Journal of Monetary Economics 26 (1990) 459-469. North-Holland

Insiders and outsiders

A review essay

Laurence Ball * Princeton Utzr~ erWy, Prmcrtotz, NJ 08544, USA

1. Introduction

What causes involuntary unemployment? Why is unemployment so high in Europe? How do unions get their power ? These questions and more are addressed in a series of thought-provoking papers published by Assar Lindbeck and Dennis Snower between 1985 and 1988. These papers are now gathered in The Insider-Outsider Theory of Employment and Unemployment (MIT Press, 1988). The early papers present a theory of wage and employ- ment determination that emphasizes the market power of ‘insiders’ - in- cumbent workers. Later papers apply the theory to central questions about the labor market.

In the insider-outsider theory, incumbent workers have substantial influ- ence over wages, and use it to push wages above their reservation wages and those of unemployed ‘outsiders’. Several other authors, notably Blanchard and Summers (1986), explore the implications of insider power for employ- ment dynamics. A major contribution of Lindbeck and Snower is to investi- gate the sources of insider power - to derive this power from underlying microeconomic assumptions rather than simply assuming that insiders set wages. According to Lindbeck and Snower, insider power arises from costs of labor turnover. In a Walrasian labor market, incumbent workers must accept the market wage - otherwise, firms will simply hire new workers. But if it is costly to replace workers, insiders can demand higher wages without fear of being fired.

*I am grateful to Giuseppe Bertola for providmg his data. Bertola and Herschel Grossman provided helpful suggestlons.

0304.3932/90/$03.50 0 1990-Elsevier Science Pubhshers B.V. (North-Holland)

460 L. Bali. Imders and ourslders

Lindbeck and Snower gain important benefits -from deriving rather than assuming the key feature of their model. Their approach yields testable predictions about when insider power is strongest: it is strongest when turnover costs are large, so even a large markup over reservation wages does not endanger insiders’ jobs. We also gain insights into the effects of policy. For example, proposals to reduce insider power, such as restrictions on labor unions, may be ineffective if they do not reduce turnover costs.

The next section of this essay briefly discusses the turnover costs that produce insider power. I then discuss the theory of how insider power affects average wages and employment, and how it affects dynamics. Finally, I consider empirical evidence and ask whether the insider-outsider theory helps us understand European unemployment in the 1980s. The reader is left to grapple with Lindbeck and Snower’s other applications to strikes and lockouts, dual labor markets, and so on (see especially the survey of empirical and policy implications in the last chapter).

2. Turnover costs

Lindbeck and Snower cite several kinds of labor turnover costs as sources of insider power. One kind is ‘production-related’ costs arising from technol- ogy, such as training costs. These are clearly significant in many occupations. Another is costs created by government regulations, such as mandatory severance pay, long notice periods for layoffs, and costly appeals procedures. Such regulations were adopted by many European countries in the 1970s [Emerson (1988)]. Union agreements create similar, although probably smaller, costs in the U.S. [Piore (198611.

While Lindbeck and Snower discuss these well-documented turnover costs, they emphasize a more novel kind of cost: incumbents ‘harass’ new workers and refuse to cooperate with them in production. This behavior makes turnover unpleasant for new workers and costly for firms, raising both entrants’ reservation wages and the markup over those wages that insiders can demand. Thus harassment and noncooperation are in the economic interests of insiders. Lindbeck and Snower provide a neoclassical theory of why ‘people who work in close association over long periods of time.. . have more supportive personal relations with one another than with newcomers’ (p. 85).

I am skeptical of this theory: I think the neoclassical foundations are a weakness rather than a strength. Considerable evidence, such as Akerlof’s (1982) analysis of partial gift exchange, suggests that relations among employ- ees are better explained by sociological theories of fairness and personal sentiments than by microeconomics. The idea that workers harass each other for the same reasons they shop at discount stores does not ring true. It may be that incumbents harass new workers in some circumstances, for example,

L. Ball, lnslders and outsiders 461

if entrants are perceived as stealing jobs, and that turnover is therefore costly. To be convincing, however, this account of turnover costs must be based on evidence about how workers actually behave. Further case studies, like Akerlofs work on cash posters, would be useful.

