Shutdown Threats, Firm Fragmentation and the Skill Premium

Abstract

This essay investigates the interaction between demand uncertainty and non-competitive labor markets where firm owners have the option to shut down and relocate. Workers cannot find new jobs instantly and therefore accept wage reductions to avoid unemployment, if firm owners credibly threaten to shut down. The analysis shows that the expected wage rate is a mix of a competitive wage rate and a bargained wage rate and that this lowers the skill premium. Further, the option of firms to shut down and relocate increases the average size of firms. The analysis also shows that outsourcing or contracting out is more likely if demand is more uncertain, if market power is smaller, and if the markets for intermediate goods are more competitive. Fragmentation increases the skill premium because it leads to more homogenous firms, with respect to workers’ skills. With more homogenous firms, low-skill workers cannot compensate their inferior productivity in wage bargains with high-skill workers.