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

IZA Logo

IZA Seminar

Place: Schaumburg-Lippe-Str. 9, 53113 Bonn

Date: 11.04.2006, 12:15 - 13:30


Presentation by 

Alena Bicakova (CERGE-EI)


The trade-off hypothesis suggests that high wage inequality in the US and the UK and high unemployment in countries of continental Europe are the consequence of the same negative change in the demand for the low-skilled under different degree of wage rigidity. However, if labor force participation is not perfectly wage inelastic, then rising wage inequality is likely to be accompanied by an increase in the inactivity rate. An extended version of the trade-off hypothesis is therefore proposed here which states that depending on the institutions that affect wage rigidity, there is a trade-off between unemployment on one hand and wage inequality as well as high inactivity on the other. 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 partial evidence in favor of the trade-off hypothesis, as well as its extended version. In addition, the 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, but the supply effects dominated for the least and the most educated.

Download complete paper   
For more information, please contact