3. Wages, employment, and unemployment

Do turnover costs and the resulting insider power generally reduce em- ployment? It is useful to begin with the direct effects of turnover costs. Bertola (1989) takes wages as exogenous and rigorously derives the effects of turnover costs on labor demand when marginal revenue products fluctuate. Perhaps surprisingly, the effects on average employment are close to zero. Turnover costs make firms reluctant to hire workers when demand rises, but also reluctant to fire them when demand falls, and these effects roughly cancel. (The sign of the net effect depends on the discount rate and the relative importance of hiring and firing costs.) The tantalizing suggestion [e.g.. Blanchard et al. (198611 that turnover costs generally raise unemploy- ment does not withstand scrutiny.

Insider power is important because it is a channel through which turnover costs can reduce average employment. Turnover costs do not reduce employ- ment for gizsen wages, but they raise wages by giving insiders monopoly power. If insiders set wages unilaterally, they raise wages to the reservation level of outsiders plus turnover costs. The higher wages reduce the quantity of labor demanded. As Lindbeck and Snower show, these effects are moder- ated but not eliminated if firms and insiders bargain over wages.

The effects of insider power on total labor costs are eliminated if firms extract insiders’ rents through low wages when the workers are first hired. In this case, the presence of insiders does not affect employment [Bertola (199011. But as Lindbeck and Snower point out, there are obvious reasons that initial wages are not pushed sufficiently low - which probably means negative. These reasons include liquidity constraints and workers’ fear of being fired after working for the initial wage (not to mention minimum wage laws and notions of fair wages). Lindbeck and Snower do not formalize the barriers to rent extraction, but it appears that this could be done. Rents to incumbent workers also arise in efficiency wage models, and researchers have made progress in formalizing the reasons that these rents are not dissipated [e.g., Akerlof and Katz (198911.

Lindbeck and Snower emphasize that insider power causes im*oluntary unemployment. They adopt a common definition: a worker is involuntarily unemployed if he is willing to work for less than the wages of identical employed workers, but nonetheless cannot find a job. The main hurdle in explaining involuntary unemployment is explaining why the unemployed do not take jobs from the employed through underbidding. The answer in

462 L. Ball, Imders and outsiders

insider-outsider models is that turnover costs make it unprofitable for firms to accept underbidding.

Is this a satisfactory explanation? As Lindbeck and Snower acknowledge, the answer depends on the nature of turnover costs. In the case of produc- tion-related costs, the answer is no, since ‘identical workers’ are not really identical - an unemployed worker’s productivity net of training costs is less than an employed worker’s. An outsider’s net productivity may be less than his reservation wage, so he is r~oluntarily unemployed, even though he wants a job at the wage of current workers. Turnover costs arising from government regulations do explain involuntary unemployment, but the explanation is not deep: we already know that government policies, such as minimum wages, can cause unemployment. Lindbeck and Snower aspire to a theory of unemployment without regulation. The third kind of turnover cost - harrass- ment and noncooperation - potentially provides the needed foundation. Even if firms want to hire new workers and the workers are willing to pay for training, insiders can thwart the deal by threatening trouble. The possible role of harassment in explaining involuntary unemployment increases the importance of further empirical work on employee relations.

4. The dynamic effects of shocks

Insider power is potentially important for explaining not only the average level of unemployment but also its dynamic behavior. In particular, economists are interested in insider-outsider models largely because they hope to understand the behavior of European unemployment in the 1970s and 80s. Unemployment rose dramatically from the mid-1970s to the early 80s and then remained high throughout the 80s. The initial rise in unemployment can be explained by adverse shocks such as OPEC and tight fiscal and monetary policy. But the fact that unemployment remained high is inconsistent with traditional macro models, in which unemployment returns to a stable natural rate within a few years. Can turnover costs and insider power help resolve this puzzle?

It is important to be precise about our question. Suppose that unemploy- ment follows an AR(l) process, which is close to processes that fit annual European data [Barro (1988), Bertola (1990)]:’

LI,=a+pU,_,+F,, E[F~] = 0, E[ef] =a’. (1)

In discussing Europe, economists often focus on explaining the persistence of unemployment, defined as high serial correlation - a large p. (Barre, for

‘Bertola estimates an AR(2) process, but the second lag is insigmficant for many countries. Barro finds that an ARMA(l.l) fits most countries.

