Eurasian Bus Rev (2016) 6:79–99

DOI 10.1007/s40821-015-0024-2

ORIGINAL PAPER

Can labour market rigidity foster economic efficiency?

A model with non-general purpose technical change

Gianluca Grimalda1,2,3

Received: 13 January 2015 / Revised: 7 April 2015 / Accepted: 9 June 2015 /

Published online: 9 July 2015
Ó Eurasia Business and Economics Society 2015

Abstract The contrasting effects of labour market rigidity on efficiency are

investigated in a model where technological change is non-general purpose and
different types of skills are available to workers. Ex ante efficiency calls for high
labour market rigidity, as this favours workers’ acquisition of specific skills which
have higher productivity in equilibrium. Ex post efficiency calls for low market
rigidity, as this allows more workers to transfer to the innovating sector of the
economy. The trade-off between these two mechanisms results in an inverse-U
shaped relationship between output and labour market rigidity, which implies that a
positive level of labour market rigidity is in general beneficial for the economy.

Keywords Non-general purpose technology  Labour market rigidity 

Specific and general human capital

JEL Classification J24  J31  O30

Electronic supplementary material The online version of this article (doi:10.1007/s40821-015-0024-2)

contains supplementary material, which is available to authorized users.

& Gianluca Grimalda

grimalda@uji.es
1
Universitat Jaume I, Av. de Vicent Sos Baynat, 12071 Castelló de la Plana, Espanya
2
Kiel Institute for the World Economy, Christian Albrecht University of Kiel, Kiellinie 66,
24105 Kiel, Germany
3
Centre for Global Cooperation Research, University of Duisburg Essen, Essen, Germany

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80 Eurasian Bus Rev (2016) 6:79–99

1 Introduction

Labour market rigidity has been studied extensively over the last decades in relation
to the allegedly poor performance of continental Europe labour markets in
comparison to that of Anglo-Saxon countries. The various aspects that contribute to
make a labour market rigid have been analysed, generally leading to negative
conclusions as to their effects.1 A strand of this literature has focused on the impact
of labour market rigidity on labour productivity, reaching similar conclusions. The
argument of Saint-Paul (2002) has been that rigidity contributes to keep less
productive firms in the market, in addition to generating rents for employed workers
at the expense of the unemployed. A reduction in rigidity will thus cause the
replacement of less productive firms with more productive ones. Although the
consequences for overall employment may be uncertain, this change will boost both
average productivity and total output.
Even if some voices have been raised against this general view,2 the idea that a
reduction in labour market rigidities will engender beneficial effects for the
economy has received widespread support among labour market scholars. However,
even a superficial look at the reality of the OECD economies shows that this general
wisdom is not as clear-cut as it may seem. Figure 1 shows non-linearities in the
relationship between EPL and average productivity levels over three different
5-year spells. Countries at medium–high levels of rigidity seem to outperform others
in terms of productivity. Figure 2 shows that countries that have made their labour
markets more flexible, which result in a decrease in their EPL, do not seem to have
made systematic gains in terms of productivity. Grimalda (2007: 8) fits a simple
econometric model to the data presented in the Figures, and shows that both the
linear and quadratic term of EPL are strongly significant predictors of productivity.
Hence, the non-linearity apparent in Fig. 1 seems to receive some statistical support.
The aim of this paper is to build a theoretical model addressing the relationship
between productivity and labour market rigidity from the angle of technical change
and incentives in skills acquisition. The focus is on non-general-purpose technical
innovations. This type of innovation generates a non-obvious trade-off in workers’
choice between specific vis-à-vis general skills. In spite of its extreme simplicity,
the model is able to generate non-linearities in the relationship between productivity
and labour market rigidity, which makes some positive levels of rigidity generally
beneficial for the economy’s efficiency.

1
Some of the aspects that have been analysed are firing costs (Bentolila and Bertola 1990), the
unemployment benefit system (Layard et al. 1991), the loss of human capital during unemployment spells
(Ljungqvist and Sargent 2002), insider-outsiders relations (Blanchard and Summers 1987), the inability of
systems to adjust either to macroeconomic shocks (Blanchard and Wolfers 2000) or to microeconomic
ones (Gottshalk and Moffitt 1994).
2
Atkinson (1999) has objected that the rolling back of the welfare state to which the process of
liberalization would lead may in fact decrease labour markets efficiency. Nickell and Layard (1999)
conclude that the empirical evidence on the negative impact of labour market rigidity is limited to some
institutions, mainly unemployment benefits and strong and uncoordinated unions, but is at best weak for
the remaining ones. Others have pointed to the social costs associated with market liberalization (Rodrik
1997), and have noted that welfare institutions tend to be larger in more open countries, thus underlining
their positive function in absorbing macroeconomic shocks (Agell 1999). See also Howell et al. (2007).

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Eurasian Bus Rev (2016) 6:79–99 81

a 60 b

60
Mean Productivity (1988-1992)

Mean Productivity (1996-2000)

50

50
NOR

BEL
40

40
NET
GRE
IRE FRA
NOR
BEL US
NET DEN GER
ITA ITA
US SPA SWE
FIN AUT
CAN AUS
30

30
FRA UK SWI SPA
IRE SWE
DEN GER
UK CAN
AUS FIN
JAP
POR NZL
SWI GRE
POR
20

20
JAP HUN
SLO
CZE
POL MEX
KOR
10

10
0 1 2 3 4 0 1 2 3 4
EPLI 1990 EPLI 1998
Median Spline Line Median Spline Line

c
60
Mean Productivity (2001-2005)

