Skills, labour costs and vertically differentiated industries: A general equilibrium analysis

The effect of labour costs on industry profits, employment and labour income is at the heart of the current European debate on industry competitiveness. High wages paid in European countries such as Germany are generally considered harmful for industry profitability. Though, high wages appear also to be associated with high labour skills and then with superior product quality. Similarly, a reduction in labour taxes is often invoked as a tool to improve industry profitability, but this argument hardly takes into account the demand effects of such a tax reform. In this paper we analyse the trade-off between labour costs and industry profits by means of a simple general equilibrium model where one industry is oligopolistic and vertically differentiated. The manufacturing of products of a higher quality requires the employment of a larger amount of skilled labour. Given an underlying skills distribution, the model determines profits, wages and aggregate income and welfare. Results show that high net wages due to a low skills endowment in the economy are typically associated with low profits. Labour taxation unambiguously raises gross wages, but has little effect on net wages. Depending on how the tax revenue is redistributed, higher taxation may either depress or boost industry profits.