Wage Compression, Employment Restrictions, and Unemployment: The Case of Mauritius

Transcription

1 WP/04/205 Wage Compression, Employment Restrictions, an Unemployment: The Case of Mauritius Nathan Porter

2 2004 International Monetary Fun WP/04/205 IMF Working Paper Finance Department Wage Compression, Employment Restrictions, an Unemployment: The Case of Mauritius Prepare by Nathan Porter 1 Authorize for istribution by Jianhai Lin November 2004 Abstract This Working Paper shoul not be reporte as representing the views of the IMF. The views expresse in this Working Paper are those of the author(s) an o not necessarily represent those of the IMF or IMF policy. Working Papers escribe research in progress by the author(s) an are publishe to elicit comments an to further ebate. Governments often intervene in labor markets with the aim of reucing inequality an promoting employment. Such intervention often results in wage compression an restrictions on how firms use their workers. This paper investigates the impact of such interventions on the labor market conitions face by low-skill workers in Mauritius. It fins that even relatively minor intervention can ramatically increase the fragility of jobs, the length of unemployment spells, as well as the extent of unemployment an labor market churning. With institutions of the type stuie here common across many ifferent types of countries, these results have relatively general implications. JEL Classification Numbers: E24, J23, J64 Keywors: Unemployment, Labor Market Restrictions, Wage Compression Author(s) Aress: nporter@imf.org 1 I woul like to thank Izabela Karpowicz, Jianhai Lin, Calvin McDonal, Anrew Tweeie, Nancy Wagner, an James Yao for their thoughtful comments. All remaining errors are mine.

3 - 2 - Contents Page I. Introuction...3 A. Mauritius s Unemployment Problem...3 B. Mauritius s Labor Market Institutions...5 II. Evolution of Employment in the EPZ (Textiles) Sector...5 III. An Assessment of the Impact of Wage Setting an Reeployment Restrictions...7 A. Moel Environment an Equilibrium...8 Wage Determination: Decentralize Bargaining...10 Wage Determination: Exogenous Wage Scheule...11 B. Calibration...13 C. Empirical Results...14 IV. Conclusion...17 References...19 Figures 1. Decomposition of Annual EPZ Employment Growth, Annual EPZ Employment Growth an Reallocation Rates, Decomposition of Quarterly EPZ Employment Growth, Average Size of New an Closing Firms, The Impact of Labor Market Institutions Cross-Market Wage Compression: Unemployment an Job Destruction Within-Market Wage Compression: Unemployment an Job Destruction Worker Reeployment: Unemployment an Job Destruction...17 Tables 1. Quarterly Job Flow Rates Moel Output: The Impact of Labor Market Restrictions...15

4 - 3 - I. INTRODUCTION Some government interference in the operation of labor markets is almost universal. This interference is often motivate by a esire to affect the istribution of income, an promote employment. Motivate in this way, many governments implement policies that compress the wages that firms pay, an reuce the flexibility with which employers may use (or reeploy) their employees. 2 This paper investigates consequences of such policies for the labor market face by low-skill workers in Mauritius. The results suggest that even relatively minor wage compression an restrictions on the reeployment of workers can have a ramatic impact on the fragility of jobs, the length of unemployment spells, as well as the extent of unemployment an labor market churning. Moreover, restrictions on the flexibility of the labor market are likely to become increasingly important as an economy faces structural challenges, as Mauritius currently oes. Although this paper focuses on the Mauritian labor market, the issues stuie in it are relevant for many countries. Both wage compression an restrictions on the reeployment of workers are prevalent in many avance economies. For example, Bertola an Rogerson (1997) an Organization for Economic Cooperation an Development (OECD, 1994) ocument consierable wage compression in western Europe, while OECD (1995) suggests that insufficient flexibility inhibits job creation in several avance economies. Similar institutions, especially over the setting of wages, also appear to be important in many transitional economies (Svejnar, 1999; Haltiwanger an Voopivec, 2002). A. Mauritius s Unemployment Problem Notwithstaning impressive economic growth, Mauritian unemployment has increase in every year since 1991, with the unemployment rate reaching 10.2 percent in As in many countries, this unemployment is primarily experience by low-skill workers. 3 In response to this growing unemployment problem, the government has begun to aress the problem of apparent skills mismatch through far-reaching eucational reforms. 4 However, as shown in this paper, eucational reform can only be a partial solution to the unemployment problem. 2 Another typical form of labor market intervention relates to termination restrictions, or firing costs. Many paper have stuie the impact of these restrictions, incluing Lazear (1990), Bentolila an Bertola (1990), Hopenhayn an Rogerson (1993), an Garibali (1998). 3 The 2000 Census reporte that 90 percent of the unemploye have not complete the high school certificate. 4 A common measure of mismatch in the labor market the variance of relative unemployment rates across categories suggests that mismatch may have actually ecline between the 1990 an 2000 censuses. Using labor market ata by eucational category, the variance of relative unemployment rates has ecline from 17 percent to 12 percent. The intuition for this measure (continue )

