Product Market Reforms, Labour Market Institutions and Unemployment

Abstract

We analyze the impact of product market competition on unemployment and wages, and how this depends on labour market institutions. We use differential changes in regulations across OECD countries over the 1980s and 1990s to identify the effects of competition. We find that increased product market competition reduces unemployment, and that it does so more in countries with labour market institutions that increase worker bargaining power. The theoretical intuition is that both firms with market power and unions with bargaining power are constrained in their behaviour by the elasticity of demand in the product market. We also find that the effect of increased competition on real wages is beneficial to workers, but less so when they have high bargaining power. Intuitively, real wages increase through a drop in the general price level, but workers with bargaining power lose out somewhat from a reduction in the rents that they had previously captured. JEL codes: E24, J50, L50. Executive Summary High rates of unemployment remain a key policy concern across many European countries. There is a large literature investigating the role of unions, taxes, and other labour market institutions in explaining variation in unemployment rates across countries. In a recent contribution to this literature, Nickell et al (2005) find that changes in these factors can explain about 55% of the rise in European unemployment from the 1960s to the first half of the 1990s. However, it seems likely that changes in labour market institutions alone cannot explain the wide divergences in unemployment experiences across countries. For example, Blanchard (2005) argues that a complex interaction between institutions and other shocks provides an important part of the explanation. In particular, conditions in the product market are also likely to play an important role. Theory suggests that product market competition is a key determinant of employment-in imperfectly competitive markets firms restrict output and thus employment. More intense competition pulls prices closer to marginal cost, increasing output demanded by consumers and, therefore, labour demanded by producers. A number of recent theoretical papers have emphasized the role of product market competition, as well as potentially important interactions between competition and labour market institutions. A recognition of the role of competition also lies behind many of the current attempts to reform product markets in Europe, including those laid out in the Lisbon Agenda and the Services Directive. In this paper we investigate the impact of increased product market competition on employment and wages using data across OECD countries over the 1980s and 1990s. Our contribution to the literature is twofold. First, we use time-varying policy reforms to provide exogenous variation in product market conditions, enabling us to provide stronger evidence that competition increases employment and real wages than exists so far. We show that these effects have been quantitatively important in explaining...

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