A model of market and political power interactions for Southern Europe

In a representative panel of developed economies, the public sector wage premium, as measured by the ratio of the average wage rate in the public relative to the private sector, varies considerably across countries, as well as over large periods of time. Moreover, it correlates negatively with output growth and the ratio of public over total employees. This paper, motivated by the paradigm of the South European countries that top the list of developed economies with the highest wage premium, develops a simple neoclassical growth model tο provide for a unifying explanation of these stylized facts. The latter are consequences of the different organization of the labor market and an associated political system complementarity. Labor supply consists of two groups: “outsiders”, that are employed by the private sector (final good) and take the wage rate as given, and “insiders” that are employed by the public sector (services associated with intermediate goods, such as basic networks and utilities) and are members of unions that set the wage rate. This leads to a wage premium in the public sector and an associated labor misallocation effect. The number of intermediate goods raises the wage premium. Thus, unions have an incentive to cooperate, so as to control/influence government and, thereby, the maintenance of existing and creation of new intermediate goods. This is the above mentioned political system complementarity. Whether, steady state output and growth towards the steady state rise or fall with an increase in the number of intermediate goods, depends on the existing number of these goods. Further, it is shown that, a “government of insiders”, that seek to maximize the aggregate of insiders’ unions utilities, will tend to have a higher steady-state number of publicly provided intermediate goods than the number that would have been chosen by the Median Voter.