th labor markt Analysis of this intraction shds nw light on th ffcts on unmploymnt and growth of policy intrvntions in th two markts In ordr to focus on markt powr, I dviat from th xisting litratur on growth and unmploymnt that follows th crativ dstruction tradition 1 I considr a modl whr growth is drivn by th activitis of firms that ar not put out of businss by outsid innovators but ar longlivd profit cntrs that innovat rpatdly in-hous 2 Th main diffrnc btwn th two approachs is that crativ dstruction modls xhibit a ngativ rlation btwn product markt comptition and growth, whil th crativ accumulation modl that I considr xhibits a positiv rlation This rlation, supportd mpirically by th work of, among othrs, ickll (1996) and Pagano and Schivardi (2003), has th important implication that a mor comptitiv product markt gnrats both fastr growth and lowr unmploymnt Morovr, in crativ dstruction modls th dgr of comptition is an xognous paramtr whras in my crativ accumulation modl it dpnds on th mass of firms, which is ndognous Anothr important fatur of th papr is that I considr an nvironmnt with ndognous labor supply: agnts choos whthr to participat to th labor markt in th prsnc of unmploymnt risk Spcifically, unmploymnt is involuntary: housholds control th mass of mmbrs that supply labor but not thir probability of mploymnt Thus, som of th participating mmbrs do not find mploymnt vn if at th going wag thy wish to work This approach allows m to idntify sparatly supply-sid and dmand-sid dtrminants of mploymnt and unmploymnt and, mor importantly, allows m to driv from th modl s primitivs a rsrvation wag that is dcrasing in th unmploymnt rat This structur yilds intrsting rsults concrning institutions, tax policy and othr factors that affct th labor markt Spcifically: policis that rduc labor costs rais mploymnt and growth and rduc unmploymnt; th bnfits of ths policis ar largr whn on considrs thir (indirct) ffcts on th structur of th product markt 1 S Aghion and Howitt (1992 and 1998, chaptr 4) and Mortnsn (2005) for a rviw of rcnt rsults 2 S Prtto (1996, 1998, 1999) and Smuldrs and van d Klundrt (1995) for a sampl of arly paprs that dvlopd this approach 2

3 To illustrat, considr labor incom taxs (unmploymnt bnfits hav similar ffcts) Givn th structur of th product markt, highr labor incom taxs gnrat lowr mploymnt and highr unmploymnt via thir traditional ffct on th cost of labor Th conomy thn oprats at a smallr scal This rsults in lowr rturns to ntry and lss comptition in th product markt Growth is lowr bcaus firms oprat in a lss comptitiv markt Morovr, mploymnt and unmploymnt ar, rspctivly, lowr and highr than thy would if th structur of th product markt rmaind constant This is consistnt with th vidnc discussd in ickll and Layard (1997), who find that th total tax burdn on labor has a ngativ ffct on growth It is also consistnt with th vidnc discussd in Davri and Tabllini (2000), who show that th incras in unmploymnt and rduction in growth that occurrd in th rcnt dcads in th OECD is drivn by th incras in labor incom taxs Finally, it is consistnt with th vidnc providd by Wu and Zhang (2000), who show that in th OECD countris thr is a positiv corrlation btwn taxation and th mark-ups that firms charg ovr marginal cost It is also intrsting to considr factors that rais th cost of innovation, rduc product substitution and thus pric comptition, or rais ntry costs for ntrants but do not affct incumbnts Th analysis provids thr rsults: lowr costs of innovation rais mploymnt and growth and rduc unmploymnt; toughr pric comptition raiss growth and has ambiguous ffcts on mploymnt and unmploymnt; lowr barrirs to ntry rduc growth whil do not ncssarily rais mploymnt and rduc unmploymnt Ths rsults mphasiz th importanc of th dtails of th pro-growth policy that a country adopts Rducing barrirs to innovation is th most ffctiv policy bcaus it rducs at th sam tim barrirs to th cration of nw firms and barrirs to innovation within th firm As a rsult, it fostrs invstmnt on both th intnsiv and th xtnsiv margin and, mor importantly, it xploits th positiv rlation btwn comptition and growth In contrast, promoting growth by protcting incumbnts which is fairly common in Europ whr govrnmnts protct national champions might rduc mploymnt and rais unmploymnt by rstricting comptition 3

4 I organiz th papr as follows In Sction 2, I st up th modl In Sction 3, I study bargaining ovr wags and mploymnt at th firm lvl, th associatd R&D policy, and charactriz th rlation btwn wags and R&D In Sction 4, I study th labor markt and show how th xrcis of markt powr ovr prics and wags gnrats unmploymnt In Sction 5, I study th gnral quilibrium of th modl and dtrmin unmploymnt, markt structur, and growth In Sction 6, I discuss th ffcts of structural paramtrs and policy instrumnts I conclud in Sction 7 2 Th modl I considr a closd conomy A rprsntativ comptitiv firm assmbls intrmdiat diffrntiatd goods to produc a homognous final good that can b consumd or invstd Th assmbly tchnology is [ Y = 1 () 1 0 () 1 () Xi ] () () 1 di, () > 0 (1) whr () is th lasticity of product substitution, X i is th final producr s us of ach diffrntiatd good, and is th mass of intrmdiat goods (th mass of intrmdiat firms) Th lasticity of substitution is an incrasing function of th mass of firms, boundd from abov and from blow, > ( ) > (0) 1 This allows m to captur th rol of ndognous markt powr whil rtaining th dsirabl faturs of a monopolistic comptition modl dfind ovr a continuum of goods Th final good is th numrair Th final producr thus maximizs profits subjct to th budgt constraint Y = 0 P ix i di, whr P i is th pric of intrmdiat good i This yilds th dmand schdul for good i, X i = Y ( ) () Pi (2) P otic that th pric indx of intrmdiat goods, P = [ 1 0 ] 1 Pj 1 ɛ 1 ɛ dj, which th atomistic intrmdiat firms tak as givn, must b qual to th pric of th final good and thus is qual to on and can b omittd from (2) without loss of gnrality 4

