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Department of Economics

Tackling employment disparities with better cost-of-living data

European governments have long sought to reduce regional disparities in economic activity and employment, both in-country and in the EU as a whole. Economics Professor Andrea Ichino and co-authors have devised a way to generate local price indexes, a key tool for policymakers that has been lacking to date.

30 November 2021 | Publication - Research

Research - news Ichino IMG_9508_ok

EUI Economics Professor Andrea Ichino and co-authors have recently published an article, “Wage Equalization and Regional Misallocation: Evidence from Italian and German Provinces”, in the Journal of the European Economic Association. Since 2019, however, the underlying research has received considerable attention from scholars and the media alike, because it addresses a ubiquitous problem: regional disparities in economic activity and employment. What is more, the research provides a way to generate local price indexes for Italy and Germany, a key tool for policymakers that has been lacking to date.

In March 2021 The Economist summarised the research findings under the frank title, “How to solve southern Italy’s unemployment problem”. Recently the Governor of Belgium’s central bank invited Ichino to give a talk explaining the research and findings, as they might be applied to Belgium’s gap.

The article compares two European countries with major regional differences in productivity and economic activity – Germany and Italy. The point is not to explain these differences (they are taken as given, at least in the short run) but how to cope with them. For Italy, the divide is between the more productive north and the less productive south; for Germany (post-1989) it has been, respectively, between west and east.

The role of wage bargaining

Ichino and colleagues show that Germany’s system of collective wage bargaining has allowed it to mitigate the cross-regional inequality, while Italy’s system has exacerbated inequalities. Germany introduced flexibility to the bargaining framework, putting much of the bargaining at the local level. This allows regional wage variation: unions and firms can factor in local costs of living and unemployment levels. In contrast, Italy’s unions bargain over nation-wide contracts and nominal pay scales. They settle for wages that ensure an equilibrium between demand and supply in the north but are too high for the south and cause unemployment there. The north therefore attracts unemployed workers from the south, and this migration raises housing prices and reduces the real wage in the north. The equilibrium is reached when the expected real wage in the south (the average of a high real wage for the few employed and no wage for the unemployed) equals the real wage in the north, which is in full employment. At the equilibrium, migration stops even if unemployment persists in the south.

What does this mean for an individual Italian worker? An elementary school teacher in Palermo (south) earns about 34% more in real terms than the same teacher in Milan (north). A teacher in the south who is unemployed must wait in a queue, without a job, until someone retires. Migration to the north is not always attractive because the cost of living is high there. A northern worker, conversely, has no problem finding a job but her standard of living is depressed due to high local price levels. Thus, nominal wage equality across region, so dear to Italian unions, causes a mess of inequities among citizens. As the Continental Telegraph blog puts it, national collective bargaining for nominal pay scales generates a lot of poverty.

What does it mean for an Italian firm? If a firm in the south needs more workers to grow, or if the public sector needs to build better transport infrastructure for export or tourism, the hiring wage is very high with respect to local productivity, so much that labour demand is sluggish. This perverse equilibrium generates a disincentive for healthy, productive firms in the north or abroad to invest, relocate or set up a branch in the south.

In addition to the north’s higher cost of living, another reason unemployed southerners are discouraged from seeking work in the north is that the extended family serves a welfare function in Italy. A typical set-up in the south is for one family member (usually the prime-age male) to have a stable job, often in the public sector. This person is the family’s financial ‘anchor’. The others rely on this income while themselves living in unemployment or working in the precarious jobs of the informal sector. The result is that about 60% of Italian adults live within one km of their parents, and do not want to move away from the family even if the jobs are located elsewhere.

In Germany, instead, the possibility to adjust wages to local productivity and unemployment conditions has contributed to a more equal distribution of real wage rates, housing prices and unemployment rates across regions, with fewer inefficiencies.

Factoring in local costs of living

As noted, a key methodological contribution of this work is to generate local price indexes for Italy and Germany, exploiting information on housing prices and a novel methodology proposed by one of the authors (Moretti). Local price indexes are currently not computed by ISTAT, the Italian statistical office. Without this information, it is impossible to measure the paradoxical higher real wage of the south. This in turn obscures the perverse consequences of national wage bargaining in nominal terms.

Having pinned down the local cost of living as well as local real wages, the authors can run a counterfactual. If Italy were to adopt the German system of decentralised wage bargaining as a function of local productivity and unemployment differences, the geographic allocation of resources within the labour market would improve, resulting in an increase of 11.04% of overall employment, and of 7.45% of average individual earnings. As Il Foglio has noted, Italy’s gap between north and south certainly has many historical causes, but one of them could be removed quickly if wages in the south were allowed to adjust to local conditions – as advised by this research team.

Another important point the authors make is that the large informal sector in Italy, particularly in the south, would be forced to emerge (with all the related benefits this implies) if local collective bargaining allowed for lower wages. Currently, the union wage is too high in the south and many employers are faced with the choice of hiring workers in the black market or closing down.

While Ichino and colleagues have no current plans to extend their analysis to other countries, they have provided a data-collecting and -crunching recipe that is ready for use by others seeking ways to reduce regional inequalities.

Last update: 26 January 2022

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