chapter 8

© Baldwin&Wyplosz The Economics of European Integration
Economic Integration and
Labour Market Institutions

The message from theory
• Europe mostly fails on the labour mobility
criterion
• A substitute to labour mobility is labour
market flexibility
• How does Europe do on this front?

Dismal labour market performance
Unemployment rate (%)
0
2
4
6
8
10
12
1970 1974 1978 1982 1986 1990 1994 1998 2002
EU Euro area USA

But beware of averages!
0.0
2.0
4.0
6.0
8.0
10.0
12.0
14.0
BIG 4 UK SMALL 8 US
1969 1985 2003

Many other indicators of trouble
• Not just the unemployment rate, also:
– Low rates of labour participation
– Youth unemployment
– Duration of unemployment spells
• General picture
– Many people do not hold jobs
– People can remain unemployed for years
running
– Problem deeper in larger countries, with recent
improvements in the UK and the smaller
countries

Why?
• General assessment is
that labour markets are
rigid in most of
Europe
• A simple illustration:
real wage stickiness

labour
wages
S
D
D1
A
L
W
W1
A’1
A1
L1L’1

More generally
• Real wage rigidity just one example
• Other features include
– Restrictions on hiring and firing
– Restrictions on hours worked
– Minimum wages
– High unemployment benefits as disincentives to
search jobs

A deep conflict
• These features have been introduced to fight
labour market imperfections and/or social
objectives
• They make labour market rigid but serve
other purposes
• No universal response to this deep conflict

A few examples (more details later)
Market failure Standard solution Economic Cost
Dominant power of
employers
Minimum wages,
labour protection laws,
mandatory negotiations
Reduces competition
on the labour market
Information asymmetry: no
good knowledge of workers’
skills and effort at work
Collective wage
negotiations
Reduces competition
on the labour market
Workers are vulnerable to
job uncertainty
Mandatory health and
unemployment
insurance, retirement
benefits
Raises labour costs
and reduces demand
for labour

What is the link with economic integration?
• Deepening integration exacerbates
competition
• Firms compete by reacting quickly and
forecefully to opportunities or shocks
• Inflexible labour markets reduce the ability
of firms to react
• Indirectly, social systems compete against
each other
• The delicate balance achieved in each
country becomes challenged

Labour market institutions
• Existing institutions differ from country to
country
• They are the outcome of a long, and often
conflictual, history
• A look at the most important ones illustrates
the challenges posed by integration

Collective negotiations
• Social objective: protect workers from
bosses’ excessive powers
• Economic impact: an illustration

• Economic impact: involuntary
unemployment
• The role of the degree of centralization
– Plant level: induces some wage restraint
– National level: induces some wage restraint
– Branch level: less restraint

• Economic impact involuntary
unemployment

• Economic impact: unemployment
• The integration and monetary union impact
– One big market: current degree of coordination
in collective negotiations decline
– One central bank: more wage discipline
• Will trade unions respond by organizing at
EU level?

Minimum wage legislation
• Social objectives
– Protect the weakest
– Reduce inequality
• Economic impact: unemployment of the
least skilled

Minimum wage legislation
• Social objectives
– Protect the weakest
– Reduce inequality
• Economic impact: unemployment of the
least skilled
– Enhanced competition favours low cost
countries
– Accessions of CEECs will sharpen this aspect
– Trade unions fear social dumping and call for
harmonisation of social norms

Unemployment insurance
• Social objective: protect workers from a
major risk
• Economic impact:
– Paid out of labour taxes: raises labour costs
– Generous benefits reduce incentives to search
for jobs
– Overall, less employment and more
unempoyment

Unemployment insurance
• Social objective: protect workers from a
major risk
• Economic impact: more unemployment
– Asymmetric shocks create temporary
unemployment
– Generous insurance may prolong the
adjustment
– Pressure to reduce generosity, mainly duration,
of benefits. Trade unions fear social dumping

Employment protection legislation
employers’ arbitrariness
• Economic impact
– Reduces firing during downturns
– Limits hiring during expansions
– Overall no lasting effect on unemployment, but
reduces firms’ ability to deal with adverse
shocks

Employment protection legislation
employers’ arbitrariness
• Economic impact: no effect on
unemployment but reduces firms’ flexibility
– Harder to deal with adverse shocks
– Pressure to reduce strictness of legislation.
Trade unions fear social dumping

Payroll taxes
• Social objective: solidarity among workers
in fianncing unemployment, health,
retirement
• Economic impact: raises cost of labour, or
reduces wages, or both

Payroll taxes
• Social objective: solidarity among workers
in financing unemployment, health,
retirement
• Economic impact: raises cost of labour, or
reduces wages, or both
– Enhanced competition favours low cost
countries
– Incentive to either reduce welfare payments or
raise other taxes. Politically difficult.

How to respond to deeper integration?
• Deeper integration desirable because it
enhances competition on the good markets
• More competition raises the economic costs
of many labour market institutions
• A sharpening of the conflict between
economic effectiveness and social
objectives
• Existing arrangements are threatened

Three possible evolutions
• Two-speed Europe
• Deep reforms
• Social harmonization

Possible evolution No.1
• Two-speed Europe
– Some countries flex their labour markets, others
retain their highly social existing arrangements
– Firms and risk-taking individuals move to the
most flexible countries
– Welfare-conscious are attracted by welfare-
magnet countries
– Part of Europe grows fast with low
unemployment, another part grows slowly with
permanently high unemployment

Two-speed Europe: already there?
Average annual rowth rates 1995-2003
0
0.5
1
1.5
2
2.5
3
3.5
4
Big Three UK USA CEEC Three Small Nine

• Deep reforms
– Labour market institutions made more flexible
– Labour axes reduced

• Social harmonization
– The large countries export their welfare systems
through social norms applicabel to all EU
countries

In the end
• There is no better way, just different socio-
economic equilibria
• A somewhat arbitrary typology
– The continental model
– The Nordic model
– The Anglo-Saxon model
– The Southern European model
– and the evolving accessing countries

Migration flows

Migration Flows
Source: World Bank (2007)

L2
International Labor Mobility
MPL
MPL MPL*
MPL*
Home
employment
O Foreign
employment
O*
A
B
C
L1
Migration of labor
from Home to Foreign
Total world labor force
Marginal product
of labor

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