5 Th typical intrmdiat firm producs with th tchnology X i = Z i L θ i, 0 < θ < 1 (3) whr X i is output, L i is labor and Z i is th firm s cumulatd stock of costrducing innovations Th firm also runs in-hous R&D facilitis to produc a continuous flow of innovations according to Ż i = αr i, α > 0 (4) whr Żi is th flow of innovations gnratd by an R&D projct mploying R i units of th final good for an intrval of tim dt Firms ar cratd by ntrprnurs that dvlop nw products and thir manufacturing procsss Th cost of ntry is proportional to th ntry lvl of productivity Spcifically, stting up a firm with initial productivity Z i rquirs β α Z i units of final output This capturs two typs of ntry costs First, th ntrant nds to crat th initial product-spcific knowldg, and according to quation (4) crating a stock of knowldg Z i rquirs 1 α Z i units of final output Scond, th ntrant nds to pay additional costs, not rlatd to R&D, that allow oprations to bgin Th paramtr β capturs this non- R&D componnt of th ntry cost by rducing th ovrall productivity of rsourcs dvotd to ntry Th important fatur of this paramtr is that it dos not affct incumbnts Hnc, it capturs xognous barrirs to ntry Th conomy is populatd by a rprsntativ houshold with a continuum of mass λ of mmbrs Each mmbr is ndowd with on unit of labor Th houshold maximizs U(0) = 0 ρt λ [ log ( ) C + ψ log λ subjct to th flow budgt constraint ( λ L s λ )] dt, ρ > 0, ψ > 0 A = ra + L s [W (1 τ) (1 u) + Bu] + T C, 0 < τ < 1 whr ρ is th individual discount rat, C is consumption, L s is th mass of houshold mmbrs that offr thir labor for a wag (participat in th labor markt), A is assts holding, and T is a lump-sum transfr from th govrnmnt Th assts availabl to th houshold ar ownrship shars of firms Hnc, r is th rat of rturn on stocks Thr faturs of this stup ar important First, th houshold controls th mass of mmbrs that supply labor but not thir probability of mploymnt This is whr th assumption that thr is a continuum of agnts 5

6 within th houshold bcoms vry usful By th law of larg numbrs I can quat th individual probability of unmploymnt to th conomy s unmploymnt rat u 1 L L s, whr L = 0 L idi is aggrgat mploymnt Similarly, with a continuum of firms th law of larg numbrs allows m to quat an mployd workr s probability of bing assignd to firm i with th firm s shar of aggrgat mploymnt L i /L It follows that th pr-tax wag that th mployd mmbr arns is th wightd avrag W = 0 W i L i L di, whr W i is th wag paid by firm i This approach implis a job rationing mchanism that taks th form of assigning job skrs at random to th unmploymnt pool and to th mploymnt pool; thos assignd to th mploymnt pool ar thn assignd at random across th xisting firms and ngotiat th trms of mploymnt (s blow) 3 Its main advantag is that it allows m to think of th trm 1 u in th budgt constraint as th fraction of th houshold mmbrs that participat to th labor markt and arn th aftr-tax wag W (1 τ), whil u is th fraction that arn th aftr-tax unmploymnt bnfit B Th scond fatur capturs th basic trad-off that govrns labor supply and thus dtrmins workrs wag dmands Th houshold s instantanous utility contains a trm that capturs th rol of houshold mmbrs that do not participat in th labor markt; on can think of hom production or othr rlatd activitis th output of which is shard by all houshold mmbrs This dtrmins th opportunity cost of labor markt participation, and thus contributs to dtrmin th wag dmands of mployd workrs Participation taks 100% of th houshold s mmbr tim Th third fatur is that th houshold insurs its mmbrs participating in th labor markt against individual unmploymnt risk This simplifis th analysis bcaus all houshold mmbrs gt th sam flow of utility rgardlss of th outcom of th job rationing mchanism 4 Mor importantly, 3 On could think of this as a particular typ of matching mchanism With rspct to th traditional approach in sarch thory (g, Pissarids 2002), it has two advantags First, it dos not imply unfilld vacancis and thus allows m to focus only on th supply sid of th labor markt as subjct to rationing Scond, it dos not rquir tim and thus dos not forc m to modl umploymnt as a stat variabl, thrby rducing th dimnsionality of th gnral quilibrium systm (s blow) 4 Exampls of prvious work using this approach ar Mrz (1995) and Pissarids (2002) 6

7 it implis that ach individual workr is indiffrnt btwn mploymnt and unmploymnt in th bargaining procss (s blow) Th maximization problm outlind abov yilds wll-known rsults with som novl faturs Th houshold follows th usual saving rul Ċ C = r ρ (5) and quats th bnfit from th marginal houshold mmbr s participation to th cost Formally, W (1 τ) (1 u) + Bu = ψc λ L s On th lft-hand-sid of this xprssion thr is th xpctd incom from participation, on th right-hand-sid thr is th xpctd cost th forgon contribution of th marginal individual to houshold production Participation thrfor can b writtn L s ψc = λ W (1 τ) [W (1 τ) B] u (6) This is th conomy s upward sloping labor supply curv Consumption, C, ntrs ngativly bcaus it raiss th opportunity cost of participation; th unmploymnt insuranc bnfit, B, ntrs positivly bcaus it raiss th xpctd incom from participation Labor supply dpnds on th unmploymnt rat via two ffcts First, highr unmploymnt mans that th participating individual is lss likly to b mployd and thus to arn th aftr-tax wag This lowrs th xpctd bnfit of participation Scond, highr unmploymnt mans that th individual is mor likly to b unmployd and thus to draw th insuranc bnfit B This raiss th xpctd bnfit of participation Th modl s quilibrium conditions imply that th aftr-tax wag is highr than th unmploymnt bnfit so that labor supply is dcrasing in th unmploymnt rat (s blow) This capturs a discouragd workr ffct whrby wors mploymnt prospcts in th labor markt lowr a workr s xpctd incom and thus rduc participation 3 Wags, prics and R&D at th firm lvl Th typical intrmdiat firm maximizs th prsnt discountd valu of nt cash flow, V i (0) = t 0 r(v)dv Π i (t)dt, 0 7

8 subjct to th dmand schdul (2), th production function (3), th R&D function (4), Z i (0) > 0 (th initial knowldg stock is givn), Z j (t) for t > 0 and j i (th firm taks as givn th rivals innovation paths), and Żj(t) 0 for t > 0 (innovation is irrvrsibl) Instantanous profit is Π i = P i X i W i L i R i Th firm bargains with its workrs ovr th wag and mploymnt this is quivalnt to bargaining ovr th wag and th product s pric sinc mploymnt (th scal of activity of th firm) and th pric ar rlatd through th dmand curv Th firm thn sts its R&D policy taking as givn th instantanous outcom of th bargaining procss I modl bargaining as max [(1 γ) log Π i + γ log (W i (1 τ) W a ) L i ], 0 < γ < 1 W i,l i subjct to th production function (3) and th dmand curv (2) Th paramtr γ is th rlativ bargaining powr of th workrs Th firm and its workrs maximiz jointly th log-gomtric avrag of profits and mploys surplus Th firm and th workrs tak th altrnativ, W a = W (1 τ) (1 u) + Bu = ψc λ L, as givn sinc it dpnds on aggrgat variabls If ngotiations brak down, th workr can quit th firm and rntr th labor markt, in which cas h gts th xpctd labor incom Altrnativly, h can allocat all of his tim to houshold production, in which cas h gts th valu of his marginal contribution Ths two options ar quivalnt bcaus in dciding labor supply th houshold sts thm qual (s abov) Th solution of th bargaining problm yilds (s th appndix for dtails on th drivation): W i = W a 1 τ + γ Π i ; 1 γ L i L i = 1 τ θ ( 1) P i X i (7) W a Th first xprssion is vry important and quit gnral It follows solly from th first-ordr condition for th wag and says that th workrs gt th rsrvation wag (adjustd for labor incom taxation) plus a fraction of th firm s profit Th lattr trm stablishs a connction btwn th wag and th firm s R&D policy This is on of th most important faturs of th modl and is worth xploring in dtail 8

