New textbook: Frictions and Institutions

My e-textbook, Frictions and Institutions is now downloadable online for free at bookboon.com.

Click here to download Frictions and Institutions

This book is based on my lectures on labor market institutions at Humboldt University Research Training Group and IMT Lucca in August and September 2013. It is a textbook which also contains some original research; the latter is presented in a “raw form”, which is relatively close to the way the ideas were originally formulated. Hence there is little dressing up and sweeping under the carpet, which I believe has pedagogical advantages for an audience of graduate students expecting to develop a career in research.

The goal is to induce the student to work with matching models and to perform the required analysis. This is why many analytical results are presented as exercises for the reader. Also, there is substantial emphasis on proving analytical results as opposed to constructing and calibrating a dynamic stochastic general equilibrium model. Mastering the analytics is important because the economic effects being analyzed are explicitly present in the terms of the analytical equations, and interpreting them correctly is a crucial skill any applied theorist should have.

The book introduces the reader to the now largely standard Mortensen-Pissarides (1994) matching model of the labor market, and then builds a number of applications of this model that allow us to study the distributional effects of various labor market policies and institutions. The motivation is simple: many such institutions are considered as harmful for job creation, yet politically difficult to reform. We want to know why, and the framework developed in this book allows us to find out who gains and who loses from those “rigidities”. These rigidities generate conflicts of interest among workers who are otherwise identical but may be in different current situations in the labor market. The currently unemployed have different preferences from the currently employed, and the latter may also differ by the situation of their firm: Workers in firms that are doing well have different interests from workers in firms that are doing poorly.

After having introduced the basics of the matching model, the book considers a number of specific institutions. For each of those institutions, the effect on the welfare of different kinds of workers is computed. The outcome is also compared to the first best, which in most examples coincides with the market outcome if the famous “Hosios conditions” hold. These conditions state that the surplus from a match should be allocated between the two parties in proportion to the relative importance of their search input in generating new jobs, which turns out to be equal to the elasticity of that input in the matching function. That is, the more a given side of the market is important in the job creation process,
the greater the share of the surplus that we want to give it.

I start with employment protection. An important distinction is made between employment protection as a device that enhances the workers’ bargaining power versus employment protection as a tax on separations. I then study the gainers and losers from unemployment compensation. The analysis, by assuming risk neutrality, ignores the insurance dimension of such policies and focuses on its effects on welfare through wage formation and job search. Finally, I study the role of one specific active labor market policy – a subsidy to job search – in a model where workers differ by their productivity level. It is shown that in addition to the usual congestion externality, job search generates a externality on the average quality of the pool of unemployed.

Frictions and Institutions

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