Wage setting and unemployment in a general equilibrium model

The purpose of the paper is to argue that exogenous changes lowering wages may imply an increase of unemployment. To support that viewpoint, we use a general equilibrium approach. In that framework, we substitute the labour market clearing equation, which by very definition insures full employment, with the assumption that wages depend on employment and a variable representing all the other exogenous factors influencing the outcome of wage setting. We assume that an increase of that variable determines a decrease of wage for any given level of employment. We further assume that firms compete strategically in the labour market. After having proved there is a unique equilibrium for each economy, we show that an increase of the above mentioned residual variable may cause in equilibrium a decrease in real wages and wage bill along with an increase in unemployment rates and profits. That result suggests what are the effects of a large variety of policies analyzed in the current debate on the role of labour market institution.