L. Ball, Insiders and outstders 463

example, tries to explain cross-country differences in p.) But a model that generates a large p may not answer the central question of why unemploy- ment was so much higher throughout the 80s than in the early 70s. In my view, we should try harder to explain the variance of unemployment, which is a’/(1 -p’). A large variance is needed to explain large differences in unemployment in different periods. Ceterus paribus, a large p implies a large variance. But even with a large p, unemployment stays close to a stable mean if (T’, the variance of innovations, is small.

This point is important because, according to theory, turnover costs move p and a2 in opposite directions. I again begin with the direct effects of turnover costs, drawing on Bertola (1989). and then consider the effects through insider wage-setting. As described above, the direct effects are to reduce hiring when marginal revenue products rise and reduce firing when MRPs fall. These effects imply higher serial correlation, but a smaller u2 - given shocks to MRPs produce smaller innovations in employment. The overall effect on the variance of unemployment is negative. To put it differently. the higher serial correlation means not that given changes in employment become more persistent, but rather that fluctuations are damp- ened. This effect goes in the wrong direction for explaining the differences between the 80s and early 70s.

If the direct effects of turnover costs do not explain European unemploy- ment, what about the insider power that turnover costs create? Lindbeck-Snower (Chapter 9) and Blanchard-Summers (19861 argue that insider power explains the longlasting rise in unemployment. But the prob- lem with the direct effects of turnover costs arises here, too: insider power makes a given fall in employment more persistent, but a shock causes a smaller initial fall.’ In Blanchard-Summers and Lindbeck-Snower, persis- tence arises from a combination of insider power and ‘membership rules’ under which workers who become unemployed lose their insider status: only employed workers influence wages, and they forget their former coworkers. If a temporary downturn causes layoffs, it reduces the number of insiders. In the following periods, the remaining insiders push wages as high as possible while protecting their jobs rather than accepting lower wages to help employ- ment rebound.

The dampening of initial changes in employment follows from the dire consequences of unemployment. Insiders faced with a decline in demand choose between accepting wage cuts and risking layoffs to keep wages high. With the membership rules in Lindbeck-Snower, layoffs lead not just to unemployment during the current slump, but to permanent outsider status. Insiders are likely to accept lower wages, thereby stabilizing employment.

‘A number of authors have recognized this point [e.g., Blanchard and Fmher (1989, ch. 9)].

464 L Ball. Imders and outsiders

Again, a model that predicts stable employment does not fit the European experience.

This argument assumes that insiders choose whether to accept wage cuts after observing a fall in demand. Lindbeck and Snower argue that things are different if shocks are unanticipated and insiders set wages in advance. Aware of the costs of job loss, insiders set wages at which they expect to remain employed. But if demand falls unexpectedly and wages cannot adjust, then employment falls significantly - and membership rules make the lower employment permanent.

Is this point convincing? The assumption that wages are set before shocks are observed is realistic. But the assumption is unappealing in this context, because it is hard to explain why insiders do not establish more flexible wage-setting procedures. Recent attempts to explain wage and price rigidity [e.g., Ball, Mankiw, and Romer (19SS)l emphasize that rigidity is not too costly to the agents who create it - otherwise, it would be eliminated. In Lindbeck-Snower, wage rigidity is very costly to insiders. The fact that workers agree to set wages in advance suggests that this behavior is not as costly as insider-outsider models imply.

Even if we assume that wages are preset, the claims about the effects of membership rules in Lindbeck-Snower and Blanchard-Summers are mis- leading. Both pairs of authors assume that insiders’ objective functions depend on the wage and the probability that a representative insider remains employed. For a given objectirle function, employment fluctuates more if unemployed workers become outsiders than it does if membership in the insider group is permanent. A shock causes the same initial change in employment in the two cases, and the change is more persistent in the first. The problem is that different membership rules imply different objective functions: again, if losing one’s job means becoming an outsider, insiders should put a greater weight on employment relative to wages. As Blanchard and Summers show, a large weight on employment implies that insiders set wages conservatively, so that employment and the number of insiders drift upward. The expected increase in employment protects insiders from the variability that, with preset wages, they cannot reduce. Membership rules that make shocks to employment more persistent but also add upward drift in the number of insiders do not explain persistently high unemployment.

