Duke Economics Working Paper #98-16

The modern view of the labor market holds that unemployment is high in economies where unions are strong and the government and other institutions impose on firms obligations that raise the cost of labor. This view is generally correct and yields a clear policy implication: more competition in the labor market reduces unemployment. This simple prescription has been challenged on the grounds that liberalizing the labor market alone cannot solve the unemployment problem when there are frictions in the product and capital markets that limit the economy's ability to create jobs through entrepreneurship. According to this view, competition in the product market is as important as competition in the labor market for keeping unemployment low. Unemployment in Europe, for example, is higher than in the US because both the labor and the product markets are less competitive. I argue that this view is correct in pointing out that explanations that locate the source of unemployment exclusively in the labor market ignore several factors that operate in the product market that are, in fact, crucial. I show, however, that its main conclusion is wrong: labor market reforms that reduce the cost of labor have effects in the product market that reinforce the modern view that a more competitive labor market leads to lower unemployment. This implies that such reforms are even more attractive than previously thought. In agreement with the idea that product market competition matters, moreover, I show that lower barriers to entry in the product market lead to lower unemployment.

Keywords: Market Power, Market Structure, Entry, Growth, Unemployment

JEL: E10, L16, O31, O40

This paper has been replaced by 00-21