NOR
50

BEL

NET FRA
40

US IRE GER

DEN SWE
AUT
FIN
UK SWI
CAN AUS
JAPITA
30

SPA

NZL GRE

POR
20

SLO CZE
HUN KOR
POL
10

MEX

0 1 2 3 4
EPLI 2003
Median Spline Line

Fig. 1 Labour productivity and labour market rigidity over three 5-year Spells. Notes The most
commonly used indicator of market rigidity is the OECD Employment Protection Legislation Index
(EPLI), which measures various aspects of the costs that a firm has to sustain for workers’ layoffs—both
for individual and collective dismissals—as well as how easy it is to hire on temporary contracts (OECD
2004: Chapter 2). Aggregate productivity is calculated as GDP per hour of work. a–c Report some
scatterplots of the mean productivity levels over three different 5-year spells against the EPLI for a
sample of OECD economies. These spells are centred on the 3 years in which the EPLI has been issued
by the OECD (1990, 1998, 2003). Labour productivity is defined as GDP per hour worked; GDP is Gross
Domestic Product expressed in current US Dollars at PPP. Labour input is defined as total hours worked
of all persons employed. The data are derived as average hours worked from the OECD Employment
Outlook, OECD Annual National Accounts, OECD Labour Force Statistics and national sources,
multiplied by the corresponding and consistent measure of employment for each particular country.
Sources Data for productivity are taken from OECD, Statistics Portal. Data for the EPLI are from
OECD.stat, v.3.2. Data refer to the Overall EPL, version 1

The model draws on two basic notions. First, the treatment of the institutional
features of the labour market is carried out in conjunction with the classic
distinction, originally put forward by Becker (1964), between specific and general
skills. Specific skills may mainly be used by a worker in relation to a specific firm,
whereas general skills can be transferred across firms. The first mechanism that is
analysed is that rigid labour markets should foster workers’ incentives to invest in
firm-specific rather than general human capital, because of the reduced probability
of the worker being dismissed by a firm. The reason is obviously that workers being
made redundant will see firm-specific human capital become idle, as that may not be

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82 Eurasian Bus Rev (2016) 6:79–99

a b

Variation in labour productivity growth

SWE
Variation in labour productivity growth

4
1 AUS
CAN

IRE
UK
NOR
GRE

from 90's to 2000's

2
US
from 80's to 90's

GER
0

FIN
US
ITA
NET
JAP SWE

0
BEL NZE
DEN
SPA
NOR AUS FRA
DEN
FIN NET
KOR
BEL
CAN UK
GER
-1

FRA ITA IRE

-2
JAP

SPA
POR
-2

-4
-1.5 -1 -.5 0 .5 -1 -.5 0 .5
Variation in EPL from 1990 to 1998 Variation in EPL from 1998 to 2003

Fig. 2 Labour market liberalization and changes in labour productivity growth. Sources see Fig. 1

used in other firms.3 It is clear that, if there was no need for workers to change their
jobs over time, the situation in which all workers acquired firm-specific skills would
maximise total output, as by definition these would permit higher productivity at the
firm-level than general skills. Therefore, one consequence of labour market rigidity
is that it should lead to higher firm-level productivity, and thus to higher output in
the economy.
However, workers do need to change their jobs, mainly in relation to processes of
technological progress and structural change taking place in the economy. The
second mechanism that the model takes into account is related to the treatment of
technological progress. Almost all of the literature takes technologies to be general
purpose (GP), that is, applicable to the whole set of techniques currently available.
General purpose technologies (GPTs) have certainly had a major role in the
experience of developed economies (Bresnahan and Trajtenberg 1995). Information
Technologies are a typical example of GPT given their wide range of applicability
across industries and jobs, and the scope of the transformations associated with their
implementation is all too clear. However, it is also apparent that technological
progress has a strong sector-specific and firm-specific component (see e.g. Petit and
Soete 2001), partly due to the tacit nature of technological knowledge (Dosi 1988;
Vivarelli 1995).4 In spite of the obvious practical relevance of the idea of non-GPTs,
only rarely has this approach been investigated in the literature, exceptions being the
seminal work of Atkinson and Stiglitz (1969), and the model of Violante et al.
(2002) in their account of wage inequalities within a model of growth.
Taking into account this idea is crucial in the present model because the uneven
distribution of non-GPTs innovations across economic sectors calls for relevant
structural adjustments in the allocation of the workforce for efficiency reasons.
Output gains for the economy may be brought about by reallocating workers from
3
Firms too will have fewer incentives to impart on-the-job training leading to specific human capital in
more slack labour markets, given the higher probability of losing this investment should the worker leave
the firm. This model will not take into account the latter aspect, as it will only focus on workers’
incentives.
4
GP and non-GP innovations are likely to be interlinked. The introduction of a GPT is likely to generate
different paths of technical innovations in different sectors and different firms, thus triggering what are in
fact non-GP innovations.

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Eurasian Bus Rev (2016) 6:79–99 83

those technologies that have failed to innovate into those that have successfully
innovated. The distinction between general and specific skills is relevant in this
respect, because workers having acquired general skills should have a greater ability
to move across sector thanks to the greater transferability of their human capital in
comparison with specific skill workers. In this case, greater labour market flexibility
should facilitate such workforce cross-sector adjustments, thus engendering
productivity gains for the economy.
Therefore, a trade-off arises in the model between what are defined ex ante and
ex post efficiency, where the two concepts of efficiency refer to the time where a
non-GP innovation occurs. The former requires more workers to acquire specific
skills, as this increases firm-specific skills and thus raises overall productivity before
a non-GP innovation takes place. On the other hand, ex post efficiency calls for
more workers to acquire general skills, as this enables more workers to move to the
innovating sector after a non-GP innovation has occurred. Consequently, higher
labour market rigidity has a positive (negative) effect on ex ante (ex post) efficiency.
The resulting relationship between rigidity and total output is thus non-linear, and
gives rise to an inverse-U shaped pattern, with ex ante (post) efficiency being
predominant at low (high) values of rigidity.
The existing literature has generally considered these two mechanisms only
separately, thus reaching only partial results. Saint-Paul’s (2002) is a typical
example of a model only taking into account ex post efficiency. Unlike these
approaches, the present model is capable of taking into account both the ex ante and
ex post efficiency factors in a unified framework, thus offering a more compre-
hensive—and at the same time simple—interpretative model of reality. Moreover, it
innovates on the existing literature by considering workers’ choice on their skills in
relation to non-GP innovations. The structure of the paper is as follows. Section 2
presents some theoretical and empirical background over the relation between
productivity and labour market rigidity. Section 3 illustrates the model and puts
forward the equilibrium conditions for the first best. Section 4 studies efficiency in a
second best context. Section 5 discusses the results and Sect. 6 concludes.

