1 Productivity, Wage Moderation, and Specificity in Factor Inputs Eric J. Bartelsman * September, 1998 This paper considers the effect on productivity growth of the wage moderation policy embarked upon in the Netherlands starting in 1982. The paper describes how the effect depends on the macroeconomic importance of the hold-up problem that results from specificity in factor markets. The analysis is based on a vintage model of capital with embodied technology. In a traditional vintage model, a decline in wages relative to cost of capital will delay scrapping and postpone new investment, thus reducing productivity growth in the medium term. In a recent version of the vintage model, where the specific production relationship between capital and labor gives rise to problems associated with appropriability of rents, institutionalized wage moderation will increase new investment and improve productivity. A preliminary analysis of micro-level data of industrial firms does not yet lead one to reject the important role of specificity. 1 Introduction This paper provides an empirical evaluation of the macroeconomic importance of specificity in factor markets. The paper compares the model of specificity with a base model by considering the different short- and medium-term effects on productivity growth of wage moderation that took place in the Netherlands after 1982. An analysis also is made of differential behavior under the two models of a collection of indicators on investment, employment, and capital stocks in individual industrial firms in the Netherlands. In particular, observed behavior of capital investment at the micro level allows one to distinguish between the two competing hypotheses. The first model is based on a production structure with technology embodied in vintage capital. In this model, wage moderation leads to a transitional reduction in productivity growth. The mechanism is that reduced wage pressure reduces incentives for firms to invest in new capital, and delays scrapping of old capital, thus allowing a decline in the capital-labor ratio. The second model has a similar vintage production structure, but posits the existence of a rent-appropriation, or hold-up, problem associated with specificity of labor and capital in the production relationship (see Caballero and Hammour (1998)). In this model, wage moderation via consensus act as a fortuitous institutional advance that reduces the appropriability problem. In the model, reductions in specificity curb opportunism and pull resources into production, thus increasing productivity. In this paper, the empirical distinction between the two models is not based on estimation of a structural model of firm dynamics. Instead, analysis of carefully selected * Economic and Social Institute, Free University of Amsterdam, ebartelsman@econ.vu.nl.