Market vs. Institutions: The Trade-off Between Unemployment and Wage Inequality Revisited

The trade-off hypothesis suggests that high wage inequality in the US and the UK and high unemployment in countries of continental Europe are consequences of the same negative change in the demand for the low skilled under different degrees of wage rigidity. This paper uses a labor supply and labor demand model with heterogenous types of labor in order to test the trade-off hypothesis and to analyze the effect of market forces and wage rigidity on changes in the between-group variation in earnings, employment, unemployment, and inactivity in France, the UK, and the US between 1990 and 2002. The results provide clear evidence in favor of the trade-off hypothesis when France is compared to the US as well as to the UK. We also find that labor supply and labor demand are more wage elastic in the UK than in the other two countries. Counterfactual simulations based on the estimated model reveal that exogenous changes in the relative demand for skills dominated in France, while supply shifts had more impact in the US over the studied period. In the UK, the opposite effects of the supply and the demand shifts were of similar magnitude, even though the supply effects dominated for the least and the most educated. In addition, an extended version of the trade-off hypothesis is proposed which considers not only wage inequality and unemployment but also labor supply. If labor force participation is sensitive to wages, then rising wage inequality is likely to be accompanied by an increase in the inactivity rate. We find that wage elasticity of labor force participation is positive and significant in all three countries, and suggest that depending on the institutions that affect wage rigidity, there is trade-off between unemployment on one hand, and wage inequality and inactivity on the other.