2 Theoretical and empirical background

The notion of labour market rigidity can apply to both wage and non-wage aspects of a
labour contract. Here my focus is on non-wage aspects, and specifically on
employment protection legislation (EPL). This has been conceptualised as the ‘‘set
of mandatory restrictions governing the dismissals and recruitments of employees’’
(Cahuc and Koeniger 2007). The short-run impact of EPL should be to depress
productivity. Because EPL is equivalent to a tax on firing workers, firms do not adjust
employment even when marginal productivity is less than the wage. However, this
result may change in the longer run if we consider all adjustments in the labour market.
In a standard perfectly competitive model of the labour market, EPL causes a shift
inwards in labour demand. Assuming that workers derive a benefit of equal proportion
in terms of their utility—because of the added security of their contract—labour
supply shifts outwards by an equal amount. The final effect is then a reduction in

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wages, and no employment variation (Summers 1989; Lazear 1990). However, if

workers’ utility gain is different from its cost, then a wedge is created between gross
and net wages. If the benefit is lower (greater) than the cost for the firm, then welfare
and employment losses (gains) are generated. Ambiguous conclusions are also
generated within an equilibrium unemployment model (Mortensen and Pissarides
1994; Kugler et al. 2003), where wage and employment levels are determined by Nash
bargaining between entrepreneurs and trade unions. An increase in EPL causes
employees’ outside option to improve. Hence workers demand higher wages.
Employers react by reducing hiring and increasing the productivity threshold. This has
ambiguous effects on both productivity and employment levels. Similar results are
obtained by Nickell (1978), Bentolilla and Bertola (1990) and Bertola (1990). In fact,
there exists little evidence of an aggregate employment impact of EPL (Nickell et al.
2005; Bassanini and Duval 2006).
Not only does EPL have direct ramifications for the labour market equilibrium
and productivity, but also it has indirect effects through firms’ capital adoption
strategies and the technical change possibly spurred by EPL. It has been argued that,
for the same reasons outlined above, EPL determines a reduction in labour demand,
which is compensated by an increase in demand for capital. If this is the case
employment should fall while labour productivity increases. The effect on total
factor productivity (TFP) is however unclear. Conversely, it has also been argued
that EPL will depress technological innovation or slow down the adjustment to
long-run productivity levels, because of the higher costs of labour dismissal if the
innovation proves unsuccessful (Saint-Paul 2002; Bartelsman et al. 2004). Burgess
et al. (2000) and Caballero et al. (2013) provide empirical support for this idea.
More generally, Hopenhayn and Rogerson (1993) show within a general equilib-
rium framework how firing restrictions force firms to use resources less efficiently.
This will have a negative impact on TFP.
EPL may also exert independent effects at the level of the relations between
employers and employees. Some have posited that EPL will have a positive effect
on labour productivity and TFP because, as a reaction to the heightened firing costs,
firms are forced to improve the screening of their workers and this increases
productivity (Koeniger 2005; Lagos 2006). Others have posited that the effect may
be opposite, as workers who would normally be fired because of their low
productivity are kept in the job, so this reduces their productivity (Riphahn 2004;
Ichino and Riphahn 2005).
One can see that several arguments can be put forward with opposing
implications on the relationship between EPL and TFP. In the present paper we
focus on a different channel for this relationship, which has to do with the choice of
specific vs. general skills by the employee. As illustrated in the introduction, the
idea we want to examine is that in the presence of non-general purpose
technological change ex ante and ex post efficiency calls for investments in
specific or general skills, respectively. This may generate non-linearities in the
relationship between EPL and TFP.
The present model belongs to a family of models studying the incentives
underlying the choice of specific or general skills. Wasmer (2006) investigates the
structural parameters of the labour market favouring the acquisition of specific as

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opposed to general skills, so that two different steady states emerge. In his model the
acquisition of specific (general) skills is favoured by less (more) changeable
environments. Belot et al. (2007) argue that job security may incentive workers to
invest in firm-specific skills, thus increasing productivity. Soskice (1997) and Hall
and Soskice (2001) note that the German model is based on incremental
technological innovation, while the US and the UK specialise in emerging radically
new technologies. They argue that this accords well with higher job protection in
Germany vis-à-vis Anglo-Saxon countries, as incremental innovations demand
closer cooperation between firm management and the workforce. In Ljungqvist and
Sargent (2002) a ‘laissez-faire’ and a ‘welfare-state’ economy emerge as possible
equilibria of their model where the key mechanism is the loss of human capital
during unemployment spells. Jovanovic and Nyarko (1996) focus on the trade-off
between expanding the knowledge of an existing technology versus opting for a
newer technology. Depending on the degree of transferability of one’s skills towards
the latest technology, a worker may be locked into an old technology although
technologies with higher profitability are available in the economy. The model
developed in this paper is novel, though its main results are compatible with Belot
et al. (2007) and Wasmer (2006), in that it explicitly focuses on non-GP and on the
inter-sector dynamics of the labour market.
At the empirical level, Belot et al. (2007) find an inverse-U relationship between
EPL and productivity in a cross-section of OECD countries. This is consistent with
Fig. 1, and is the type of evidence that the model put forward in the present paper
can explain. However, other empirical accounts using different samples and
different levels of aggregation offer a different picture on the relationship between
EPL and productivity. De Freitas and Marshall (1998) find a negative effect of EPL
on labour productivity growth in the manufacturing sector within a sample of Asian
and Latin American countries. On the contrary, Nickell and Ladyard (1999) and
Koeniger (2005) find a positive effect on TFP growth and R&D intensity of more
stringent EPL in a sample of OECD countries. Other studies use micro data to
identify better the impact of more stringent EPL on productivity. Autor et al. (2007)
exploit the staggered implementation of EPL reforms in different US states as a
‘‘natural experiment’’ to investigate the impact on different industries productivity.
They find that increased EPL leads to reduced entry and increased plant survival,
reduced job turnover in sectors characterised by high seasonal job turnover,
increased employment, especially from continuing firms, although causality is
questionable for the latter inference. They also find capital deepening, which goes
hand-in-hand with a reduction in TFP but an increase in labour productivity. Similar
results are obtained by Cingano et al. (2010), and Micco (2006). Bassanini et al.
(2009) examine the effects of dismissal regulation on productivity in the OECD
using industry-level time-series data on productivity and cross-country aggregate
data on EPL. They find a negative impact of EPL on productivity growth, which are
concentrated in industries where EPL is most likely to be binding. We believe that
the results coming from industry-level analysis are not necessarily incompatible
with those obtained in cross-country analysis, because of the differences in time-
span and level of aggregation. Moreover, it is plausible that EPL reforms may have
different short-run and long-run impacts. Specifically, the choice over the type of