5 - 4 - In the face of strong economic growth, such an increase in unemployment suggests that the root of the problem coul lie in Mauritius labor market institutions. These institutions which compress the wage istribution an limit the ability of employer s to reeploy their workers may have seriously impaire the functioning of the labor market. While they may not have resulte in significant unemployment in earlier ecaes, the increasing importance of (high-wage) service sectors in Mauritius, which have increase the impact of cross-market wage compression, as well as the graual ecline in the eman for low-skill workers, has probably exacerbate the impact of these institutions. The impact of these restrictions will most likely become increasingly etrimental as Mauritius faces significant structural challenges consierably changing the market for low-skill workers in coming years. The most significant of these challenges is the eventual loss of preferential arrangements for its sugar an textile exports. While it is still uncertain when the preferential sugar regime will en, Mauritius quota uner the Agreement on Textiles an Clothing is set to lapse by en Although the preferential access grante uner the U.S. African Growth an Opportunity Act may mitigate some of this impact, the Mauritian economy will unoubtely go through a perio of restructuring, as the textile sector ajusts to its new environment. As iscusse in Section II, signs of ajustment are alreay evient in textiles. Changes in the eman for sugar workers have alreay begun with the government s Sugar Sector Strategy, which has reuce employment by aroun a quarter. By elaying the reform of its labor market institutions, Mauritius will exacerbate the pain involve in this ajustment, especially for those with few skills. In light of these challenges, this paper analyzes the market for low-skill workers, who risk being neglecte as the government focuses on eveloping other sectors. With the export processing zone (EPZ) being an important source of low-skill employment, the paper first investigates the evolution of this sector (in Section II). In Section III, a simple stylize moel of the job creation an estruction processes is employe (an calibrate) to assess the potential benefits of labor market reform. As such, this paper complements the work of McDonal an Yao (2003), who looke at the impact of Mauritius institutions on the prospects for eveloping new sectors, an the consequent labor market transition. This paper concentrates on how these institutions affect the prospects for low-skill workers by changing the incentives to create an estroy jobs in both new as well as existing areas that they are able to perform. With these workers the most likely to suffer from the structural transformation, eregulation coul potentially improve the labor market conitions these workers face in a relatively short space of time. is that the greater the ispersion in unemployment rates, the greater the mismatch in the labor market (Layar, Nickell, an Jackman, 1991, Ch. 6).

6 - 5 - B. Mauritius s Labor Market Institutions The Mauritian labor market is highly regulate, with wages an conitions of employment etermine centrally rather than at the firm level. The government establishes a separate set of labor market regulations, calle Remuneration Orers (RO), for each inustry. 5 These regulations specify the exact uties of every type of worker in the firm in great etail. With these regulations being aggressively enforce by the Ministry of Labor, worker reeployment is extremely ifficult. Therefore, wages an conitions o not reflect the prouctivity or circumstances of iniviual firms. Moreover, terminations ten to be costly an time consuming, requiring approval of the Termination of Contracts Services Boar, an often leaing to elays on the orer of four months. The centralize wage etermination process tens to compress the wage istribution. Basic wages for each occupation are set in the RO, with the annual tripartite wage setting process resulting in a new wage for all categories. In most years, this process results in wage growth inexe to inflation, with lower wages rising by more than higher ones. Once every five years, the Pay Research Bureau establishes a catch-up wage increase for the public sector, which typically puts some aitional pressure on private sector wages. The ability of the economy to ajust in the face of its structural challenges will be inhibite by these regulations (see Section III). With wages being compresse an workers unable to be reeploye as circumstances change, jobs become substantially more fragile. Moreover, the incentive to create new jobs can also be reuce significantly. Therefore, even with the government encouraging the creation of new inustries, such as the information, communication an technology (ICT) sector, many of these opportunities, at least for some time, may bypass much of Mauritius low-skill workforce. Employment opportunities for these workers can be enhance over the meium term by simply liberalizing the regulations that govern the labor market. II. EVOLUTION OF EMPLOYMENT IN THE EPZ (TEXTILES) SECTOR 6 Textile prouction, especially in the EPZ sector, has contribute significantly to the Mauritian growth miracle. Figure 1 shows the ecomposition of EPZ employment growth 5 For example, the RO for the catering inustry efines assistant barman, barman, an hea barman as separate occupations with each unable to perform the uties of the other an assistant barman cannot prepare a rink if a barman is at the bar. These regulations o not cover the EPZ sector, an are not expecte to cover new information, communications, an technology (ICT) activity. 6 With textiles accounting for almost 90 percent of EPZ sector employment, textiles an EPZ will be referre to interchangeably in this section.

