Involuntary Unemployment and Intrafirm Bargaining with Replacement Workers

This paper reconsiders the result of Stole and Zwiebel (1996) that when a firm bargains with its workers over the wages in non-binding contracts, the firm will over-employ workers to reduce the hold-up power of any one. This result has stood in contrast to conclusions drawn in the literature on involuntary employment that bargaining would lead to un- or under-employment. We demonstrate that the Stole-Zwiebel conclusion critically relies on the lack of replacement workers. When insiders can be easily replaced from a finite pool of workers, then the firm chooses to under- rather than over-employ workers. Only when the replacement pool of workers is infinite do neoclassical outcomes occur. Moreover we demonstrate that the key driving force between the differing conclusions of these models is the degree of substitutability between replacement and insider workers