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skill to adopt, which is the object of analysis of this paper, are likely to exert effects
in the longer run. Negative evidence found over short-time spans may be
inconclusive in this respect.

3 The model

3.1 General features

The model developed in this section is related to Violante et al. (2002) in assuming
that two different technologies are available to produce a certain commodity, and in
that technological change is not GP. That is, innovations occurring for a technology
cannot be used to improve the productivity of the other. I model technological
change by assuming that a technical innovation occurs for just one of the two
technologies, with even probability for this event to happen. In other words,
although there is certainty that an innovation will occur, it is a priori unknown for
which technology the innovation will take place. The model is static and thus
abstracts away from dynamic economies of scale, which may make innovations
more or less likely in one of the two sectors depending on the past history of
technical progress. Technologies are exactly equivalent prior to the occurrence of
the innovation.
Workers of this economy may choose between specific and general skills.
Specific skill workers are highly specialised in the use of one of the two
technologies, but little specialised in the other. Conversely, general skill workers do
not acquire any technique-specific specialisation, so that their productivity is, ceteris
paribus, the same in the two techniques. A crucial assumption is that a cost must be
paid for specific skill workers to acquire their technique-specific specialisation. This
should be regarded as a payment for the training they receive in the use of the
technique in which they become specialised. In turn, the use of specific skill workers
makes a certain technology ceteris paribus more productive than when general skill
workers are employed. This means that total factor productivity is higher when
specific skill workers are employed. Since it is assumed that returns to scale are
decreasing in labour, the same may not necessarily be true for marginal
productivity. However, as will be demonstrated, the entry cost for specialised
workers makes their average equilibrium wages higher than that of general skill.
This creates a gap in the marginal productivity of specific and general skill labour
that advantages the former. As a result, the marginal productivity of specific skilled
labour will in general be higher than that of general skill workers.
Specific skill workers may be seen as the workers ‘elite’, in that they receive
more years of training—or a more intensive educational activity—and are thus
better able to boost production in a certain sector. However, a general skill worker is
able to transfer her skills across the two technologies more easily than a specific
skill worker. For simplicity, I assume that specific skill workers may only be
employed in one technology, whereas general skill workers may migrate across the
two technologies, up to a transfer cost. Another way to look at this assumption is to
think that a specific skill worker executes a specific investment in the firm at which

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she is hired, which makes it economically unprofitable to switch to the alternative

technology. Workers have to choose in which technological sector to locate prior to
receiving their training. Being the individual probability of innovation equal to ‘,
agents are indifferent as to which technological sector to choose, so that they will
distribute equally across the two sectors. In this version of the model, it is assumed
that firms may not move across sectors.
The timing of the model is described in Fig. 3. First, agents decide which
technological sector to enter. For the law of large numbers workers will distribute evenly
across the two sectors. They then decide whether to acquire technology-specific or
general skills. Their type of skill remains fixed thereafter. Once such a choice has been
made, a worker joins a firm. Subsequently, workers observe in which technique the
innovation has occurred, and general skill workers may decide to migrate towards the
alternative sector upon the payment of a transfer cost. At this point, production occurs
and wages are paid according to workers’ marginal productivity.
We consider the transfer costs that general skill workers have to sustain to move
across sectors as a measure of labour market rigidity. In other words, rigidity is seen
in this model as hampering workers’ capacity to leave a firm to move to another one.
Admittedly, this way of modelling rigidity is fairly general and does not capture all
of the more fine-grained aspects associated with labour market rigidity. Even so, we
believe that the model captures the most important characteristics of rigidity and
that the results we obtain are robust to more detailed specifications.

3.2 Basic setting

We proceed backwards to illustrate the formal specification of the model. The

superscripts S, G denote whether agents have acquired a specific or a general type of
skill, respectively. The subscript I, N and M denote the sectors where workers are
located. I stands for innovating sector, N for non-innovating sector, and
M characterises those workers with general skills who migrate from the non-
innovating to the innovating sector.
First, let us deal with the innovating sectors. Managers who are active in this
sector maximise the following profit function:
pI ¼ YIS þ YIG  wSI lSI  wG G G
I ðlI þ lM Þ ð1Þ
where the production functions have a Cobb-Douglas form:

YIS ¼ AS ð1 þ cÞðlSI Þa ð2Þ

Workers Workers Workers are An innovation Some general Production

choose in choose which assigned to a occurs in one skill workers takes place and
which of the type of skill to firm. of the two swap sector. workers are
two sectors adopt. technologies. paid their
to locate. wages.