7 - 6 - into its separate components job creation an job estruction since This figure shows the remarkable transformation that occurre in the early 1980s, before the extent of job creation an estruction stabilize aroun their longer-term values. This figure also shows that the creation an estruction of jobs is a persistent an continual process of renewal, with sizable job estruction occurring even uring perios of high employment growth. This continual creation an estruction suggests substantial reallocation of activity across firms within the EPZ sector. Figure 2, which epicts the job reallocation an excess job reallocation rates, shows that the exceptional job reallocation seen initially, reflecting the rapi creation of new EPZ sector jobs uring the early 1980s, subsequently ecline as the inustry mature. 8 As measure by the excess job reallocation rate, the extent of churning in the labor market also ecline as the inustry mature. Figure 1. Decomposition of Annual EPZ Employment Growth, Figure 2. Annual EPZ Employment Growth an Reallocation Rates, Job Creation Rate Job Destruction Rate Employment Growth Rate Job Reallication Rate Excess JR Rate Employment Growth Rate Sources: Central Statistical Office, Mauritius, an author's estimates. Source: Central Statistical Office, Mauritius, an authror's estimates. 7 The job creation, estruction, an employment growth rates use in this section are calculate by iviing the change in employment between two perios by the average employment in those perios. While slightly ifferent from the stanar efinition of growth rates, it is consistent with the efinition typically applie in the job flows literature see Davis, Haltiwanger an Schuh (1997). 8 Following Davis, Haltiwanger an Schuh (1997), the job reallocation rate is efine as the sum of job creation an estruction rates. This efinition reflects the fact that reallocation of jobs an workers from one type of activity to another typically requires the creation of jobs at expaning enterprises an estruction of jobs at contracting ones. Define in this way, job reallocation also equals the maximal reallocation of workers inuce by the reshuffling of employment opportunities across enterprises. The excess job reallocation rate is efine as job reallocation in excess of absolute employment growth, inicating the reallocation of jobs above the amount require to accommoate net employment changes, an may be also thought of as a measure of churning.

8 - 7 - Quarterly job creation an estruction ata show signs of a weakening in textiles uring Figure 3 shows the quarterly ecomposition of employment growth (from March 1986 to September 2003), an is analogous to Figure 1. This figure also shows the rapi growth in EPZ employment in the mi-1980s, before a moeration in employment growth throughout the 1990s. However, the ata for the first three quarters of 2003 show a substantial ecline in the rate of job creation (to its lowest level ever), an a rapi increase in the rate of job estruction. In aition, Figure 4 shows a marke increase in the average size of firms closing own in the last two years. Although relatively recent, the ramatic nature of the increase in job estruction an ecline in job creation in the last year woul be consistent with a rapi structural ecline in Mauritian textiles. While the inustry is unlikely to even in the long-run isappear, it coul very well be much smaller in the coming years. Mauritius restrictive labor market institutions mean that it shares many characteristics with other highly regulate labor markets, such as those in western Europe. In aition to Mauritius relatively high unemployment, unemploye workers face exceptionally long spells, with an average (meian) unemployment uration of 20 (9) months. Moreover, consistent with the stagnant nature of the unemployment pool, Mauritius has relatively low rates of job flows. Table 1 compares the rates of job creation an estruction in the Unite States, Portuguese manufacturing, an the Mauritian EPZ sector (which is preominantly textiles). The Mauritian an Portuguese labor markets ten to exhibit much smaller quarterly job flows than seen in the Unite States, suggesting they are less ynamic than the relatively unregulate U.S. one. That is, flows of workers into an out of unemployment seem less frequent, thereby leaving the unemploye strane for longer Figure 3. Decomposition of Quarterly EPZ Employment Growth, / Job Creation Rate Job Destruction Rate Employment Growth Figure 4. Average Size of New an Closing Firms, (Number of Employees) New Firms Closing Firms Mar-86 Sep-87 Mar-89 Sep-90 Mar-92 Sep-93 Mar-95 Sep-96 Mar-98 Sep-99 Mar-01 Sep-02 1/ Seasonally Ajuste. Source: Central Statistical Office, Mauritius, an author's estimates. 0 Mar-86 Sep-87 Mar-89 Sep-90 Mar-92 Sep-93 Mar-95 Sep-96 Mar-98 Sep-99 Mar-01 Sep-02 Source: Central Statistical Office, Mauritius, an author's estimates. III. AN ASSESSMENT OF THE IMPACT OF WAGE SETTING AND REDEPLOYMENT RESTRICTIONS This section investigates the impact of labor market institutions that compress wages an inhibit the reeployment of workers by using a calibrate equilibrium labor market moel. It fins that even relatively small istortions can substantially affect the nature an incience of unemployment. The moel use in this section is specifically chosen to highlight the effect of institutions on the creation an estruction of jobs, an ultimately unemployment.