9 Th xprssion for firm mploymnt (7) and th dfinition of profit allow m to writ W i = W a 1 τ + γ P [ ix i θ ( 1) R ] i L i P i X i whr = W a 1 τ (1 + m i), (8) [ θ ( 1) m i γ R ] i (9) θ ( 1) P i X i This is th markup of th aftr-tax wag ovr th rsrvation wag that th firm and its workrs agr on It says that on top of th rsrvation wag, ach workr gts a fraction of rvnus givn by th product of th bargaining powr of workrs, γ, tims a trm that rsults from subtracting R&D intnsity from th margin of rvnus ovr th rsrvation wag bill This is important: th firm s R&D activity rducs th markup bcaus R&D xpnditur which is a rcurrnt fixd cost rducs th firm s cash flow and thus rducs what is availabl to distribut as xtra wags to workrs and as dividnds to stockholdrs 5 Th xprssions for firm wag and mploymnt yild th rducd-form profit function (s th appndix for dtails on th drivation) [ ] θ ( 1) Π i = (1 γ) P i X i R i, (10) whr P i X i = ( ) 1 [ Y θ( 1) Wa 1 τ ] θ( 1) θ( 1) θ ( 1) Z 1 θ( 1) i If th firm has no bargaining powr, if γ = 1, rducd-form profit is zro bcaus workrs xtract all rnts in th form of highr wags If th firm has all th bargaining powr, if γ = 0, th firm capturs all rnts and th wag is st at th comptitiv lvl Th firm chooss R i in ordr to maximiz V i valuatd using this rducd-form profit function Th R&D stratgy can b charactrizd in an intuitiv way Suppos that th firm financs R&D by issuing ownrship claims on th flow of profits gnratd by cost-rducing innovations Lt th markt valu of such financial assts b q i Th firm is willing to undrtak R&D if th valu of 5 Th markup is positiv bcaus of th non-ngativity constraint on profits, which follows from th fact that firms can always choos to st R&D qual to zro 9

10 th innovation is qual to its cost, if q i = 1 α If conditions ar such that q i < 1 α, th firm dos zro R&D (s blow) Situations with q i > 1 α cannot b quilibria bcaus thy ntail infinit invstmnt in R&D, which violats th conomy s rsourcs constraint Sinc th innovation is implmntd inhous, its bnfits ar dtrmind by th marginal profit it gnrats Thus, th valu of th innovation must satisfy th arbitrag condition Th marginal profit rads: r = Π i Z i 1 q i + q i q i ( ) 1 [ Wa Π i Y θ( 1) 1 τ = (1 γ) ] θ( 1) θ( 1) Z i θ ( 1) = (1 γ) ( 1) P ix i Z i Z 1 θ( 1) 1 i 1 Taking logs and tim-drivativs of q i = 1 α, substituting into th arbitrag condition and rarranging trms yilds r = α (1 γ) ( 1) P ix i Z i, (11) which dfins th rat of rturn to in-hous innovation To justify my focus on symmtric quilibria, I nd to argu that th conomic rturns to th firm s R&D ar diminishing Othrwis, on firm could tak ovr th whol markt by xploiting physical incrasing rturns to knowldg and labor th fact that cost falls linarly with Z i Intuitivly, this involvs a rstriction on th pric lasticity of dmand such that marginal profit is monotonically dcrasing in Z i A suffi cint condition for this to happn is 1 θ ( 1) < 1 < 1 + θ, θ which says that th marginal profit approachs infinity as th firm s knowldg stock approachs zro whil it approachs zro as th firms knowldg stock approachs infinity 6 6 Th radr familiar with this class of ndognous growth modls might b intrstd to notic that this condition for symmtry dos not rquir diminishing rturns to knowldg or spillovrs across firms It solly follows from diminishing rturns to labor, which yild 10

11 Entrants anticipat that onc in th markt thy st wag, pric and R&D spnding according to th abov charactrization Th associatd valu of th firm must satisfy th arbitrag condition r = Π i V i + V i V i Entrants ar activ if th valu of ntry is qual to its cost, if V i = β α Z i Taking logs and tim drivativs and substituting into th arbitrag condition, I obtain r = απ i βz i + Żi Z i Using th rducd-form xprssion for profits (10) and th R&D tchnology (4), I obtain α (1 γ) θ ( 1) P i X i r = + αr ( i 1 1 γ ) (12) β Z i Z i β This quation holds as long as thr is ntry If conditions ar such that V i < β α Z i, thr is no ntry and th modl works lik on with an xognous mass of firms (s blow) Situations with V i > β α Z i cannot b quilibria bcaus thy ntail infinit invstmnt in ntry, which violats th conomy s rsourcs constraint Equations (11) and (12) dfin th rturns to two typs of invstmnt A standard arbitrag argumnt for th assts markt rquirs that thy yild qual rats of rturn Hnc, { R i = P i X i [ (β + θ) 1 ] 1 γ (13) β+γ 1 > 0 This quation dtrmins th firm s R&D intnsity as a function of product markt comptition, th ntry cost and th firm s bargaining powr To undrstand th proprtis of this quilibrium, on can rprsnt th intraction of incumbnts and ntrants in a diagram with th rat of rturn, r, on th vrtical axis and R&D, R i, on th horizontal axis Th quilibrium that th marginal cost is a convx function of output Th rason why this implis symmtry, if th pric lasticity of dmand is suffi cintly low, is that xpanding output too rapidly raiss production costs and offsts th cost advantag stmming from knowldg accumulation On can visualiz this in a simpl diagram with an incrasing and convx marginal cost curv Innovation shifts th curv down; th rsulting output xpansion involvs a movmnt up along th nw curv 11

