DP9640 | A Neoclassical Growth Model for the Insiders ? Outsiders Society

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The wage premium in the public sector, as measured by the ratio of the average wage rate in the public sector relative to the average wage rate in the private sector, varies considerably across developed economies. And, varies in some developed economies over large periods of time. Further, this wage premium in the public sector correlates negatively with the conditional growth rate, in a representative panel of developed economies. This paper develops a simple neoclassical growth model, motivated by the paradigm of the South European countries that top the list of developed economies with the highest wage premium in the public sector, to provide for a unifying explanation for these stylized facts. According to this model, the latter are consequences of the different organization of the labor market and an associated political system complementarity. Labor supply consists of two groups: ?outsiders?, that are employed by the private sector (final good) and take the wage rate as given, and ?insiders? that are employed by the public sector (services associated with intermediate goods, such as basic networks and utilities) and are members of unions that set the wage rate. In this case, there will be a wage premium in the public sector and an associated labor misallocation effect. The number of intermediate goods raises the wage premium due to the assumed gross complementarity in the production of the final good. Thus, unions have an incentive to cooperate, so as to control/influence government and, thereby, the maintenance of existing and the creation of new intermediate goods. This is the above mentioned political system complementarity. Whether, steady state output and growth towards the steady state rise or fall with an increase in the number of intermediate goods, depends on the existing number of these goods. If this number is relatively low (high), the ?variety? effect dominates over (is dominated by) the combination of the labor misallocation and distorting taxation effects. The latter stems from distortionary income taxation, needed to finance the infrastructure of the publicly provided intermediate goods. Then, it is shown that, for plausible parameter values, in the steady state, a ?government of insiders?, that seeks to maximize the aggregate of insiders? unions utilities, will tend to have a higher number of publicly provided intermediate goods than the number that would have been chosen by the Median Voter. These results form the basis for explaining the above mentioned stylized facts, as well as important aspects of the present crisis of the South European economies.