Fig. 3 Timing of the model

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G a
YIG ¼ AG ð1 þ cÞðlG
I þ lM Þ ð3Þ

and where the following set of restrictions apply:

AS [ AG ; c [ 0; a 2 ð0; 1Þ ð4Þ

Managers can employ both specific and general skill workers, whose respective
contributions to production are additively separable. General skill labour input
comprises both incumbent workers and those migrating after the innovation takes
place. Different wage rates are paid to specific and general skill workers on the basis
of their marginal productivity, but the same wage rate is paid to general skill
workers, regardless of whether they are incumbent or they have migrated.
Furthermore, output has decreasing returns to scale in labour in both the specific
and the general labour input. The ‘scarce’ factor in the production function is
assumed to be managerial competences, as for instance in Rigolini (2004) and
Mookherjee and Ray (2003). Specific skill workers are characterised as being more
effective in using a certain technology. This is reflected in AS [ AG, i.e. total factor
productivity in YIS is higher than in YIG . c represents the productivity bonus brought
about by the innovation. Although specific skill workers may be thought of as being
better able to exploit the benefits of an innovation, for simplicity it is assumed that
both categories of workers are equally able to reap the innovation bonus.
Maximisation of the profit function with respect to either labour input yields the
following optimality conditions:
wSI ¼ aAS ð1 þ cÞðlSI Þa1 ð5Þ

M a1
wG G G
I ¼ aA ð1 þ cÞðlI þ lI Þ ð6Þ

Additionally, it is assumed that the transfer costs for general skill workers
moving from the non-innovating to the innovating sector equal a proportion cT of
their wage. Their net wage is then equal to:
wG G
M ¼ wI ð1  cT Þ ð7Þ
cT is a key parameter of the model because it identifies the economy’s level of
market rigidity. The main idea is that economies with higher (lower) labour market
rigidity will be characterised by higher (lower) transfer costs for workers wanting to
leave a firm and join another one. Such costs may be thought of as a penalty that a
general skill worker has to pay to her former firm in the non-innovating sector—or
to the government—in order to leave that firm and move to a firm in the innovating
sector.5 Although transfer costs may include a variety of costs not directly

5
It might appear counter-intuitive that market rigidity engenders a cost for a worker, rather than
representing a form of protection. However, this characteristic of the model may be easily made more
realistic by modelling explicitly managers’ choices, and assuming that the transfer cost was paid by the
firm rather than by the worker. Even in this case, transfer costs would hinder workers’ cross-sector
transferability and would reduce the possibility of being re-employed in the innovating sector of the
economy. Hence, the same results would be obtained as in the present form of the model.

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Eurasian Bus Rev (2016) 6:79–99 89

controlled by a policy-maker—such as costs for geographical relocations, fixed

legal costs, etc.—cT will be thought of as a variable of economic policy, so that it is
possible to link explicitly its value to different institutional settings.
Let us now consider the sector that does not innovate. Managers who are active
therein will maximise the following profit function:
pN ¼ YNS þ YNG  wSN lSN  wG G
N lN ð8Þ

YNS ¼ AS ðlSN Þa ð9Þ

a
YNG ¼ AG ðlG
NÞ ð10Þ

This is identical to (1) through (3) except for the absence of c. lG

N is the number of
general skill workers who do not migrate to the innovating sector. Optimal
employment of labour yields the following conditions:
wSN ¼ aAS ðlSN Þa1 ð11Þ

G G a1
wG
N ¼ aA ðlN Þ ð12Þ

3.3 The equilibrium conditions

Since managers are assumed not to be able to move across sectors, the equilibrium
conditions only concern workers’ decisions. There are five different categories of
workers (specific and general skill workers active in either the innovating or in the
non-innovating sector, and general skill workers migrating to the innovating
sectors). Five conditions are thus needed. Equations (5–7) and (11–12) above set
wages accordingly.
Firstly, conditions (13) and (14) are direct consequences of the way the model
has been constructed:
lSI ¼ lSN ð13Þ

lG G M
I ¼ lN þ lI ð14Þ

Each condition requires the distribution of workers across the two technological
sectors to be even. The reason is that workers have to choose a sector before the
innovation occurs, and each sector looks equally profitable to both specific and
general skill workers. Condition (15) requires the number of workers employed be
equal to the total supply of labour L.
lSI þ lSN þ lG M G
I þ lI þ lN ¼ L ð15Þ

Full employment is assumed, so that (15) is always satisfied. Condition (16)

requires general skill workers who are located in the non-innovating sector to be
indifferent between migrating to the alternative sector and remaining in the current
sector:

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wG G
M ¼ wN ð16Þ

The final condition concerns which type of skill to acquire. Since a specific skill
worker has a probability equal to ‘ of earning a wage in either the innovating or in
the non-innovating sector, her expected wage, denoted with w ~S , is:
1
~S ¼ ðwSI þ wSN Þð1  cS Þ
w ð17Þ
2
cS is the training cost that specific skill workers have to pay in order to acquire their
specialisation. It is assumed to be a portion of the expected wage that will be earned
once employed. Similarly, a general skill worker’s average wage is equal to:
1
~G ¼ ðwG
w þ wG
NÞ ð18Þ
2 I
Equation (18) makes use of condition (16) above in that a worker who is
originally located in the non-innovating sector earns the same wage whether she
moves to the alternative sector or remains in the non-innovating sector. Moreover, it
is assumed that no additional cost is required to acquire this type of skill, unlike
specific skill workers.
Condition (19) requires the expected wage of specific and non-specific skill
workers to be equal to one another:
~S ¼ w
w ~G ð19Þ

A steady state of the system is defined as the set of wage rates and labour
allocations that satisfies the system of 10 equations given by (5–7), (11–16) and
(19). The analytical solution is derived in the Supplementary Online Material
(SOM): Section S1.1.

