Endogenous Distortions in Product and Labor Markets

Abstract

Product and labor market distortions move in the same direction in response to economic and social changes. Conditionality by foreign agencies should target product market distortions. Once they are removed or diminished, labor market distortions will adjust in the desired direction.

Rama and Tabellini use the common agency approach to analyze the joint determination of product and labor market distortions in a small (developing) open economy.

Capital owners and union members lobby the government on tariffs and minimum wages, while factors of production in agriculture (the informal sector) are not organized. The government cares about social welfare, but also values the contributions (monetary or else) made by organized groups.

Rama and Tabellini show that product and labor market distortions move in the same direction in response to changes in the relevant economic and political parameters, and that the level of those distortions is not modified by social pacts between capital and labor. They also show that conditionality by foreign agencies should target product market distortions, not labor market distortions. Labor market distortions ought not to be targeted because they are second best: they are the optimal response to the product market distortions. Labor market distortions are likely to adjust in the desired direction once product market distortions are removed or diminished.

This paper - a product of the Poverty and Human Resources Division, Policy Research Department - is part of a larger effort in the department to analyze the implications of labor market distortions. The study was funded by the Bank's Research Support Budget under the research project The Impact of Labor Market Policies and Institutions on Economic Performance (RPO 678-46). Martin Rama may be contacted at [e-mail].