9 - 8 - It is also a fairly stanar labor market moel, being similar to that evelope by Pissaries (2000) an Mortensen an Pissaries (1994). An important avantage of this type of moel is that it explicitly captures the frictional nature of labor markets. Table 1. Quarterly Job Flows Rates Country Sector Job Creation Job Destruction Unite States 1972(2)-1993(4) Manufacturing Apparel an Textiles Portugal 1991(1)-1995(4) Manufacturing Portugal/U.S. 1/ Mauritius 1989(1)-2003(1) EPZ Mauritius/U.S. 2/ Sources: Unite States: Davis, et. al., Job Creation an Job Destruction, 1997, MIT Press. Portugal: Blanchar, O. an P. Portugal, "What Hies Behin the Unemployment Rate," American Economic Review, March, Mauritius: Central Statistical Office, Mauritius an author's estimates. 1/ Compare with U.S. manufacturing sector. 2/ Compare with U.S. apparel an textile sectors. A. Moel Environment an Equilibrium In the moel economy assume here, a large number of entrepreneurs can create job openings. Once create, the entrepreneur searches for a worker to fill the position which, epening on the extent of frictions in the market, may be very ifficult an time consuming. When a worker an an entrepreneur meet, they, if allowe, bargain over the wage an ecie whether to work together, thereby creating a job. However, if the government legally imposes the wage to be pai, prouction only occurs if profitable at that given wage. The profitability of these jobs evolve in a persistent manner, reflecting changes in eman an technology. If, as a result of this evolution, the job becomes unprofitable, the entrepreneur will estroy it an possibly create a new job opening, while the worker becomes unemploye an is able to search again. Entrepreneurs are assume to be risk neutral, an value consumption, but suffer isutility of k for each vacancy they post. 9 That is, assuming they iscount the future by a factor β ( 0,1), t β c kv. t= 0 their lifetime preferences may be represente as ( ) t t 9 This assumption is mae without loss of generality, an can be shown to be equivalent to assuming that there is a resource cost to posting vacancies.

10 - 9 - An entrepreneur will attempt to create a job by posting a vacancy whenever it is profitable to o so. This means that the equilibrium number of vacancies poste is etermine by a zero profit conition (1) k + βq( ) J ( ε ) = 0, whenever v>0, an where k is the cost of posting the vacancy, q(.)is the (enogenous) rate at which entrepreneurs meet searching workers, an J ( ε ) is the value receive by the entrepreneur from being matche with a worker. As mentione above, these jobs are subject to iiosyncratic uncertainty represente by the job s prouctivity level ε which makes its value change from perio to perio. However, for analytical convenience, an without any real loss of generality, all new matches are assume to begin with the highest value of ε. The value of each match must satisfy the following Bellman equation: (2) J ( ε ) f ( ε ) w( ε ) + β ( 1 γ ) J ( ε ) + βγe max{ J ( ε '),0} =, where f ( ε ) is the output generate by the match, ( ε ) w is the negotiate wage, an γ is the probability that the job will be subject to a change in its output. If the value of continuing with the worker in this job falls below zero, the match is estroye. The shock, ε, is rawn from a F ε. 10 istribution, ( ) Workers are also assume to be risk neutral, caring only about their consumption, an β 0,1. That is, a worker s life-time utility is represente iscounting the future by the factor ( ) e β. Therefore, the value of working enjoye by an employe worker ( V ( ε ) by t=0 given by a Bellman equation analogous to (2) t ct {,0} e e ( ε ) w( ε ) + β ( 1 γ ) V ( ε ) βγe max V ( ε ') e V = +, where w ( ε ) is the wage pai to the worker. The Emax operator reflects the fact that the wage bargaining process results in a wage so that worker an entrepreneur will always agree on whether the match shoul continue or be estroye. An unemploye worker receives a value equal to the expecte iscounte value of fining a job with probability p (), so that u e u V = β [ p( ) V ( ε ) + ( 1 p( ) ) V ], where p(.) is the (enogenous) probability that an unemploye worker receives a job offer. The costly an time consuming matching process is represente in a very stylize way, with the number of jobs forme in any perio being a function of the number of vacancies an unemploye workers, m ( u, v). As is common in the labor market matching literature, we assume this is a constant returns-to-scale function, meaning the job- an worker-fining rates ) is 10 Although somewhat non-stanar, the process for iiosyncratic prouctivity efines a persistent stochastic process.

