Labor Unions, Directed Technical Change and Cross-Country Income Inequality

This study explores the macroeconomics effects of labor unions in a two-country model of directed technical change in which the market size of each country determines the incentives for innovation. We find that an increase in the bargaining power of a wage-oriented union leads to a decrease in employment in the domestic economy. This result has two important implications on innovation. First, it reduces the rates of innovation and economic growth. Second, it causes innovation to be directed to the foreign economy, which in turn causes a negative effect on domestic wages relative to foreign wages in the long run. We also calibrate our model to data in the US and the UK. We find that the degree of unions' wage preference must be stronger in the UK than in the US in order for the calibrated economies to replicate the simultaneous decrease in labor income share and unemployment in the two countries. We also explore the quantitative implications of labor unions on social welfare and relative wage across countries. In summary, our calibrated model is able to explain about half of the decrease in relative wage between the US and the UK from 1980 to 2007.