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Labor Market Institutions, Wages, and Investment

Labor market institutions affect the outcomes of workers in a variety of ways. Many of these institutions are related to the wage setting process, and hence influence the wages paid to workers directly. But even institutions like unemployment insurance or employment protection will affect wages indirectly, because they change workers’ bargaining power in the wage setting process. The wages actually set will in turn influence the hiring decisions of firms, and hence employment outcomes. There is a vast literature studying these issues, both theoretically and empirically.

In this paper, I will focus on a more indirect impact of labor market institutions, and of the resulting wage structure, namely their effect on investment decisions made by firms. These decisions to invest in training of the work force and physical capital will change the productivities of workers, and hence also influence wage and employment outcomes. I will focus on a particular premise: frictions in the labor market are important, so that these markets deviate from the competitive benchmark.

These frictions will lead to rents for the firms. Labor market institutions distort the wage structure, and hence the amount of employment rents firms earn from workers with different productivities. This in turn will influence the decisions of firms as to what investment to make in particular workers or jobs. Because labor market institutions, and hence the wage structure, are so different in Anglo Saxon and continental European countries, this story helps us understand the different evolutions of the labor markets in these countries, as I will argue.

The discussion in this paper will draw heavily on work which Daron Acemoglu and I, as well as others, have done in order to understand the financing of on-the-job training. The traditional framework for human capital investment implies that workers will pay for skills which are transferable between employers, and reap the full rewards of this investment. In a series of papers (Acemoglu and Pischke 1998; 1999a; b), we have shown that this may not be true in frictional labor markets. I will start in the next section by reviewing the key theoretical arguments for why frictions and the wage structure matter for human capital investment decisions.

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Labor Market Institutions, Wages, and Investment