11 only epen on the tightness of the labor market the ratio of vacancies to searching workers. v m( u, v) v m( u, v) Given this, the fining rates can be represente by: p =, an q =. u u u v * * δ * Finally, steay state unemployment is given by u =, where δ is the steay state p * (). + δ measure of jobs enogenously estroye. Having escribe the basic elements of the moel, we now erive the conitions unerlying the steay state equilibrium of the moel: first in the case when firms an workers are free to bargain, an then when the government artificially compresses the wages pai. In this simple moel, two ecision rules are sufficient to characterize the job creation (etermining the extent of labor market tightness, u v ) an estruction (etermining the threshol iiosyncratic prouctivity, ε ) ecisions in equilibrium. Wage Determination: Decentralize Bargaining In the case where firms an workers are free to bargain, the bargain process is assume to satisfy the Nash axiomatic solution, which results in wages sufficient to compensate the worker for their value for searching plus a share equal to their bargaining power, θ of the surplus e u u e u generate by the match ( S ( ε )), i.e., V ( ε ) = V + θs( ε ) = V + θ[ J ( ε ) + V ( ε ) V ]. It is easy to show that for linear prouction functions, the equilibrium wage function ( w ( ε )) will be linear in prouctivity: w ( ε ) = w 0 + w1ε (see Pissaries, 2000, Chap. 2). The enogenous equilibrium creation an estruction ecisions can be neatly summarize by two elements: the reservation prouctivity below which the match is estroye ( ε ); an the extent of labor market tightness efine as the ratio of vacancies to the number of unemploye ( u v ). In this case, the v * equilibrium creation an estruction ecision rules ( an ε ) satisfy (3) an (4), u (3) v * q = u β k ( 1 θ ) S( ε ), an (4) S( ε ) = f ( ε ) + β ( 1 γ ) S( ε ) + βγe max{ S( ε '),0} βpθs( ε ) = 0, respectively. One attractive property of this equilibrium relates to the efficiency of the equilibrium allocation. As shown by Hosios (1990), given the extent of matching frictions, the equilibrium is efficient when the elasticity of the matching function with respect to unemployment equals θ. We will return to this property in the calibration of the moel, which will be calibrate so that the ecentralize bargaining equilibrium is efficient. Therefore, the resulting impact of labor market institutions will be eviations from the efficient allocation.

12 Wage Determination: Exogenous Wage Scheule In the case where the government imposes a (compresse) wage scheule, ( ε ) erive by an entrepreneur from being matche, (2), is moifie to become ~ ~ {,0} ~ ~ =. (5) J ( ε ) f ( ε ) w( ε ) + β ( 1 γ ) J ( ε ) + βγe max J ( ε ') The resulting equilibrium creation an estruction ecision rules satisfy the following equations, (6) v ~ * k q = ~, an u βj ( ε ) ~ ~ ~ (7) J ( ε ) = f ( ε ) w~ ( ε ) + β ( 1 γ ) J ( ε ) + βγe max J ( ε ') {,0} = 0 w ~, the value, respectively. The solution of this moel with exogenous wages may be represente in a simple iagram. The equilibrium ecisions relating to job creation (JC) an estruction (JD) can then be v summarize in Figure 5, which represent feasible combinations of ε an that are u consistent with the optimal creation an estruction of jobs. The intuition for the negative relation between the ecision rules that unerlie the JC relation reflects the fact that an increase in the tightness of the labor market leas to an increase in the expecte cost of creating a new job by reucing the chance a vacant position will be fille this perio meaning that existing jobs will be more urable an, therefore, less prouctive jobs will survive. When the wage is set by the government, the reservation prouctivity unerlying the amount of job estruction is inepenent of the tightness of the labor market, an hence results in a vertical JD curve. 11 The simple nature of this stylize moel means that the impact of policies an institutions can easily be stuie. For the questions consiere in this section, two comparative statics are relevant: (i) the impact of an exogenous compression in the wages relative to the results of bargaining; an (ii) the impact of limits on the ability to reeploy workers. The wage compression assume in this paper reflects both some cross-market compression, as well as 11 This iffers from the solution in the stanar Mortensen an Pissaries (1994) moel where wages are bargaine. In that moel, there is a negative relation unerlying the JD curve, which v reflects that a tighter labor market (higher ) increases workers bargaining power an u hence their wages meaning that more marginal jobs will become unprofitable an hence will be estroye.

