American Economic Association Wage Bargaining and Employment Author(s): Ian M. McDonald and Robert M. Solow Reviewed work(s): Source: The American Economic Review, Vol. 71, No. 5 (Dec., 1981), pp. 896-908 Published by: American Economic Association Stable URL: http://www.jstor.org/stable/1803472 . Accessed: 08/12/2011 21:15 Your use of the JSTOR archive indicates your acceptance of the Terms & Conditions of Use, available at . http://www.jstor.org/page/info/about/policies/terms.jsp JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range of content in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new forms of scholarship. For more information about JSTOR, please contact support@jstor.org. American Economic Association is collaborating with JSTOR to digitize, preserve and extend access to The American Economic Review. http://www.jstor.org

Wage Bargaining and Employment By IAN M. MCDONALD AND ROBERT M. SOLOW* One of the perennial problems of business cycle theory has been the search for a con- vincing empirical description and theoretical explanation of the behavior of wage rates during fluctuations in output and employ- ment. Even the empirical question is hardly settled, although the most recent careful study (see P. T. Geary and John Kennan) confirms the prevailing view that real-wage movements are more or less independent of the business cycle. There are really two sub- questions here. The first presumes that nomi- nal wage stickiness is the main route by which nominal disturbances have real macro- economic effects, and asks why nominal wages should be sticky. The second focuses on real wages, and asks why fluctuations in the demand for labor should so often lead to large changes in employment and small, un- systematic, changes in the real wage. We address only the second of these sub- questions. We do so in the context of explicit bargaining over wages and employment by a trade union and a firm or group of firms, though one could hope that the results might apply loosely even where an informally organized labor pool bargains implicitly with one or more long-time employers. We do not harbor the illusion that trade unions are the only important source of wage stickiness. There are other plausible (and implausible) stories. Some, like this one, rest partially on optimizing decisions others do not. The impulse to this study was macroeco- nomic, but our focus is on a single employer and a single labor pool. Our methods, and therefore our conclusions, are entirely partial equilibrium. If the short-run mobility of labor is slight, and if fluctuations in real aggregate demand affect many sectors synchronously, then perhaps the mechanism we uncover here could be important in the business cycle context. But the work of embedding it in a complete macroeconomic model remains to be done. We begin with a model in which the union is a simple monopolist, setting the wage rate unilaterally to maximize the expected or total utility of its members, and allowing the em- ployer complete discretion over employment. We then consider a more complex institu- tional setup in which the union and the firm are supposed to bargain over both wage and employment and reach an outcome efficient for them both. (The monopoly outcome is not efficient, for the traditional reason.) There is, of course, a whole range of efficient bargains. A complete theory must single out one of them, but there is unlikely ever to be universal agreement on the right way to do so. Our approach is simply to try out several simple conventions and several formal solu- tions to the bargaining problem. We provide a framework within which they are all seen to bear a family resemblance to one another. Moreover, there is a certain assumption which makes all the proposed solutions share an important characteristic: the effects of a downswing or upswing in final demand on the negotiated outcome can be decomposed into two steps which reinforce each other with respect to employment and offset each other with respect to the wage. So it would not be surprising to find large fluctuations in employment and small unsystematic fluctua- tions in real wages during business cycles. The key assumption is that product-market conditions are more sensitive to the business cycle than the reservation wage is. This would be the case, for instance, if (a) nonmarket opportunities including unemployment in- surance benefits, which are not cyclically vulnerable, play an important role in the determination of the reservation wage, and/or (b) interemployer mobility is so limited that outside market opportunities figure only slightly in workers' calculations. *University of Melbourne and Massachusetts In- stitute of Technology, respectively. 896