12 with positiv R&D is at th intrsction of th horizontal lin (11) with th upward sloping lin (12) 7 It xists if (11) is highr than th intrcpt of (12), othrwis (11) and (12) cross for a ngativ valu of R i, th non-ngativity constraint on R&D is binding, and R i = 0 Hnc, thr xists a thrshold 0, dtrmind by () = β+θ, such that R i > 0 for > 0 and R i = 0 for 0 0 According to quation (13), R&D is proportional to th firm s rvnus, P i X i To s why, not that th rat of rturn to R&D incrass with th scal of production ovr which cost-rducing innovations apply Similarly, th rat of rturn to ntry incrass with th anticipatd scal of production of th firm In both cass, th intuition is that R&D and ntry costs ar fixd costs that largr firms sprad ovr largr volums of production Rcnt work by Cohn and Klppr (1996a, 1996b) and Adams and Jaff (1996) shows that this cost-sprading mchanism is important in xplaining th rol of firm siz mphasizd in many mpirical studis To charactriz th labor markt mor sharply, it is usful to assum that th govrnmnt cannot borrow and satisfis th budgt constraint T = τw L d B(L s L d ), which dtrmins th lump-sum transfr, T, as th diffrnc btwn tax rvnus and xpnditur on bnfits 8 It is also usful to assum that th unmploymnt bnfit is a constant fraction of th wag I thus posit B = σw I now mak us of th fact that symmtry implis that all firms pay th sam wag so that W i = W Th wag quation (8) yilds 1 = (1 τ) (1 u) + σu 1 τ This can b solvd for u = 1 τ m 1 τ σ 1 + m otic that u > 0 bcaus m > 0, whil u < 1 if 1 + m < 1 τ σ (1 + m) (14) 7 This quilibrium is stabl in th following sns: to its right th rat of rturn to R&D is lowr than th rat of rturn to ntry and invstors wish to rduc growth sinc this rducs th rat of rturn to ntry; to its lft th rat of rturn to R&D is highr than th rat of rturn to ntry and invstors wish to rais growth sinc this raiss th rat of rturn to ntry 8 This stup kps to a minimum th ffct of th govrnmnt on conomic activity Only two distortions mattr: taxation, which lowrs labor supply and raiss th pr-tax wag that unions dmand, and th unmploymnt bnfit, which raiss both labor supply and th pr-tax wag that unions dmand 12

13 This says that, givn th markup m, if th rplacmnt ratio is too high unmploymnt is 100% To s what this mans, us th wag quation (8) to rwrit th condition as σ < W a W B < (1 τ) W This is intuitiv: a rplacmnt ratio that is too high is on that maks unmploymnt a bttr outcom than mploymnt 9 To rul out situations lik this it is suffi cint to impos σ < 1 τ It is clar from th wag quation (8) that unmploymnt is dcrasing in R&D intnsity bcaus th firm s R&D activity rducs th markup ovr th rsrvation wag Mor importantly, th rlation btwn unmploymnt and R&D activity is invariant to th spcifics of th dtrmination of R&D intnsity Hnc, th implid ngativ rlation btwn growth and unmploymnt is causal and gnral: howvr R&D intnsity is dtrmind, th highr is R&D intnsity, th lowr is th markup and th lowr is unmploymnt Th spcifics of th rlation, on th othr hand, dpnd on whthr ntrants ar activ or not Whn ntrants ar activ, quation (12) applis and R&D spnding is dtrmind by th arbitrag condition (13); whn ntrants ar not activ, quation (12) dos not apply and R&D spnding is dtrmind by th conomy s rsourcs constraint Thus, splling out th dtails of th rlation btwn unmploymnt and growth rquirs analysis of th conomy s gnral quilibrium Th xprssion for firm mploymnt (7), th wag quation (8) and aggrgation across firms yild L = 0 L i di = 1 + m W θ ( 1) Y Th assmbly tchnology (1), th production tchnology (3) and symmtry yild th rducd-form production function ( ) L θ Y = Z = Z 1 θ L θ (15) 9 This raiss th qustion of how th govrnmnt can pay for unmploymnt bnfits if nobody works In this papr s stup this is not ncssarily a problm bcaus th govrnmnt pays (nt) lump-sum transfrs that can b convrtd to lump-sum taxs Th qustion, howvr, is rally about how on can justify as an quilibrium a situation with 100% unmploymnt On should also notic that th condition for u < 1 is surly satisfid if unmploymnt bnfits ar taxd at th sam rat as wags Mor gnrally, th condition should b that th rplacmnt ratio b lowr than th ratio 1 τ W 1 τ B, whr and τ B ar, rspctivly, th tax rat on wags and bnfits τ W 13

14 Hnc, W = (1 + m) θ ( 1) Z ( ) L (1 θ) Th wag is incrasing in product markt comptition and th markup m, and is proportional to productivity Z Employmnt pr firm L ntrs ngativly bcaus of diminishing rturns to labor To calculat mploymnt now obsrv that L = (1 u) L s [ 1 τ σ (1 + m) = λ 1 ψ ( ) L 1 θ ] (1 τ σ) (1 + m) (1 τ) θ ( 1) c, (16) whr c C λz dnots consumption pr ffctiv prson (not workr) It is straightforward to show that L is incrasing in and dcrasing in c This is intuitiv: highr consumption lowrs labor supply and thus mploymnt (holding constant th unmploymnt rat u which dos not dpnd dirctly on c) Th rason why mploymnt riss with th mass of firms is twofold First, a largr mass of firms disprss mploymnt and rducs firm siz As a rsult, th marginal product of labor riss, th wag riss and labor supply riss Scond, a largr mass of firms raiss th pric lasticity of dmand This in turn has two ffcts: it raiss th wag and thus labor supply, and it lowrs th markup and thus unmploymnt 4 Gnral Equilibrium To charactriz th gnral quilibrium of this conomy I impos output and capital markt claring Th partial quilibrium of th labor markt affcts th path of th conomy through th rducd-form production function (15) which dtrmins th rsourcs constraint (otic that th mass of firms plays th rol of capital in an othrwis standard rducd-form production function) Th saving schdul (5) dtrmins th rat of rturn to saving that th houshold dmands Th construction of th gnral quilibrium of this conomy is thn straightforward Thr is an Eulr quation charactrizing th quilibrium of th assts markt, whrby all rats of rturn ar qualizd, and an quation charactrizing th quilibrium of th goods markt, whrby output is allocatd to consumption and invstmnt Th lattr quation is whr this modl dviats from th standard stup bcaus th stat variabl of this conomy is th mass of firms 14