13 some within-market compression. More specifically, the nature of wage compression is assume to be such that, for a constant istribution of prouctivity across jobs, average wages are g percent higher than they woul be if bargaine, an the slope of the wage scheule becomes flatter by a factor φ ( g = 0 means no cross-market compression, an φ = 1 means no within-market compression). 12 For the secon comparative static, we assume that the notion of reeployment restrictions can be capture by lower average per perio output from the worker. 13 The qualitative impact of wage compression on the creation an estruction ecisions of firms is clearly shown in Figure 5(a). First, raising the average wage pai to low-skill workers, especially the wages of the lowest pai, makes the most marginal jobs unprofitable, resulting in their estruction. Therefore, the prouctivity of the marginal job, ε, must rise, increasing the total amount of estruction (the JD curve moves right). There is a slightly offsetting effect on job creation. Since all new jobs are assume to begin with high prouctivity in this moel, an as relative wage compression reuces the relative wage pai in higher wage jobs, the incentive to create new jobs (at the same time as estroy ol jobs) rises slightly (the JC curve moves right). In aggregate, more jobs are estroye, an fewer jobs are typically create. The impact of restrictions on the flexibility of workers has very intuitive effects, which are shown in Figure 5(b). By reucing the expecte output of a worker in any given perio, keeping workers in more marginal jobs is no longer profitable (an so the JD curve moves right). 14 ~ ~ w ~ 12 This can be accomplishe by a compresse wage scheule of the form w ( ε ) = w0 + 1ε, where w ~ w 1 = φ 1 an w ~ 0 ( ε ) = w0 ( 1+ g) + w1 ( 1 φ + g) E( w( ε )). Using (6) an (7) one can ε w( ε ) ε formally erive that > 0, an g JD φ JD < 0, meaning < 0. Other things equal, φ ε ε > 0 an = 0, although job creation is affecte in the latter case though the rise φ g JC JC in job estruction. 13 Since the ability of firms to reeploy workers reuces the value a firm can expect from a worker in any perio, it is moele as a reuction in the level of output expecte in any perio. That is, with some probability a worker may nee to perform the uties of another occupational category. Since employment restrictions inhibit this re-eployment, the worker is less valuable. 14 Assuming that f ( ε ) = ˆ ε + ε, an using (6) an (7), one can erive the following comparative ε ε statics for a change in εˆ : < 0, an = 0. ˆ ε ˆ ε JD JC JD

14 Reflecting the increasing fragility of jobs, the estruction of jobs increases, as oes inirectly the creation of new jobs. 15 These effects are quite general an apply both beyon the EPZ sector as well as the Mauritian labor market. In particular, even if some sectors are grante a preferential regulatory environment, the opportunities for low-skill workers will still be unnecessarily restricte. Inee, as the structure of the economy an the eman for low-skill workers changes over the coming years, the ifferential regulatory treatment coul become increasingly etrimental. Figure 5. The Impact of Labor Market Institutions (a) Wage Compression (b) Reeployment Restrictions v u JC0 JD0 JD1 v u JC0 JD0 JD1 v u v u 1 0 JC1 v u 0 v u 1 ε o ε 1 ε B. Calibration ε o ε 1 ε To make this analysis more concrete, this stylize moel of job creation an estruction is calibrate to salient features of the Mauritian economy. This involves choosing values for all of the moel s parameters, an a functional form for the matching function. First, we take a moel perio to be a quarter, therefore setting the iscount factor to β = Following much of the matching an job flows literature, we choose a Cobb-Douglas form for the matching function. Several empirical stuies have estimate the elasticity of the matching 15 In this context, the fragility of a job refers to the likelihoo it is estroye. By relative wage compression we mean that possibly ue to centralize wage etermination the wages pai to workers are artificially more similar than they woul be if wages were the result of firm-level bargaining (Bertola an Rogerson, 1997). This means that ifferential wages o not fully reflect ifferences in prouctivity or working conitions. More specifically, this coul mean that wages in a particular sector are linke to wages in a higher paying sector (cross-market compression), an/or that wages within an inustry are closer to each other, although the average wage is much the same (within-market compression). Invariably, both of these types of compression occur together. 16 This is consistent with an annual iscount rate of 4 percent.

