For many years, one of the major issues in macroeconomics has been the link between unemployment, wages and productivity. Indeed, in their influential work, Bruno and Sachs (1985) suggested that the rise in the real wage gap, defined as the proportion of real wages in excess of the full employment marginal productivity of labor, was one of the main contributor to the rise in the OECD unemployment rate during the 1970’s. However, ten years after their finding, Gordon (1995) pointed out that an examination of the wage gap data for Europe and the US became obsolete during the 1980’s. He showed that there was no cross-country correlation between the increase in unemployment and the increase in the manufacturing wage gap during this period. Together with these two studies, there was an abundant literature dealing with the link between the wage-productivity gap and unemployment, showing a small positive effect or even the lack of support for the wage gap as a determinant of unemployment.
Yet, it is still a question of controversy whether unemployment is the result of real wages which are “too” high. For example, using various panel data techniques on 22 OECD countries over the period 1960 to 1993, Junankar and Madsen (2004) find a statistically significant, but economically insignificant, positive relationship between unemployment and the wage gap. In turn, applying a set of unit root and cointegration tests with non-linear error correction mechanism, Pascalau (2007) finds mixed evidence on the response of unemployment to increments on the wage productivity gap. Moreover, these studies also reflect heterogeneous results across countries.
In addition, there is still an important question that remains unanswer: What can explain the differences observed in the relationship between the wage gap and unemployment across countries?. In this paper we propose that the influence of institutions on the performance of the labor market can help us to answer this question. In particular, the employment protection legislation can play a central role behind the observed behavior between the wage gap and unemployment.
Indeed, since the middle of the 1980s, a set of labor market reforms introduced in many OECD countries have affected the relative strictness of the Employment Protection Legislation (EPL) on fixed-term and permanent contracts. According to the OECD (2004), most of these reforms have alleviated the relative strictness of EPL for fixed-term contracts relative to the one on permanent contracts. As a result, two types of labor market characteristics can be found in many OECD economies. The first type shows a small degree of EPL in regular contracts, and no limitations on the renewal and duration of temporary contracts. The second type of countries combines a high degree of employment protection in the regular segment with a limited flexibility in the use of temporary contracts.