15 Th phas diagram in Figur 1 and th following Proposition charactriz dynamics in (, c) spac Proposition 1 Thr is a uniqu prfct-forsight gnral quilibrium If th initial mass of firms is smallr than, th conomy jumps on th saddl path and convrgs to th stady stat (, c ) If th initial mass of firms is largr than, th conomy ntrs immdiatly a stady stat with no ntry Proof S th Appndix This proposition implis that thr is a continuum of stady stats to th right of whr th mass of firms is xognous This is th rgion of hystrsis whr ntry is not profitabl and th mass of firms dos not rspond to paramtr changs To fully apprciat th modl s implications, ths must b takn into account Lt g Ż Z b th rat of innovation, th rat of growth of labor productivity To charactriz th tripl (g, u, L ) associatd to th stady stat (, c ) it is usful to procd as follows Th R&D intnsity quation (13) and th R&D tchnology (4) yild { g = P X Z α [ 1 (β + θ) 1 ] 1 γ (17) β+γ 1 > 0 Equation (11) yilds th rat of rturn to invstmnt (both in-hous R&D and ntry sinc arbitrag qualizs rturns) ow notic that working with consumption pr ffctiv prson implis that asst markt quilibrium rquirs that th rat of rturn b qual to th discount rat plus th growth rat, r = ρ + g Hnc, ρ + g = P X Z α (1 γ) ( 1) (18) Solving this quation for P X Z and substituting into (17) yilds an quation that dscribs growth as an incrasing function of markt comptition, g = { ρ (GG) > 0 (β+θ) 1 1 (1 γ+θ) 1 An important proprty of this quation is that th paramtr α is missing This is bcaus its ffcts on th intnsiv and xtnsiv margins ar idntical 15

16 and thus cancl out in th arbitrag condition that qualizs th rturns to R&D by incumbnts and R&D by ntrants 10 A similar quation charactrizing quilibria with ntry in (, u) spac obtains by valuating th unmploymnt quation (14) at th rlvant valus of th markup Substituting th R&D intnsity quation (13) into th markup quation (9) yilds Accordingly, m = γ θ( 1) θ( 1) 0 0 ( ) > 0 γ (1 γ+θ)( 1) θ( 1) 1 1 γ β u = 1 τ m 1 τ σ 1 + m (UU) dfins a kinkd curv that is monotonically dcrasing in Th conomy s rsourcs constraint and th rducd-form production function (15) yild a rlation btwn R&D intnsity and consumption, R P X = 1 λc ( ) L θ Solving th markup quation (9) for R&D intnsity and substituting into this xprssion allows on to liminat consumption from th mploymnt quation (16) and writ [ (1 τ σ) (1 + m) L = λ 1 τ σ (1 + m) + ψ ( )] m 1 1 τ γ + 1 (LL) Evaluating this at th markup givn abov yilds a kinkd mploymnt curv in (, L) spac that is monotonically incrasing Whn ntrants ar not activ, th rat of rturn to invstmnt is givn by th rat of rturn to R&D (11) Asst markt quilibrium rquirs r = ρ+g Hnc, { α(1 γ)( 1) ( L ) θ g = ρ 0 < 1 (HH g ) Th radr should also not that th quation dos not contain trms that masur th siz of th conomy Hnc, th conomy s labor ndowmnt affcts growth only through its (positiv) ffct on th numbr of firms As a rsult, th modl xhibits a nonlinar scal ffct, boundd from abov Sinc I hav alrady discussd this proprty of this class of modls in Prtto (1998, 1999), I do not xamin this ffct hr and rfr th radr to thos paprs for dtails 16

17 On can charactriz firm siz L as a function of th mass of firms so that this quation dscribs a locus in (, g) spac To s this, obsrv that th procdur followd abov yilds [ (1 τ σ) (1 + m) L = λ 1 τ σ (1 + m) + ψ ( )] m 1 1 τ γ + 1 (HH L ) and u = 1 τ m 1 τ σ 1 + m, (HH u) whr th assts markt quilibrium condition yilds [ γ (1 γ+θ)( 1) θ( 1) + ρ ( L ) ] θ θ( 1) α 0 < 1 m = γ θ( 1) θ( 1) 1 Ths two quations dtrmin mploymnt L and th markup m as functions of (Th dtaild analysis is availabl on rqust) Accordingly, thy dtrmin th unmploymnt and mploymnt quations, (HH u ) and (HH L ), that apply in th hystrsis rgion Thr ar two ffcts of th mass of firms Th first is th standard on of toughr comptition that rducs markt powr Th scond is spcific to quilibria with no ntry whrin R&D is dtrmind by th rsourcs constraint and contrary to quilibria with ntry is dcrasing in As a consqunc, a largr mass of firms can rsult in a highr markup Th appndix discusss a suffi cint condition for th formr ffct to dominat and thus hav th plausibl proprty that th (HH L ) curv is upward sloping whil th markup m is dcrasing in In this cas, quation (HH g ) dscribs a monotonically dcrasing curv in (, g) spac It intrscts th horizontal axis at point 1, which mans that R&D is zro whnvr th mass of firms is too larg This is intuitiv: whn thr ar too many firms, ach firm is small and th rturns to innovation ar low As a rsult, firms st R&D to zro Similarly, quation (HH u ) is downward sloping Th valus g, L, u associatd to (, c ) ar at th intrsction of (GG) with (HH g ), (LL) with (HH L ), and (UU) with (HH u ) All points on th (HH g ), (HH L ) and (HH u ) curvs to th right of ar stady stats Ths ar situations whr ntry is not profitabl and th mass of firms dos not rspond to shocks and changs in policy variabls Figur 2 illustrats Comparativ statics ar as follows Proposition 2 Growth g is incrasing in α, β, ɛ, and dcrasing in γ, τ, σ Th mass of firms is incrasing in α, dcrasing in γ, τ, σ, β whil 17

