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Labour Market Institutions and Wage Inequality

Wage inequality is not only substantially lower in continental European countries than in the US or UK, but also its evolution over time is very different across countries. A fairly consensual position is that the wage distribution reflects both supply and demand factors and the institutional environment. However, it is still debated whether pure factor demand and supply or labor market institutions are quantitatively more important for wage inequality.

A substantial amount of research on wage inequality has studied the forces that may shift the relative demand for skills such as changing trade patterns and skill-biased technical change (see, for example, Machin and van Reenen, 1998, and their references). Since developed economies operate in the same global environment with integrated trade and equal access to technology, exogenous shifts in demand are likely to have been fairly similar across developed countries.

Moreover, although countries expanded their education systems at different times, the proportion of the educated workforce has risen in all countries. Exogenous changes in supply and demand for skills are therefore unlikely to fully explain the different evolution of wage inequality across countries. Indeed, Acemoglu (2003) ?nds that the relative supply and demand framework does not provide an entirely satisfactory explanation of the behavior of skill premia across countries. Hence, there is scope for labor market institutions to be an important part of the story.

Of course, it is empirically very demanding to disentangle the effect of factor supply and demand from institutions. On the one hand, labor market institutions affect the relative market price for skills and therefore they change skill demand and supply. On the other hand, it is likely that institutions themselves respond to market forces (Acemoglu et al., 2001). In fact, the debate on the importance of skill supply and demand for wage inequality compared with institutions is still ongoing. Whereas Blau and Kahn (1996, 2005) stress that a substantial portion of cross-country wage differentials can be explained by labor market institutions, Nickell and Bell (1996), Nickell and Layard (1999) and Leuven et al. (2004) emphasize the importance of the net supply of skills. Unlike this literature, which investigates cross-country differences using cross sectional data, we focus on the different evolution of wage inequality within countries over time.

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Labour Market Institutions and Wage Inequality