The employment consequences of long-term investments have for a long time been a controversial issue in economics and this issue seems to underlie many disputes between firm owners and labor unions. In conventional models of imperfectly competitive labor markets, for example Layard, Nickell and Jackmann (1991), the investments have no effect on equilibrium unemployment. This is due to the specification of a Cobb-Douglas production function, which implies a constant wage elasticity of labor demand. For this class of production functions, investments or interest rates will have no effect on the wage determination, achieved through wage negotiations due to the constant wage elasticity, and therefore no effect on equilibrium unemployment.
Many reservations can be raised against the Cobb-Douglas specification, according to which the elasticity of substitution between labor and capital is equal to one. For the U.S. economy empirical studies have produced estimates according to which the elasticity of substitution empirical studies lies well below one (see e.g. Lucas (1969), Chirinko (2002), Chirinko et.al (2004) and Antras (2004)). Also empirical evidence concerning international data seems to consistently yield estimates, which do not lie in conformity with the Cobb-Douglas specification (see e.g. Rowthorn (1995), (1999), Duffy and Papageorgiou (2000) and Pessoa et. al (2004)). Berthold et. al (1999) have argued that the elasticity of substitution between capital and labor for Germany and France are higher than one. It has also been argued that when trying to explain variations in the labor share there is a need to depart from the usual assumption of a Cobb-Douglas production function (see Bentolila and Saint-Paul (2002)).
Moreover, and related, medium- to long-term changes in unemployment tend to be correlated with medium- to long-term changes in interest rates and thereby private investment – a feature which seems to be inconsistent with predictions generated by models with Cobb-Douglas production functions (for some empirics, see e.g. Herbertsson and Zoega (2002)). On the theoretical side Phelps (2004) has argued, applying an intertemporal consumer market model, that higher real interest rates will raise the mark-ups in the product markets, leading to higher equilibrium unemployment. In the present paper we abandon the Cobb-Douglas specification and introduce a link between the long-term investment decisions and the negotiated wages by focusing on a more general class of CES production functions.
We analyze the effects of simultaneous labor and product market imperfections on equilibrium unemployment under exogenous as well as endogenous capital intensity. Our study fulfils several purposes. Firstly, we explore the impact of long term investments on wage formation, and thereby on unemployment, in an economy characterized by labor and product market imperfections. Secondly, we investigate the consequences of imperfections in the product market on equilibrium unemployment. We design a theoretical model, which establishes important interaction effects between labor market imperfections, product market imperfections and long-term investments. We demonstrate how these effects have implications for equilibrium unemployment under exogenous capital intensity. Finally, we characterize the qualitative properties of equilibrium unemployment in the long run under endogenous capital intensity with a particular focus on the total long-run effects of interest rates and of labor and product market imperfections on equilibrium unemployment.
