Wage-setting and capital in unionized markets: Evidence from South Europe ☆ Thanassis Kazanas a , Natasha Miaouli b, ⁎ a Centre of Planning and Economic Research, 11 Amerikis Str., Athens 106 72, Greece b Athens University of Economics and Business, Department of Economics, 76 Patission Str., Athens 10434, Greece abstract article info Article history: Accepted 20 November 2013 JEL classification: J51 E22 E24 Keywords: Trade unions Wage setting Capital stock Error correction models Structural breaks Cointegration The present paper analyzes the optimal response of real wages to the installed capital stock in a dynamic monop- oly union. We use data from five Southern European countries during the period 1970–2010. We explore how this rent-extraction response changes over time and across countries depending on the labor market regulatory environment or regime. Regimes are allowed to be determined endogenously by the econometric methodology and seem to be consistent with relevant anecdotal evidence. We find that wages responded positively to the cap- ital stock during periods of heavy regulation, while this response was significantly lower or even negative when labor markets became more flexible. © 2013 Elsevier B.V. All rights reserved. 1. Introduction It has long been recognized that, in non-competitive markets, the wage is chosen so as to extract rents created by firms. The degree of rent-extraction depends, among other things, on firms' initial condi- tions and labor market institutions. For instance, a trade union is expect- ed to raise its wage demands when there is evidence that the firm is doing well and has invested heavily in the recent past (see Grout, 1984, and Van Der Ploeg, 1987, for early papers) and/or when higher wage claims do not risk a rise in unemployment because of labor market restrictive regulations (see Blanchard, 2004, for regulation and rent- extraction in European labor markets). 1 The present paper investigates the optimal response of real wages to the installed capital stock, and shows how this rent-extraction response changes over time and across countries depending on the labor market regulatory environment or regime. Regimes are allowed to be deter- mined endogenously by the econometric methodology. More specifically, we apply the instability test of Hansen (1992), the residual based test of Gregory and Hansen (1996) and Bai and Perron's (2003) methodology to investigate the existence of multiple structural breaks in the postulated cointegrating relationship. These regimes seem to be consistent with anecdotal evidence from a number of South European countries. We focus on installed capital due to its important role as an economic fundamental in wage setting. Although the wage–capital relation has been studied by Arestis et al. (2007), here we show that this relation can change depending on the labor market regulatory environment. We begin with a theoretical model that characterizes time- consistent optimal wages in a dynamic monopoly union model. We then let the data decide how wages are affected by the installed capital stock. We use annual data from five Southern European countries (France, Greece, Italy, Portugal and Spain) during 1970–2010. These countries have been chosen because of their similarities in their labor market structure, such as the wage bargaining system, high unioniza- tion or coverage rates, generous social welfare systems and stringent employment protection legislation (Bentolila et al., 2010; World Economic Forum, 2011). 2 Changes in these institutions are used as sig- nals to detect regime switches in the labor market. Economic Modelling 37 (2014) 368–376 ☆ We would like to thank P. Korliras, E. Tzavalis and A. Philippopoulos for their helpful discussions and suggestions. Any errors are ours. ⁎ Corresponding author. E-mail addresses: tkazanas@aueb.gr (T. Kazanas), miaouli@aueb.gr (N. Miaouli). 1 This might be linked with reduced investment incentives, and consequently with the persistently high European unemployment rates of the last decades (Blanchard & Wolfers, 2000). 2 The relevant summary EPL indicator index is for all these countries very close to the max (2.9–3.5). For a more detailed analysis of other common characteristics of these coun- tries see Miaouli (2001). 0264-9993/$ – see front matter © 2013 Elsevier B.V. All rights reserved. http://dx.doi.org/10.1016/j.econmod.2013.11.027 Contents lists available at ScienceDirect Economic Modelling journal homepage: www.elsevier.com/locate/ecmod