Wage Formation and the Persistence of Unemployment

Two reasons often mentioned as the source of the European unemployment problem are examined using a basic trade union model. These reasons are: 1. The unemployment is Keynesian in nature, caused by deficient aggregate demand. 2. The unemployment is classical in nature, resulting from trade unions' influence on wage setting. The model incorporates 3 characteristics of many European economies: 1. trade unions' roles in wage formation, 2. employers' discretion in employment decisions, and 3. the fact that employed workers are very rarely exchanged for unemployed workers. The model assumes that there is a single union that has organized all the employees in a firm or industry. The union sets the normal wage rate before it knows the realization of a demand shock that, along with the wage, determines the demand for labor. The results of the analysis suggest that the return to full employment may take time because of the induced effects on wage formation.