3.4 Efficiency and first best

The normative criterion that is used for efficiency analysis is unconstrained

maximisation of expected output. This does not require Pareto-efficiency for each
labour category, as in Saint-Paul (2002), because side-transfers are implicitly
assumed to be possible. Maximisation is unconstrained because both transfer costs
and skill upgrade costs are assumed to be revenues for some other agents who are
part of the economic system. Consequently, the relative costs and benefits cancel out
in the policy-maker’s objective function. Cross-sector transfer costs are considered
as instruments of economic policy, alike fiscal revenues for the government, which
are redistributed in some forms to the agents after their collection. The
maximisation is on ‘expected’ output because it is assumed that the policy-maker
is subject to the same informational constraints outlined in Sect. 3.2. This implies
that conditions (13), (14), and (15), relative to the ex ante allocation of labour across
sector, will act as constraints for the policy-maker’s maximisation problem. The
equilibrium conditions (16) and (19) relative to workers’ incentives to move across

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sectors do not instead act as constraints, as an increase in total output may derive
from the violation of these conditions.
Once the constraints (13), (14), (15) are substituted into the policy-maker’s
objective function, this boils down to the following expression:
a G a G a G a
maxfAS ð1 þ cÞðL=2  lG S G G G G
I Þ þ A ðL=2  lI Þ þ A ð1 þ cÞðlI þ lM Þ þ A ðlI  lM Þ g
lG G
I ;lM

ð20Þ

The two first-order conditions yield:

 G  G
MPG G G G G
I  oYI oðlI þ lM Þ ¼ oYN olN  MPN ð21Þ
    G
MPSI þ MPSN  oYIS olSI þ oYNS olSN ¼ oYIG oðlG G G G G
I þ lM Þ þ oYN olN  MPI þ MPN
ð22Þ

Condition (21) captures ex post efficiency. It prescribes that marginal produc-

tivity be the same in the two sectors employing general skills. Since non-GP
innovations increase total factor productivity in the innovating sector but not in the
non-innovating one, optimal allocation of labour requires the shift of some workers
towards the latter until marginal productivity is equalised. The term ex post
emphasises that the achievement of this target requires an adjustment of workers
after the innovation has occurred. Condition (22) refers to ex ante efficiency. Given
the impossibility for a specific skill worker to move across sectors, a condition
analogous to (21) is impossible. Condition (22) prescribes instead that the loss in Y S
from ‘‘transforming’’ a general skill worker into a specific skill worker should be
compensated by an increase in Y G of the same size. In other words, the allocation of
workers across the two sectors must be optimal before the innovation occurs, so that
no reallocation of workers may increase total expected output.

4 Second best analysis: the impact of an increase in labour market

rigidity

4.1 An overview

Conditions (21) and (22) define the first best solution for the economy.
Nevertheless, the presence of both labour market rigidity and training costs to
acquire specific skills introduce a gap between marginal productivities, leading to
the violation of these conditions (see SOM: Figure S4). The terms ex post and ex
ante inefficiencies—or output losses—will be used to denote departures from such
first best. In this section I analyse second best optimality conditions, where the
transfer costs cS are taken to be structural parameters of the model—and thus
outside the control of policy-makers, whereas transfer costs cT are the variable
subject of economy policy. Rather than determining analytically the second best

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solution, I will show that, given a positive cS , it is optimal for the policy-maker to
set a positive cT, which determines a unique maximum for overall output.
There are two channels whereby cT affects total output. As far ex ante efficiency
is concerned, an increase in cT will make more attractive for workers to acquire
specific skills. The reason is that the higher cT , the lower the expected wage for
general skill workers because of their reduced cross-sector transferability. Conse-
quently, more workers will be employed in the specific skill sectors of production in
the economy, which will increase total output given the higher average marginal
productivity in that sector. Second, an increase in cT will ex post curtail the
possibility for general skill workers to move towards the innovating sector. As a
result, fewer workers will be able to move to the sector of the economy where the
technology is more efficient, thus reducing output. Therefore, an increase in cT has
at the same time a positive effect on output in that it makes ex ante more convenient
for workers to acquire specific skills, but has a negative effect in that it hinders the
possibility for general skill workers to migrate to the more efficient sector of the
economy ex post. The next sections demonstrate that the trade-off between ex ante
and ex post second-best efficiency leads to an interior maximum.

4.2 Effects on general skill labour

The following proposition holds:

Proposition 1 As cT increases, overall production by general skill workers will
decrease:

oY G ocT \0 8cT \
cT
where:

Y G ¼ YIG þ YNG ð23Þ

The value of cT is given in ESM: expression (31). It is the value beyond which
transfer costs are too high for workers to move across-sectors and a corner solution
would emerge. This case is not analysed. Proposition 1 states that higher transfer
costs decrease the overall output produced by general skill workers. The proof is
developed in ESM: section S1.2.1. This result seems intuitive but is less clear-cut
than what one could expect. On the one hand, an increase in cT clearly reduces lG M
because cross-sector movements from the non-innovating to the innovating sector
are more costly (see ESM: Lemma 1). Additionally, increased cT also affects the
incentives that workers have in choosing generalised skills in the first place. In
principle, one would expect that fewer workers would choose general skills because
of the lower expected wage rate. However, Lemma 2 in the ESM shows that this is
the case only below a certain threshold c^T 2 ð0; cT Þ, whose expression is given in
ESM: (33). Lemma 3 demonstrates that the overall effect is for production in the
innovating sector to drop as cT increases. Conversely, output in the non-innovating
sector of the economy increases as cT increases, for the simple reason that more

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workers remain ‘‘trapped’’ in that sector because of the increased transfer costs.
Comparing the size of the decrease in YIG and of the increase YNG leads to non-
ambiguous conclusion that the former effect dominates, as stated in Proposition 1.
Intuitively, the marginal product that is lost in the innovating sector because some
workers cannot transfer exceeds the additional product in the non-innovating sector.
Proposition 1 reflects ex post efficiency (see Sect. 3.4). The increase in transfer costs
hampers the possibility of transferring labour inputs of the general type towards the more
efficient sector of the economy, so that condition (21) of equality of marginal
productivity is violated. In this sense, higher labour market rigidity is detrimental to the
economy in that it prevents adjustment to sectors with higher productivity. This idea may
be restated more formally in the following Proposition (see ESM: S1.2.2 for its proof):
Proposition 2 The only ex post efficient allocation of labour inputs is for cT ¼ 0.
The higher cT, the more ex post-inefficient the allocation.