18 th ffct of ɛ is ambiguous Employmnt L is incrasing in α, dcrasing in γ, τ, σ, whil th ffcts of β and ɛ ar ambiguous Unmploymnt u is dcrasing in α, incrasing in γ, τ, σ, whil th ffcts of β and ɛ ar ambiguous In th rgion 0 < < 1, th figur mphasizs th undrlying mploymnt and unmploymnt curvs for th cas with zro R&D bcaus comparing ths curvs to th othr two highlights that thr is mor mploymnt and lss unmploymnt whn thr is growth this is illustratd by th fact that th mploymnt and unmploymnt curvs for quilibria with R&D ar, rspctivly, abov and blow th curvs for th cas without Th positiv rlation btwn comptition and growth capturd by th (GG) locus dtrmins th growth ffcts of policy intrvntions and xognous shocks that affct th labor markt Spcifically, changs in labor markt quilibrium ar transmittd to th product markt through shifts of th (HH g ) locus that produc a movmnt along th (GG) locus This happns, for xampl, in th cas of rductions of th labor tax τ or th rplacmnt ratio σ Thus, policy intrvntions in th labor markt that rais mploymnt bcaus thy lowr unmploymnt, rais labor supply or do both attract ntry and, as a rsult of toughr comptition, rais growth This growth ffct is largr th lss comptitiv is th conomy and vanishs whn th conomy approachs th uppr bound for th lasticity of substitution Th slops of th (LL) and (UU) loci dtrmin th mploymnt and unmploymnt ffcts of policy intrvntions and xognous shocks that affct th product markt Spcifically, changs in product markt quilibrium ar transmittd to th labor markt through shifts of th (HH L ) and (HH u ) loci that produc movmnts along th (LL) and (UU) curvs On can s that policy intrvntions in th product markt that attract ntry rais mploymnt and rduc unmploymnt purly bcaus thy incras comptition and thus rduc th wag prmium I discuss in dtail th ffcts of intrvntions in th labor and product markts in th nxt sction 5 Implications for th analysis of rforms Th dynamic rspons of th conomy to a chang in paramtrs is subjct to hystrsis sinc incrass in th mass of firms ar irrvrsibl It is thus ncssary to distinguish btwn (a) rsults that charactriz conomis with diffrnt paramtrs (comparativ statics rsults) and (b) rsults that char- 18

19 actriz th rspons of on conomy to a paramtr chang (comparativ dynamics rsults) 51 Labor markt rforms Thr paramtrs captur institutional faturs of th labor markt that affct labor costs for firms: th tax on wags, τ, th rplacmnt ratio, σ, and th bargaining powr of workrs, γ This subsction maks thr rlatd points: policis that rduc labor costs rais mploymnt by raising labor markt participation and rduc unmploymnt; th ris in mploymnt and th rduction in unmploymnt ar largr whn on considrs th ndognous mass of firms; bcaus ths improvmnts in labor markt conditions ar associatd to mor comptition, ths policis rais growth To illustrat, I considr th ffcts of labor incom taxs Proposition 3 Effcts of th labor incom tax rat, τ (a) An conomy with highr τ convrgs to a stady stat with lowr growth, a smallr mass of firms, lowr mploymnt and highr unmploymnt than conomis with lowr τ (b) In rspons to an incras in τ, th conomy jumps to a stady stat with lowr growth, th sam mass of firms, lowr mploymnt and highr unmploymnt In rspons to a rduction in τ, th conomy convrgs to a stady stat with highr growth, a largr mass of firms, highr mploymnt and lowr unmploymnt Considr Figur 3 Point A is th stady stat rachd by an conomy with a high tax rat; point B is th stady stat rachd by an conomy with a low tax rat Th arrows dscrib th shifts du to a rduction of th tax rat Considr th conomy at point B If τ incrass, th conomy is in th hystrsis rgion and mploymnt and growth fall immdiatly whil unmploymnt raiss This is th jump from point B to point C on th hystrsis curvs corrsponding to th high tax rat If τ rturns to th original valu, mploymnt, output, growth, and unmploymnt rturn to th original valus Considr now th conomy at point A If τ dcrass, th conomy jumps on th saddl path that convrgs to point B Th conomics bhind ths rsults is as follows Th lowr labor tax yilds a highr aftr-tax wag for workrs and a lowr pr-tax wag for firms 19

20 Hnc, it raiss labor supply (participation) and lowrs th wag prmium As a rsult, givn th mass of firms, it is associatd to highr mploymnt and lowr unmploymnt This is capturd by th shift up of th (HH L ) curv and th shift down of th (HH u ) curv Ths ar just th traditional ffcts of lowr labor incom taxation on participation and unmploymnt On top of ths, thr ar th indirct ffcts du to th mass of firms Th highr lvl of activity du to highr mploymnt mans that firm siz is largr To kp th nt rat of rturn qual to th discount rat, th mass of firms must b largr so that thr is a compnsating markt shar ffct Th ffct of th chang in th mass of firms is capturd by th movmnts along th (GG), (LL) and (UU) loci which incorporat ntry Sinc th (GG) locus dos not shift, bcaus it dos not dpnd dirctly on th tax, growth is highr purly bcaus th lowr tax yilds mor comptition Th (LL) and (UU) loci shift, rspctivly, up and down As on can s, th lowr tax is associatd to highr mploymnt and lowr unmploymnt Considr now th dynamics Whn th tax incrass, th mass of firms dos not chang whil unmploymnt riss Holding constant labor supply, this rducs th firms scal of activity and thrby rducs growth Labor supply howvr is ndognous Th highr tax rat causs labor supply, and thus mploymnt, to fall Ths ffcts ar in lin with traditional intuition built on modls that ignor th ffcts of th ndognous structur of th product markt Things ar quit diffrnt whn th mass of firms adjusts ndognously, as it happns whn taxs ar rducd A lowr tax gnrats a positiv fdback through th product markt that rinforcs th bnfits of lowr taxation Ths bnfits ar rapd ovr tim as th mass of firms raiss Figur 3 illustrats this point by sparating th pro-comptitiv or product markt ffct of th lowr tax rat from its traditional labor markt ffct Givn th mass of firms, th lowr tax rat yilds a lowr (HH u ) locus and a highr (HH L ) locus, and thus rducs unmploymnt and raiss mploymnt Ths ffcts ar capturd in th figur by th movmnt from point A to point A Th largr mass of firms thn rducs unmploymnt furthr This is capturd by th movmnt from point A to point B along th nw (LL) and (UU) curvs Th asymmtric rspons of th conomy to dcrass and incrass in th labor incom tax rat rquirs on to distinguish th tim-sris implications of th modl from its cross-sction implications Th modl prdicts that countris with highr labor incom taxs xhibit highr unmploymnt and lowr growth This is consistnt with intuition This corrlation, howvr, is vry hard to dtct in studis that covr svral countris at a momnt in tim bcaus it is dominatd by country-spcific fixd ffcts in 20

