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The insider-outsider theory examines the behavior of economic agents in markets where some participants have more privileged positions than others. Incumbent workers in the labor market, the "insiders," often enjoy more favorable employment opportunities than the "outsiders." The reason for this disparity is that firms incur labor turnover costs when they replace insiders by outsiders. In practice, the distinction between insiders and outsiders is a matter of degree.
The most obvious labor turnover costs are the costs of hiring, firing and providing firm-specific training, but further costs can arise from the attempts of insiders to resist competition with outsiders by refusing to cooperate with or harassing outsiders who try to underbid the wages of incumbent workers. Since these costs are borne, at least in part, by the employers, they give the insiders market power. The insiders use this power to push their wages above the marketclearing level, but firms do not try to replace them with outsiders since it would be costly to do so. The insider-outsider theory then proceeds to examine the implications of this behavior for employment and unemployment (Lindbeck and Snower, 1984, 1986).
Insider-outsider theory was originally constructed as a microeconomic founlotion for the existence of unemployment, and hence it focused on explaining the absence of wage underbidding even when many unemployed workers are willing to work for wages lower than existing insider wages (normalized for productivity differences). In labor economics, there are three main ways of explaining why such underbidding does not occur. First, legislation may keep the wage above its marketclearing level (the minimum-wage explanation). Second, firms may not accept the outsiders' underbidding, since a fall in the wage may reduce productivity or increase the rate of labor turnover (the efficiency wage explanation). Third, it may not be in the insiders' interests to permit outsider underbidding. Insiders may be able to impose their interests on their employers, since the insiders' positions are protected by labor turnover costs (the insider-outsider theory explanation).
The insider-outsider distinction has also been applied to more specific labor market issues, like the different employment experiences in Europe and the United States in recent decades. The theory also provides a rationale for unions, explains what gives unions their clout, and identifies sources of unions' wage bargaining power....