On the Political Economy of Labor Market Flexibility

This paper starts from the observation that despite the very high level of unemployment in major European countries, the resources devoted to fight it are very small. This suggests that there is little political concern about high unemployment. I develop a model where the government tries to increase employment by increasing labor market flexibility, and where any reform must pass majority voting. It is shown that the employed will block a complete reform of the labor market. A two-tier system will, however, generate consensus over the reform. In the long run, when the two-tier system prevails, political support gradually builds up in favor of further increases in flexibility. This, however, creates a time-consistency problem, thus putting bounds on the reform that can ex ante be implemented. The model may generate complementarities between the economic system and the political system and lead to multiple equilibria. I also review various pieces of evidence, which lend support to the hypotheses brought up in the paper.