QUEST II. A Multi-Country Business Cycle and Growth Model

costs would have to rise. As noted above, except for the case of zero bargaining power of
workers, a decline in taxes or social security contributions will not lead to a fully
proportional decline in wages since workers will increase their share in total surplus. It is
also obvious from equation (25) that no different effects on wage costs should be expected
from a policy of reducing wage taxes as opposed to cutting social security contributions. It
should be expected from a model with informed bargaining behaviour that tax incidence is
independent of who pays the tax. Yet, changes in either the tax rate or social security
contributions can still lead to different results depending on how employment benefits will
respond to these changes.

It is interesting to notice the generality of equation (25). It encompasses the neo-classical
labour supply hypothesis - based on consumption leisure choice - and formulations of wage
equations known from the bargaining literature where wage rules are postulated, which
identify productivity and labour market tightness as major determinants of wage claims by
workers. Which feature of the labour supply dominates in this model depends crucially on
the bargaining strength of workers which we have left undetermined so far. Some
theoretical insights can be gained by specifying alternative institutional details governing
the interaction between firms and workers in the labour market. Consider first the oldest
solution to the pricing problem which is due to Diamond (1971) where employers would
post wage offers and workers search among them randomly without recall. In this situation
it is optimal for firms to set wages equal to the reservation wage since this will be the
lowest wage workers will accept. As Mortensen (1989) has pointed out, the assumption that
employers post wage offers are sufficient to ensure full bargaining power of firms. Also, he
observes, since workers are indifferent between employment and unemployment in this
equilibrium, unemployment can be termed "voluntary". Recently some other models have
been suggested to explain "involuntary" unemployment especially in Europe. Most
prominent among these is the insider-outsider model of Lindbeck and Snower (1987).
Under this hypothesis incumbent workers have bargaining power because replacing them
would be costly for the firm due to search costs. Therefore they can extract a share of the
rents generated by these costs from the firm. Though the insider-outsider story is usually
told under the assumption that workers possess complete bargaining power, Lindbeck and
Snower point out that it is sufficient to assume that insiders receive some part of the rent
generated by turnover costs (β > 0). Since under the assumption of some bargaining strength
of workers the wage exceeds the reservation wage, this hypothesis can explain the existence
of "involuntary" unemployment.

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