864 Macroeconometric Modeling for Policy
supply side, which we refer to as ICM in the following (see Bårdsenet al., 2005,
Chs. 5 and 6). In applications, the gap between the formal relationships of the
theory and the empirical relationships that may be present in the data must be
closed. The modeling assumption aboutI( 1 )-ness introduced above is an impor-
tant part of the bridge between theory and data. This is becauseI( 1 )-ness allows
us to interpret the theoretical wage and price equations as hypothesized cointe-
gration relationships. From that premise, a dynamic model of the supply side in
equilibrium-correction form follows logically.
There is a number of specialized models of “non-competitive” wage-setting. Our
aim here is to represent the common features of these approaches by extending
the model in Nymoen and Rødseth (2003) with monopolistic competition among
firms.
We start with the assumption of a large number of firms, each facing downward-
sloping demand functions. The firms are price-setters and equate marginal revenue
to marginal costs. With labor being the only variable factor of production (and
constant returns to scale), we have the price-setting relationship:
Qi=ElQY
ElQY− 1Wi( 1 +T (^1) i)
Zi
,
whereZi=Yi/Niis average labor productivity,Yiis output andNiis labor input.Wi
is the wage rate in the firm, andT (^1) iis a payroll tax rate.ElQY>1 denotes the abso-
lute value of the elasticity of demand facing each firmiwith respect to the firm’s
own price. In general,ElQYis a function of relative prices, which provides a ratio-
nale for the inclusion of, e.g., the real exchange rate in aggregate price equations.
However, it is a common simplification to assume that the elasticity is indepen-
dent of other firms prices and is identical for all firms. With constant returns
technology, aggregation is no problem, but for simplicity we assume that average
labor productivity is the same for all firms and that the aggregate price equation is
given by:
Q=
ElQY
ElQY− 1
W( 1 +T 1 )
Z
. (17.15)
The expression for real profits () is therefore
=Y−W( 1 +T 1 )
Q
N=(
1 −W( 1 +T 1 )
Q1
Z)
Y.We assume that the wageWis set in accordance with the principle of maximizing
the Nash product:
(V−V 0 )^1 −, (17.16)whereVdenotes union utility andV 0 denotes the fallback utility or reference
utility. The corresponding break-point utility for the firms has already been set to
zero in (17.16), but for unions the utility during a conflict (e.g., strike or work-to-
rule) is non-zero because of compensation from strike funds. Finally,represents
the relative bargaining power of unions.