July 1999

IZA DP No. 49: Unemployment and Labor-Market Reform: A Contract Theoretic Approach

published in: Scandinavian Journal of Economics, 2002, 104 (4), 641-656

Why do many democracies fail to reform their labor market institutions? We study the feasibility of reforms that include the compensation of the insiders for the removal of labor market regulations. In our model workers differ in their ability to perform well on a liberalized labor market. The workers’ ability is unobservable for the government. This informational asymmetry generates additional costs for a government that wants to implement a compensation package together with a labor market reform. Under asymmetric information, a reformer who wants to ’’buy’’ the approval of voters has to pay them an informational rent in addition to the pure costs of compensation that would arise under symmetric information. In this setting unemployment may be constrained Pareto-efficient. Consequently, no reform is accepted unanimously by voters. We show that this result can further be strengthened: under majority voting labor market reforms may fail politically because there exists no reform package that gets the approval of a majority of voters. Our model explains the emergence of political deadlocks where low rates of unemployment can be removed in the political process while high rates of unemployment tend to be politically stable.