15 function with respect to unemployment, α, an foun that estimates in the range of (Petrongolo an Pissaries, 2001). For the purposes of this exercise the relatively conservative lower estimate of α = 0. 4 is chosen. In the unistorte equilibrium, where firms an workers bargain over the wage, the bargaining power of the worker is assume to be consistent with an efficient equilibrium allocation. That is, following Hosios (1990), we set θ = α = 0.4. We also assume that iiosyncratic prouctivity, ε, is istribute uniformly. The remaining parameters, k an γ are chosen to match the average EPZ job estruction rate following the establishment of the sector (of 4.02 percent uring ), an the unemployment rate for low-skill workers recore in the 2000 census (of 9.6 percent). 17 Finally, the parameter governing the efficiency of the matching process is chosen so that a reasonable egree of labor market tightness two-thirs woul result in a ecentralize bargaining market. The final choice we nee to make is the extent of wage compression in the economy. While Mauritius labor market institutions unoubtely compress wages, there is unfortunately no concrete measure of the egree of this compression in Mauritius. 18 In the baseline calibration, we conservatively assume a small amount of bleeing of wages from highwage sectors to low-wage workers ( g = ), as well as some moerate compression of wages pai within low skill inustries consistent with the cross-market effect ( φ = 0. 5). The benchmark moel results (with matche unemployment an job estruction rates) are reporte at the top of Table 2. C. Empirical Results Even assuming relatively minimal wage compression, there is a noticeable impact on unemployment, the average length of an unemployment spell, an although to a lesser extent unit labor costs. All of the policy experiments are performe relative to an environment where firm-level wage bargaining is the norm. Table 2 reveals a significant increase in unemployment, as well as the average length of unemployment spells. These changes reflect a significant reuction in the creation of new jobs evience by the 20 percent jump in the job fining rate when compression is remove an an increase in job fragility seen in the rate of job estruction. Even small amounts of wage compression can, therefore, lea to a significant reuction in the welfare of workers (an employers). A move to firm-level wage bargaining coul bring significant benefits to these workers. While wage compression also tens to increase unit labor costs, it has a relatively minor impact because wage compression leas to the closure of the less prouctive jobs, raising average prouctivity. 17 It is implicitly assume that all low-skill jobs share the job estruction rate of the EPZ sector. In 2000, the overall unemployment rate was 8.8 percent. 18 For example, Mauritius oes not have estimates of traitional measures of wage ispersion, such as the wage ifferential, or the cross-sectional variance of wages pai.

16 Table 2. Moel Output: The Impact of Labor Market Restrictions Unemployment Unemployment Job Fining Job Destruction Unit Labor Excess Job Rate Duration (mths) Rate Rate Costs Reallocation Baseline Results Benchmark 1/ No Wage Compression % Difference Wage Compression No Cross-Market Comp % Difference 2/ No Within-Market Comp % Difference 2/ Reeployment Restrictions No Wage Compression 10% lower reeployment rate % Difference 2/ Wage Compression 10% lower reeployment rate % Difference 2/ % Difference No Wage Comp / Assumes some cross-market (g = 0.02) an within-market (φ=0.5) wage compression. 2/ Difference from No Wage Compression simulation. While both types of wage compression are costly, cross-market compression seems more harmful. Removing the cross-market compression leas to a much larger reuction in unemployment, than removing the within-market compression. Reflecting its immeiate effect on profitability, removing the cross-market compression leas to a big increase in the rate of job creation, an a small reuction in the job estruction. Removing the assume amount of withinmarket compression has a smaller effect on the creation of new jobs, but leas to a bigger fall in the fragility of existing jobs as it has a bigger impact on the profitability of the most marginal jobs. A small reuction in the ability of firms to reeploy workers also leas to an increase in unemployment, an the length of average unemployment spells. In this exercise, it is assume that such regulations result in a 10 percent reuction in the level of output. 19 The increases in unemployment an unemployment uration reflect increases in the fragility of jobs (an increase in job estruction), as well as a lower job fining rate given the fall in profitability. Table 2 also shows that wage compression significantly worsens the impact of these employment restrictions, with these restrictions resulting in a 4.1 percent rise in unemployment in the absence of wage setting restrictions, an a 34.2 percent rise in unemployment with such restrictions. 19 As iscusse above (in Section III A, an especially footnote 12) the impact of reeployment restrictions is moele as a reuction in the expecte prouct of a worker in any perio.