4.3 Effects on specific skill labour allocation

Let us now turn the attention to specific skill workers. The key result is the
following (see ESM: S1.3.1 for its proof):
Proposition 3 There exists an internal maximum in the steady state production
from specific skill workers with respect to transfer costs. In particular, production
from specific skill labour is increasing (decreasing) in cT for values smaller
(greater) than c^T . Moreover, such a maximum is unique. That is,
 [ \
oY S ocT  0 , cT  c^T ; c^T \
cT
\ [

where:

Y S ¼ YIS þ YNS ð24Þ

The existence of the maximum c^T is due to two opposing effects. On the one
hand, as cT increases, more workers will acquire specific skills, as the expectation of
higher mobility costs in the alternative type of skill will hinder mobility and thus
decrease the expected wage were they to acquire general skills. On the other hand,
as general skill becomes a scarcer factor, general skill workers’ marginal
productivity in the innovating sector will increase and consequently their wage
will tend to rise. This effect is magnified when cT is relatively higher, because
general skill workers become even scarcer. Proposition 3 demonstrates that the
latter effect dominates the former when cT 2 ðc^T ; cT Þ.
Proposition 3 underpins the ex ante efficiency argument set out above. It states
that higher transfer costs have, for values of cT below the threshold c^T , a positive
impact on production from specific skill workers. The reason is that higher transfer
costs imply a decline in the expected general skill wage, so that more workers will
find it optimal to acquire specific skills. Proposition 4 restates the argument above in
terms of efficiency (see ESM: S1.3.2 for its proof):

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Proposition 4 The only ex ante-efficient allocation of labour inputs is for cT ¼ c^T .

The closer the economy to this value, the more ex ante-efficient the allocation.

4.4 Overall effects

We have seen how ex ante efficiency prescribes to allocate more resources to

specific skills (Proposition 4), whereas ex post efficiency calls for increasing the
share of general skill workers (Proposition 2), which makes it possible a better use
of technical innovations. Proposition 5 states a general result over these two effects.
Proposition 5 Suppose cS is positive. Then, there exists a maximum in the region
ð0; c^T  where total output as a function of cT is maximised:
9 cT 2 ð0; c^T Þ such that cT ¼ argmax fY S ðcT Þ þ Y G ðcT Þg
cT
Proposition 5 thus claims that an economic system will maximise its output when
labour market rigidity is set at some positive levels.
The underlying reason for the result in Proposition 5 lies in the distortions
brought about by the training costs cS . This represents an entry cost in the labour
market for specific skill workers, which is compensated by a rent in terms of higher
average wages after their entry. Only under the expectation of a higher average
wage would workers take up specific-skills in the first place. Another way to look at
this aspect of the model, is to consider higher average specific-skill wages as the
cost that firms are available to pay to their specific skill workers in exchange of their
higher productivity.
The presence of a rent inevitably brings about some kind of inefficiency in the
economy. In the present model, this is given by the reduction in the number of
specific skill workers with respect to the first best (see Sect. 3.4). This is necessary
in order for their average wage to rise above the first best level, but causes average
marginal productivity of specific skill workers to be higher than that of generic skill
workers. This entails an output loss with respect to the first best, which is partially
offset if the number of specific skill workers increases. In other words, the more
specific skill workers, the lower their wage and thus their rent, thus reducing the
inefficiency in the economy. An increase in cT is thereby efficiency-enhancing
because it rises the incentives for workers to invest in specific skills, thus reducing
their rent. This is nothing but a restatement of the ex ante efficiency argument.
Ex post inefficiency arises because an increase in cT simultaneously curbs the
possibility, up to some degree, for general skill workers to transfer to the innovating
sector of the economy. Proposition 5 determines the value of cT that trades off
optimally ex ante against ex post efficiency, and ensures that such a value lies in the
interior of the feasible range for cT . Therefore, some positive level of labour market
rigidity leads to higher efficiency in the economy.
The reason why ex ante efficiency prevails over ex post efficiency at relatively
low values of cT depends on the nature of the distortions associated with the two
forms of efficiency. By definition, the output losses associated with ex post
inefficiency equal zero when cT is equal to zero, and then monotonically increase
with cT . Conversely, the output losses brought about by ex ante inefficiency are

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strictly positive when cT is equal to zero, the reason being that this form of
inefficiency is originated by the training costs cS . So, provided that training costs are
positive, ex ante inefficiency will be positive even when cT is equal to zero, and then
progressively diminishes as cT increases. Figure S5 in the ESM plots a typical
pattern of the output losses associated with ex ante and ex post inefficiency.
Table 1 reports the numerical values for the maximum and maximand of total
output for different values of cS . This shows that the maximum is located in the
origin when cS equals zero, and that this shifts rightwards as cS increases. Moreover,
the absolute level of the maximum decreases as cS increases, because the distortion
in ex ante efficiency increases. Figure S6 in the ESM plots the relationship between
output and cT for various levels of cS .
Numerical simulations show that not only have positive levels of transfer costs an
output-enhancing effect, but the same is true for the training costs. An interior solution
for cS in the problem of output maximisation given a certain value of cT , is the case for
some feasible values of cT . In this region ex ante efficiency losses are at its lowest (see
Figure S5), so an increase in cS increases the number of general skill workers and
reduces ex post efficiency losses. Figure S7 in the ESM plots one of such cases.

