Insider-outsider theory of employment

The insider-outsider theory is a theory of labor economics that explains how firm behavior, national welfare, and wage negotiations are affected by a group in a more privileged position.^[1] The theory was developed by Assar Lindbeck and Dennis Snower in a series of publications beginning in 1984.^[1][2][3]

The insiders, those employed by a firm, and the employers are the bargainers over wages. Because the insiders are already employed, they are in a position of power and are ultimately uninterested in expanding the number of jobs available for those who are not already employed. In other words, they are interested in maximizing their own wages rather than expanding jobs by holding wages down and allowing outsiders to become employed.^[5] Firms have a strong incentive to bargain with the insiders because of the high cost of replacing those workers. This cost, called labor turnover cost, includes severance pay, hiring process expenditures, and firm-specific training.^[3] Because the rate of unemployment has no weight to the monopoly of the union and employers on wage-setting, the natural rate of unemployment rises as the actual rate does. The outsiders (unemployed) become increasingly less relevant in the bargain.^[5] Because insiders commonly use their position of power to dissuade outsiders from underbidding their current wage. The result is a labor market that does not see any wage underbidding despite the willingness of many unemployed workers to work at a lower wage.^[3] This results in a market failure, meaning that the wage is not being set according to the labor market's needs or preferences.

A behavior of the insider-outsider model is illustrated at right, where Nd represents the optimal level of employment of labor firms and Ns represents the quantity of labor time workers desire to supply at a given wage rate. Insiders leverage their position of power to negotiate a wage that is much higher than the market-clearing wage rate. This bargain sets the wage rate for the whole labor market, meaning that unemployed workers are hired less often, even if they are willing to work for a lower wage. The disparity results in a new level of unemployment, which can lead to permanent unemployment.^[4]