Over the last three decades, there has emerged a vast and well developed literature on the theory of search unemployment both in closed and open economies. Empirical support for the existence of substantial search frictions and their importance in generating unemployment has made the introduction of such frictions into economic models of labor markets the most standard and accepted way of modeling unemployment. This does not mean that there do not exist other additional distortions or other possible shocks that can interact with search frictions to magnify or reduce their impact. The objective of our paper is to study such interactions and their spillover from the point of impact to the rest of the economy. While this is primarily a theoretical paper, we focus on distortions and shocks that have empirical relevance.
The first distortion we introduce is a fair-wage constraint. Akerlof and Shiller (2009) argue that fairness is an important aspect of "animal spirits" or "the thought patterns that animate people's ideas and feelings," whose study is crucial in understanding how economies behave. Akerlof and Yellen (1990) actually focus on such fairness or fair wage considerations to explain the existence of unemployment. Surveys of managers and workers, sociological studies of work environments, firm level studies of pay structures, experiments, personnel management textbooks etc. provide a wealth of evidence supporting the assumption or idea of a fair wage.
The second shock we introduce in the model is the off shoring of unskilled jobs. The subject of off shoring has attracted a lot of attention from the public, politicians and the media, especially because developed country firms have been shifting operations overseas or are contracting out manufacturing of their production and service inputs to businesses in developing countries to cut costs. The alarming, though questionable, estimates by Bardhan and Kroll (2003) and McKinsey (2005), that 11 percent of our jobs are potentially at risk of being off shored, further adds to the importance of the study of off shoring.
By introducing fair wage concerns into a model of search unemployment with two types of labor, namely skilled and unskilled, we obtain several new results. One of the key results, which we find quite interesting, is that introducing fairness considerations in a search model leads not only to an increase in the unemployment of unskilled workers, a group for whom the fair wage constraint is binding, but also leads to a change in the unemployment of skilled workers, a group for whom the fair wage constraint is not binding. That is, there could be a positive or negative spillover effect on the skilled labor market. Whether the spillover effect is positive or negative depends on the strength of the "strategic effect" in the wage and employment decision of firms, first identified by Stole and Zweibel (1996). Since wages are determined through Nash bargaining with workers in the second stage conditional on the employment choice in the first stage, the "strategic effect" refers to a firm's incentive to over or under hire workers in the first stage to keep the wages lower in the second stage.
Abstracting from the "strategic effect," it is shown that the introduction of the "fair wage" constraint leads to an increase in the unemployment of skilled workers. Intuitively, a binding fair wage constraint makes it more expensive to hire unskilled workers and hence raises the cost of producing output for competitive firms. The ensuing losses lead to a reduction in industry output and consequently losses of both skilled and unskilled labor jobs resulting in increased unemployment and lower wages of skilled labor as well. Increased skilled unemployment and lower skilled wage offsets the effect of fair wage constraint on the cost and hence profitability of competitive firms. The presence of the "strategic effect" makes the effect of the fair wage constraint ambiguous on skilled unemployment, which now can go down for high enough values of the elasticity of substitution between skilled and unskilled labor in the firm's production function.