21 cross-sctional rgrssions On thn nds to chck how variations of tax rats ovr tim affct unmploymnt within a country (Davri and Tabllini 2000) If labor taxation kps incrasing ovr a priod of tim, th timpaths of unmploymnt and growth track th tim-path of th tax rat Mor prcisly, th modl prdicts that ach tim th tax rat riss, unmploymnt riss and growth falls This is consistnt with th mpirical vidnc providd by Davri and Tabllini (2000) for th OECD countris Thy show that th upward trnd in labor incom tax rats drivs th upward trnd in unmploymnt and th downward trnd in growth 11 On th othr hand, th modl prdicts that th ffcts of tax braks ar sprad ovr tim and gnrat a protractd xpansion of output accompanid by a falling rat of unmploymnt Th rplacmnt ratio has ffcts similar to thos of th tax with th diffrnc that th labor incom tax rducs labor supply (bcaus it rducs xpctd incom) whil th rplacmnt ratio raiss it Hnc, th tax is associatd to lss mploymnt than th rplacmnt ratio Th paramtr capturing th bargaining powr of workrs has intuitiv ffcts that ar similar to th ons outlind abov Bcaus it raiss th wag prmium, it rducs mploymnt and th mass of firms two masurs of th scal of conomic activity and through th associatd anti-comptitiv ffct riss unmploymnt and rducs growth 52 Product markt rforms Svral factors dtrmin comptition in th product markt Th modl allows m to considr th following: rgulations/frictions that rais th cost of innovation can b modld as a lowr α; 11 Th modl undrstats th ngativ ffct of rising taxs bcaus it dos not allow for xit, and thus ruls out th possibility that th upward trnd in taxation lad to fwr firms and lss comptition Including xit, for xampl by positing that firms incur instantanous fixd costs, complicats th algbra but dos not chang th rsults discussd in th txt In particular, allowing for xit rducs th siz of th rgion of hystrsis but dos not liminat it Th siz of this rgion dpnds on how larg is th ntry sunk cost rlativ to th instantanous fixd cost If th lattr is zro, as in this modl, firms nvr xit and th rgion of hystrsis xtnds from th intrior stady stat to infinity; if it is positiv, th rgion of hystrsis is a finit intrval In th lattr cas, th ngativ ffct of taxation on firms cash flow could b larg nough to push thm against th xit margin thrby triggring a fdback through th product markt that rinforcs th ngativ ffcts of taxation of labor by rducing comptition 21

22 rgulations/frictions that rduc product substitution and thus pric comptition can b modld as a lowr ɛ, whr ɛ is a paramtr that shifts up th function (; ɛ); rgulations/frictions that rais ntry costs for ntrants but do not affct incumbnts can b modld as a highr β This subsction maks th following points, which illustrat th intractions btwn th labor and product markts: lowr costs of innovation rais growth and mploymnt and rduc unmploymnt; toughr pric comptition raiss growth and has an ambiguous ffct on mploymnt and unmploymnt; lowr barrirs to ntry rduc growth and ambiguous ffcts on mploymnt and unmploymnt Ths rsults suggst that th dtails of th pro-comptitiv policy that a country adopts mattr In particular, rducing barrirs to innovation is th bst policy bcaus it rducs at th sam tim barrirs to ntry and barrirs to innovation within th firm As a rsult, it fostrs invstmnt on both th intnsiv and th xtnsiv margin and, mor importantly, it xploits th positiv rlation btwn comptition and growth and th ngativ rlation btwn comptition and unmploymnt I now illustrat ths rsults in som dtail Proposition 4 Effcts of th R&D productivity paramtr, α (a) An conomy with highr α convrgs to a stady stat with highr growth, a largr mass of firms, highr mploymnt and lowr unmploymnt (b) In rspons to an incras in α, th conomy convrgs to a stady stat with highr growth, a largr mass of firms, highr mploymnt and lowr unmploymnt In rspons to a dcras in α, th conomy jumps to a stady stat with lowr growth, th sam mass of firms, and th sam lvls of mploymnt and unmploymnt It is simpl to s what drivs ths rsults Th dirct ffct of th highr α is to shift up th (HH g ) and (HH L ) loci and to shift down th (HH u ) locus Growth and mploymnt ris whil unmploymnt falls Th highr α also implis that to kp th nt rat of rturn qual to th discount rat th mass of firms must b largr Th ris in th mass of firms fds back 22

23 positivly on mploymnt and growth and ngativly on unmploymnt Th ky intuition bhind ths rsults is that th highr α boosts productivity of invstmnt on both th xtnsiv and th intnsiv margin Hnc, th conomy supports fastr growth and a larg mass of firms, with all th bnfits that follow for th labor markt Proposition 5 Eff cts of th lasticity of product substitution, ɛ (a) An conomy with highr ɛ convrgs to a stady stat with a smallr mass of firms If th dirct ffct of ɛ dominats ovr th indirct ffct, growth and mploymnt ar highr and unmploymnt is lowr in th conomy with highr ɛ (b) In rspons to an incras in ɛ, th conomy jumps to a stady stat with th sam mass of firms, highr growth and mploymnt and lowr unmploymnt In rspons to a dcras in ɛ, th conomy convrgs to a stady stat with a largr mass of firms If th dirct ffct of ɛ dominats ovr th indirct ff ct, growth and mploymnt ar lowr and unmploymnt is highr in th nw stady stat Ths rsults ar rlativly straightforward Holding constant th mass of firms, in th product markt th dirct ffct of toughr pric comptition is to rais growth whil in th labor markt it is to rais mploymnt and lowr unmploymnt Thr ar two conflicting ffcts on th mass of firms Th incras in th firms scal of activity associatd to highr mploymnt implis that to kp th nt rat of rturn qual to th discount rat th mass of firms must b highr Howvr, toughr pric comptition lads firms to spnd mor on R&D, which is a fixd cost that maks incumbncy mor costly Firms, morovr, ar lss profitabl bcaus pric-cost margins ar lowr Both ths forcs tnd to rduc th mass of firms As a rsult of this conflict, th ffct of ɛ on th mass of firms in ambiguous If it is positiv if th mass of firms riss bcaus th mploymnt ffct dominats ovr th incumbncy cost and th profit margin ffcts th ovrall ffct of ɛ is to ris growth and mploymnt and rduc unmploymnt bcaus th pro-comptitiv indirct ffcts associatd to th largr mass of firms work in th sam dirction as th dirct ffcts associatd to th lowr pric and wag markups Proposition 6 Eff cts of th ntry cost paramtr, β (a) An conomy with highr β convrgs to a stady stat a smallr mass of firms, lowr mploymnt and highr unmploymnt If growth is vry rsponsiv to product markt comptition, it is lowr in th conomy with th smallr mass of firms (b) In rspons to a rduction in β, th conomy convrgs to 23