Are these points fatal, or can some version of the insider-outsider theory explain persistently high unemployment? I think the best hope lies in introducing seniority rules, which are discussed by Lindbeck-Snower (Chapter 10) and Oswald (1987). The basic models of Blanchard-Summers and Lindbeck-Snower assume that all employed workers are insiders, and that they share the risk of layoffs equally. Suppose instead that seniority rules require that recent hires are fired first, so that senior workers are safe. Senior

L. Ball, Insiders und outsiders 465

workers may control wage-setting - either because junior workers are ‘en- trants’ without insider power or simply because the median worker is fairly senior. It is plausible that senior workers resist wage cuts in downturns, because they do not bear the costs. And downturns have permanent effects: they eliminate junior workers who would eventually grow into insiders with job security.

This argument needs fleshing out. We need to explain seniority rules for layoffs and more generally the treatment of junior workers by seniors with insider power. As Lindbeck and Snower point out, insiders who gain by allowing layoffs of juniors in recessions could also gain by pushing wages up in booms. so that juniors are always laid off. Perhaps insiders desire a stock of entrants as a buffer against employment fluctuations, but this idea has not been formalized. And making the model a bit more realistic introduces complications; for example, firms obviously need a flow of new workers to replace retirees. Finally, as discussed above, relations among groups of workers should not be studied from a purely neoclassical perspective; surely customs and notions of fairness are important.

5. Empirical evidence

Do insider-outsider theories fit the stylized facts of European labor markets? In many countries, unemployment appears to be concentrated among outsiders, Unemployment has risen not because of greater job separa- tions - insiders are not at greater risk of unemployment - but because the unemployed are hired at low rates. As a result, the proportion of unemploy- ment accounted for by the long-term unemployed has risen dramatically. In the U.K., for example, the percentage of the unemployed with spells greater than a year rose from ten in the 1960s to forty in the late 80s [Budd et al. (198711. More generally, it appears that the long-term unemployed have been excluded from a labor market that works well for insiders: output growth, productivity growth, and rates of overtime are high in many countries with high unemployment [Blanchard and Summers (198811. A final piece of evi- dence is Layard and Nickell’s (1986) finding that the level of short-term unemployment has a negative effect on U.K. wage growth - the usual Phillips curve - but that the level of long-term unemployment does not. Outsiders with long unemployment spells do not put pressure on the labor market.

Nevertheless, while there is clearly a large group of outsiders, broadly defined, it is not clear that the source of their problems is insider wage- setting. The main alternative explanation is based on ‘human capital’ (e.g., Layard and Nickell). According to this view, high unemployment perpetuates itself because the long-term unemployed lose their skills, become less at- tached to the labor force, or acquire stigma in the eyes of employers. These

466 L. Ball, Insiders and outsiders

effects could explain why workers with long unemployment spells stay unem- ployed in an otherwise healthy economy.

In my view, one frequently cited piece of evidence favors the human capital theory over the insider wage-setting theory. The percentage of British workers who thought they could easily find new jobs if they lost their current ones rose from 40% to 45% from 1977 to 1985, even though the unemploy- ment rate doubled [Blanchard and Summers (198811. This result fits the broad idea that incumbents are secure despite the poor outlook for outsiders. But it is inconsistent with the Lindbeck-Snower model. in which ‘insiders’ are insiders only at their current firms, where they are protected by turnover costs. A worker who loses his current job is an outsider when he applies elsewhere, and should be pessimistic about his prospects. In the human capital theory, by contrast. a newly laid-off worker still has his skills and work ethic. Thus he can find a new job despite high unemployment among workers whose human capital has deteriorated.

How can we further distinguish the Lindbeck-Snower model from other theories of European unemployment ? One approach is to study the cross- country relation between the behavior of unemployment and institutions that, according to Lindbeck-Snower, produce insider power. I begin with the costs of firing workers. Emerson (19881 ranks OECD countries by the size of firing costs, and Bertola (1990) compares these rankings to the average level and persistence of unemployment. The country with highest firing costs is Italy, where firing a worker was virtually impossible through much of the 1970s and 80s; the fifth ranked is Germany. where there are significant severance pay and notice requirements; and the lowest is the U.S., with far fewer regula- tions.