5 Discussion

In spite of the high level of abstraction of the model, and of the restrictions due to
some of its hypotheses, I believe that the basic intuition of the model can be applied
to a broad range of cases. The model has been framed in terms of two competing
non-GP technologies. An example of this case may be the competition between
DOS and UNIX operating systems for personal computers. But the model could be
easily generalised to different contexts. It may be recast in terms of two different
products competing for the same market, such as for instance Sony Betamax vis-à-
vis VHS in the video-cassette recording market, or between the QWERTY vis-à-vis
DSK in type-writing keyboards (see David 1985; David and Greenstein 1990). It
may also be applied to study the productivity dynamics of two different application
sectors of the same technology (Bresnahan and Trajtenberg 1995). For instance,
nuclear power may be produced using light-water, or gas-cooled, or heavy-water, or

Table 1 Optimal output and

Values for cS Optimal value of cT Optimal value
optimal value of labour market
of output
rigidity as a function of training
costs
0 0 81.85
0.05 0.08 81.85
0.1 0.15 81.82
0.15 0.21 81.77
0.2 0.27 81.67
0.25 0.31 81.54
The diagram has been obtained
for the following set of 0.3 0.35 81.32
parameters: fa ¼ 0:5; 0.35 0.38 81.01
AS ¼ 3; AG ¼ 1; c ¼ 3; 0.40 0.41 80.55
cS ¼ 0:2; L ¼ 100g

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sodium-cooled reactors, while solar energy can be created by crystalline-silicon or

amorphous-silicon technologies (Arthur 1989). In principle, the insight of the
models may also be extended to two GP-technologies that are competing against
each other before one gains an advantage over the other and ‘‘takes over’’ the
economy. This may be the case, for instance, for hydrogen fuel cell vis-à-vis
gasoline-powered engines, or alternating vis-à-vis direct electricity generation.
What matters for the application of the present model is the type of skills required in
the two technological sectors is different enough, so that specialized skills yield a
higher productivity than general skills. Clearly, the model applies to industrial
sectors where technological innovations occur more frequently and are more
productivity-enhancing. The model clearly has less to say for economies that are
more specialized in sectors at low technological intensity.
One of the most restrictive assumptions made in the model concerns the market-
clearing nature of the wages. Markets are supposed to clear instantaneously so no
unemployment occurs. Relaxing this assumption would not change the qualitative
nature of the conclusions. However, the normative perspective would clearly need
to take into account the economic and social costs of unemployment. Unemploy-
ment caused by aggregate macroeconomic shocks is in principle likely to affect both
technological sectors equally, at least a priori. Nevertheless, generalized skills
should be preferred by risk-averse workers, because of the protection offered against
the uncertainty over which sectors will fail to innovate. In equilibrium generalised
skill workers receive a constant wage, while specialised skill workers’ wage will be
lower in the sector that fails to innovate. In other words, general skill workers are
better able to respond to negative macro-economic shocks. This would call for a
reduction in the optimal value of cT . On the other hand, it is natural to think that
‘‘search unemployment’’ would be generated by generalized skill workers willing to
transfer from one sector to the other sector of the economy after the innovation has
occurred. This would of course represent a cost for the policy-maker, which would
lead to an increase in the optimal cT , thus possibly counter-balancing the previous
effect.
Furthermore, some have argued that economies characterized by higher labour
market rigidity are slower in adjusting to macro-economic shocks, because they
prevent downward adjustment in wages (Blanchard and Wolfers 2000). This point
cannot be fully examined within our model because rigidity does not affect
downward wage adjustments, but only transfer costs and consequently inter-sectoral
productivity gaps. The evidence on the impact of labour market rigidity is
nevertheless mixed, as argued in Sect. 2 (see also Howell et al. 2007). Even if it
would of course be interesting to generalize the model allowing for unemployment,
I believe that the main conclusion of the model would still hold. It is of course a
matter of empirical analysis to ascertain its actual relevance and its magnitude in
comparison to other possibly contrasting factors.
A final caveat concerns the use of a Cobb-Douglas production function. It is
apparent that some of the results depend on the elasticity of substitution between the
two production functions and their curvature. It is possible that some of these results
may be lost with more general specifications. We note, nevertheless, that the
intuition given to explain Proposition 5 seems to ensure that this would hold for a

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broad variety of production functions satisfying the Inada conditions. The key result
of the model thus appears not to be restricted to Cobb-Douglas functional forms.

6 Conclusions

The paper has developed a simple model where two contrasting effects of rigidity in
the labour market may be analysed. Ex post efficiency calls for low market rigidity,
as this permits workers having acquired general skills to transfer to the innovating
sector of the economy more easily. Ex ante efficiency requires high labour market
rigidity, as this encourages workers to acquire specific skills. This increases output
in equilibrium. This is crucially due to the presence of a rent accruing to specific
skill workers for the cost they have to sustain for their skill acquisition. The analysis
demonstrates that the interaction between these two effects leads to an internal
optimum for rigidity. The resulting inverse-U relation between labour market
rigidity and output is consistent with the observed non-linear relationship between
labour productivity growth rates and degrees of employment protection illustrated in
Sect. 2.
The model contradicts the argument that removing market rigidities will
necessarily increase output by boosting productivity. When technical change is non-
GP and factors of production are scarce—so that in particular the production
function has decreasing returns to scale in labour, removing market rigidity will
lower the incentives for workers to acquire specific productivity-enhancing skills.
The loss in output associated with this effect cannot be compensated by the fact that
with less rigidity workers may move towards the innovating sector of the economy
with greater ease.
As argued in Sect. 2, the relationship between labour market rigidity and labour
market performance is complex and encompasses several distinct aspects. The present
model has admittedly focussed on only one of such aspects. More theoretical and
empirical research needs to be carried out to understand the relevance of the result
uncovered in this paper when other factors are taken into account.

Acknowledgments I thank Donatella Gatti for useful discussions on the basic ideas of this paper, and
Elena Meschi for her comments to the previous draft of the paper. I also thank two anonymous referees
for their comments, and Karen Whyte for efficient proofreading and assistance. All errors are my sole
responsibility. I acknowledge financial support from the Spanish Ministry of Science and Innovation
(grant ECO 2011-23634), Bancaixa (P11A2010-17), Junta de Andalucı́a (P07-SEJ-03155), and
Generalitat Valenciana (grant GV/2012/045).

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