24 a stady stat with a largr mass of firms, highr mploymnt and lowr unmploymnt If growth is vry rsponsiv to product markt comptition, it is highr in th nw stady stat An incras in β has no ffcts This cas provids a surpris of sort in that lowr barrirs to ntry ar not ncssarily associatd to highr mploymnt and lowr unmploymnt Hr is why Th highr cost of ntry yilds highr growth This is du to th protction ff ct: incumbnt firms protctd by high barrirs to ntry ar largr and do mor R&D Quit important is th fact that fastr growth is du to highr R&D intnsity, which as argud in dtail in Sction 4 rducs th wag markup and thus is associatd to highr mploymnt and lowr unmploymnt Opposit ths dirct ffcts, thr is th fact that highr barrirs to ntry ar associatd to fwr firms, which mans wakr comptition and a highr wag markup, a forc that tnds to lowr mploymnt and rais unmploymnt Th tnsion btwn th dirct and indirct ffcts of barrirs to ntry givs ris to ambiguous rsults This ambiguity can b rsolvd if on can show that th (HH L ) is upward sloping and th (HH u ) locus is downward sloping, which is th cas if thr is a suffi cintly strong rspons of th lasticity of substitution to th mass of firms Th appndix provids a formal analysis of th conditions undr which this happns Figurs 2 and 3 illustrat this cas An important point that mrgs from this discussion is that prfrntial tratmnt of incumbnts in ordr to boost growth a policy that can b modld as a high β is potntially slf-dfating bcaus fastr growth might com at th cost of wors conditions in th labor markt Givn th importanc that rcnt studis attach to th rol of barrirs to ntry for labor markt outcoms, two additional rmarks concrning ths rsults ar in ordr First, th rsult that highr barrirs to ntry rduc th wag markup bcaus thy promot growth dpnds crucially on th assumption of ffi cint bargaining btwn firms and workrs If th wag stting procss taks th form of a standard right to manag modl with monopolistic unions, th wag follows W i = W W a W 1 1 τ, 1 W 1 θ 1 which producs a markup that dos not dpnd on R&D intnsity Braking th link btwn th wag markup and R&D intnsity has th crucial implication that th wag markup dos not dcras dirctly with barrirs to ntry lik in quation (9) and thrfor th only ffct of barrirs to 24

25 ntry is through th mass of firms It is thn immdiat to show that barrirs to ntry rduc mploymnt and rais unmploymnt simply bcaus thy rduc product markt comptition Mor gnrally, on should obsrv that th rsult that highr barrirs to ntry do not ncssarily worsn labor markt outcoms is prdicatd on (a) a strong rspons of th wag markup to R&D intnsity and (b) a wak rspons of th wag markup to product markt comptition Lt m strss that th comparativ statics rsults discussd abov concrning th othr paramtrs ar robust to this chang in th dscription of th bargaining procss and thus do not dpnd on ths two conditions Barrirs to ntry, in contrast, appar to play a spcial rol in this nvironmnt whr firms undrtak R&D invstmnt, and thir ffcts dpnd on th strngth of th rlationship btwn R&D intnsity and th wag markup Th scond rmark concrns th gnral implications of this lin of analysis for th rcnt litratur on th rol of labor and product markt rforms as diffrnt mans to th sam nd of improving labor markt prformanc Sinc th ffct of pric comptition and barrirs to ntry ar potntially ambiguous, rforms of th product markt do not substitut for rforms of th labor markt On could s in th rcnt litratur on th labor markt ffcts of product markt drgulation an argumnt that th sam dsirabl outcoms highr mploymnt, lowr unmploymnt could b accomplishd by rforming th product markt instad of th labor markt Th analysis in this sction suggsts that th mchanisms involvd ar quit diffrnt Rforming th labor markt triggrs indirct ffcts through th product markt that work in th sam dirction as th dirct ffcts bcaus th transmission channl runs through largr markt siz (highr mploymnt) that attracts ntry and thus raiss comptition This mchanism, morovr, applis to all th thr dimnsions of labor markt rform considrd hr: taxation, unmploymnt bnfits, bargaining powr of workrs It follows that rforming th labor markt is unambiguously good for mploymnt and unmploymnt, with th additional bonus that it fostrs growth Rforming th product markt instad triggrs indirct ffcts that potntially offst th dirct ffcts Mor importantly, th ovrall ffcts ar spcific to th particular dimnsion that on wishs to pursu lowr costs of innovation for both incumbnts and ntrants, toughr pric comptition, lowr barrirs to ntry and to th particular form of th wag bargaining procss Th robust rsult that mrgs is that product markt drgulation that rducs innovation costs for both incumbnts and ntrants boosts growth and producs bttr labor markt prformanc 25

26 6 Conclusion Th viw that unmploymnt is high in conomis whr th wlfar stat provids long-lasting unmploymnt bnfits that ar unrlatd to th individual s ffort to find work, th labor forc is organizd in sctoral or firm-lvl unions that do not coordinat thir activitis, and taxation raiss th cost of labor, is gnrally corrct and supportd by much of th availabl mpirical vidnc It is, howvr, incomplt bcaus it ignors th charactristics of th product markt Thr ar good rasons, thortical and mpirical, to think that in addition to labor markt frictions, unmploymnt dpnds on a broad class of factors that charactriz th structur of th product markt An intrsting implication of this argumnt is that thr xists a rlation btwn unmploymnt and growth Th rason is that growth is drivn by firms R&D invstmnts, which ar affctd by th structur of th product markt In this papr, I discussd a modl whr firms and workrs st wags abov th markt-claring lvl Unmploymnt is thus gnratd by thir xrcis of markt powr Bcaus both th labor and product markts ar imprfctly comptitiv, markt powr in th labor markt intracts with markt powr in th product markt This intraction shds nw light on th ffcts of policy intrvntions on unmploymnt and growth For xampl, labor markt rforms that rduc labor costs rduc unmploymnt and boost growth bcaus thy xpand th scal of th conomy and gnrat mor comptition in th product markt Morovr, th rduction in unmploymnt is largr than on would xpct if th rforms ffcts in th product markt wr ignord If such rforms ar implmntd jointly with a rduction of barrirs to innovation an vn largr rduction in unmploymnt is achivd Th approach dvlopd hr lnds itslf asily to xtnsions and furthr analysis of important issus that ar part of th currnt policy dbat First and formost, it would b worthwhil to xplor how diffrnt bargaining nvironmnts, or surplus sharing arrangmnts diffrnt from bargaining, might affct th rsults For xampl, if th surplus sharing procss is construd as bargaining btwn th firm and its unionizd workforc, thn it is possibl to obtain diffrnt solutions according to whthr on taks a right to manag approach or an approach whr bargaining covrs both mploymnt and th wag Evn mor intrsting would b to invstigat how th solution changs if th firm bargains with th workforc ovr th R&D stratgy as wll Although rarly obsrvd, such arrangmnts might yild surpriss: in prliminary work, for xampl, I found that it would lad to 26