17 Figures 6 8 show the consequences of various egrees of wage compression an employment restrictions for labor market outcomes, as we move from an unistorte equilibrium in which firms an workers are free to bargain over wages. Figure 6 shows the impact of cross-market compression up to a 5 percent increase in average wages. Figure 7 shows the impact of increasing within-market wage compression so that average wages remain relatively unchange. Figure 8 shows the effect of reucing the ifficulty of reeploying workers, as reflecte in an increase in expecte output. Increases in the extent of cross-market wage compression lea to monotonic increases in unemployment an the fragility of jobs. Although not shown, they also increase the length of the average unemployment spell an the extent of inefficient churning. Increases in the extent of within-market wage compression ten to increase unemployment an the fragility of jobs. There is also an increase in the extent of inefficient churning, an the average uration of each job falls by over 10 percent. For very high amounts of wage compression, there is a slight reuction in unemployment reflecting the fact that given the assumption that new jobs are create with the highest level of prouctivity higher within-market wages ten to increase the job fining rate. Increases in ability to reeploy workers significantly reuce unemployment an job fragility. Although not shown, the average length of unemployment spells an the extent of inefficient churning also fall. Moreover, all these improvements are greater when wages are not compresse. Figure 6: Cross-Market Wage Compression: Unemployment an Job Destruction (a) Unemployment Rate Wage Compression Percent increase in average wage (b) Job Destruction Rate Wage Compression Percent increase in average wage Wage compression significantly worsens the impact of negative shocks. As can be seen from Table 2, the impact of a 10 percent reuction in the level of output significantly increases the extent of unemployment an the length of unemployment spells. With the main employers of low-skill workers unergoing significant changes in coming years, reform to these wage setting institutions will become increasingly important.

18 Figure 7: Within-Market Wage Compression: Unemployment an Job Destruction Wage Compression (a) Unemployment Rate Within Market Compression (b) Job Destruction Rate Wage Compression Within Market Compression Figure 8: Worker Reeployment: Unemployment an Job Destruction (a) Unemployment Rate Wage Compression Complete reeployment an no compression Degree of Reeployment (b) Job Destruction Rate Wage Compression Complete reeployment an no compression Degree of Reeployment IV. CONCLUSION Sectors that intensively employ low-skill workers, such as sugar an EPZ, have contribute significantly to the Mauritian growth miracle (Subramanian an Roy, 2001). The rapi economic transformation that resulte from the EPZ sector creation is clearly seen in Figures 1 an 2. However, in the face of impening changes in these markets, low-skill workers will face very ifferent employment prospects in the coming years. Inee, the evience presente in Section II suggests these changes, at least for textile workers, have alreay begun. Therefore, the nee for labor market reform is now urgent. While several factors have contribute to the incience of unemployment in Mauritius, the results of a simple moeling exercise show that even minimal wage compression an reeployment restrictions reuce the employment of the affecte workers an increase the length of the resulting unemployment spells. Moreover, all of these policies result in excessive turnover in the economy, which will ultimately reuce the ability of workers to acquire skills when employe an hasten their atrophy when workers become unemploye. Inee, the harm resulting from any of these istortions is intensifie when other istortions coexist. Moreover, wage compression imposes costs beyon those iscusse in this paper. As Haltiwanger an Voopivec (2002, p. 5) fin in their stuy on Slovenia,... businesses with

19 more compresse wages have... greater excess turnover for high quality workers,... [an] wage compression creates excessive instability of jobs an imposes aitional worker islocation costs, as well as reuces firms ability to achieve quality firm-worker matches. As iscusse above, institutions that compress wages are foun in many countries. Shieling some sectors from restrictive institutions may ameliorate the effects temporarily, but ultimately these istortions will harm the opportunities for low-skill workers an, more broaly, longer-term growth prospects. By istorting the incentives to reallocate economic activity into new, unimagine, areas, these institutions limit the opportunities for lowskill workers an inhibit the reshaping of the economy. This will become increasingly so, as the economy unergoes an enforce structural transformation in the coming years. Although eucation is often seen as a solution to poor labor market outcomes in many countries, ignoring institutions that inhibit the eman for labor can have significant consequences. While the Mauritian government has embarke on a bol an necessary series of eucational reforms, general labor market reform remains crucial. These eucational reforms will unoubtely help Mauritius move into other high-tech fiels, but will not be able to assist all low-skill workers. First, these eucational reforms will take some time to bear fruit. Secon, with only 7.3 percent of Mauritians having their higher school certificate, it will take consierable time before these new eneavors can absorb much of Mauritius low-skill labor force. Therefore, as in many countries, eucational reform can, at most, be only a partial solution to unemployment problems.

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