Bertola finds no relation between firing costs and average unemployment in the 1970s or 80s which is consistent with his theoretical results about the direct effects of turnover costs. Bertola’s empirical finding is not consistent with Lindbeck-Snower’s theory that turnover costs produce higher insider wages and thus lower employment. Bertola also looks directly for a link between firing costs and wages and fails to find it: there is no relation between firing costs and Gordon’s (1987) wage-productivity gaps. At least for ten countries, the central effects of turnover costs in Lindbeck-Snower do not show up in aggregate data.

Bertola reports more positive results about unemployment dynamics. Across his ten countries, there is a strong positive relation between turnover costs and the serial correlation in unemployment. This result fits both Bertola’s theory of the direct effects of turnover costs and Lindbeck-Snower’s theory of the effects through insider wage-setting.

As described above, whether turnover costs explain the European experi- ence depends on how they affect the variance of innovations in unemploy-

L. Ball, Insrders and outsiders 467

Table 1

Firing costs and unemployment dynamics.

Country Firing cost rank P var(U)

Italy Belgmm France Sweden Germany Japan UK Netherlands Denmark us

0.979 0.835 0.953 0.588 0.870 0 782 0.852 0.892 0 676 0.514

0.228 11.43 0.352 1.96 0.104 3.50 0.150 0.59 0.465 2.80 0.018 0.35 0.746 3.14 0.982 4.86 0.933 1.78 0.891 1.28

ment as well as serial correlation. Thus I extend Bertola’s analysis as follows. For his ten countries, I estimate an AR(l) model, eq. (l), for annual unemployment over 196147.’ Table 1 lists the countries in order of firing costs, along with estimates of p and (T’ and the implied variance of unemployment, a’/(1 - ~‘1. The rank correlation between firing costs and p is 0.62, confirming the theoretical prediction (and Bertola’s finding) of a positive relation. The rank correlation between firing costs and a2 is -0.67. This result confirms the prediction that turnover costs reduce the initial employment effect of a given shock. The correlation between firing costs and the variance of unemployment is 0.33, so (at least in my small sample) the effect on p outweighs the effect on CT’: turnover costs destabilize employ- ment. This result contradicts Bertola’s theory of the direct effects of turnover costs, but might be explained by insider-outsider models augmented with seniority rules. Overall, the data suggest that turnover costs are an important determinant of employment dynamics.

Another feature of labor markets that might influence unemployment is the degree of unionization. Unions are not essential for insider power, but Lindbeck and Snower argue that they enhance it: insiders are more powerful if they bargain as a unit and can threaten strikes. Using Barro’s (1988) measure of the percentage of the work force in unions, I find no relation across Bertola’s ten countries between unionization and any feature of unemployment - its mean, variance, or serial correlation. Barro himself finds no postwar relation between unionization and serial correlation in a larger sample of countries. Versions of the insider-outsider theory that emphasize unions do not seem useful for explaining cross-country data.

‘Followmg Bertola. I allow the intercept to shift in 1973.

468 I.. Ball, Insiders and outsiders

6. Future research

Cross-county comparisons should be extended to more countries and to comparisons across time periods [see Bentolila and Bertola (1990) for a step in this direction]. However, the most important subject for future work is the institutional details of labor markets. Understanding institutions is always useful, but it is especially important here. The results of insider-outsider theories vary considerably with subtle changes in institutional assumptions. In Blanchard and Summers’ model, for example, the number of periods that it takes for a laid-off worker to lose insider status determines which sequences of shocks raise unemployment permanently. In Lindbeck-Snower, the rela- tive speeds at which laid-off workers become outsiders and new workers become insiders determine whether unempIoyment persistence is ‘symmetric’ or ‘asymmetric’. The importance of other institutions, such as seniority rules, is discussed above.

Unfortunately, we do not currently know which institutional assumptions are realistic. Who counts as an insider, and how does one gain or lose that status? How do senior workers treat junior workers? Do nonunionized workers have the same influence over their wages as unionized workers? Why don’t firms hire the long-term unemployed - because these workers’ produc- tivity is low, because they have bad attitudes, or because incumbents will not cooperate with them? Without answering these questions, we cannot choose among the many versions of insider-outsider and human capital theories. And regressions with aggregate data are unlikely to provide the answers. A more promising approach is for researchers to spend time talking to workers and managers in high-unemployment countries about how they behave and why. The work of Piore (1979) could be a model for this approach. Mean- while, we know that lots can happen depending on our choice of assump- tions.

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