Since unification, the economy of eastern Germany has undergone rapid changes in response to the shift in trading patterns away from the Council for Mutual Economic Assistance countries, the liberalization of prices, and privatization. One result has been a fall in overall manufacturing employment of about 65 percent in 1991-93. At the same time, equity concerns have led to a sharp increase in wages in eastern Germany, from about 30 percent to 60 percent of western German levels. Both the shift in industrial composition and the wage increases should, in principle, have contributed to the employment decline.
This paper quantifies the factors affecting labor demand in eastern Germany by estimating a dynamic model of labor demand that treats skilled, semiskilled, and unskilled workers as different factor inputs having potentially different degrees of complementarity with capital. The model is also estimated for western Germany, which has a substantially different production structure and employment history.
The results show that labor demand in eastern Germany is responsive to wage rates, even more so than in the west. This finding contradicts union claims that the policy of raising eastern German wages toward western levels has not been a major contributor to employment declines. Moreover, capital and skill appear to be complements in production, implying that unskilled labor was much more affected by the wage increases than skilled labor.
These results have implications beyond the eastern German labor market. The skill-capital complementarity means that unskilled labor in developed economies is particularly vulnerable to competition from low-wage labor in developing countries. This observation lends support to the hypothesis that unemployment in the United States has been held down by a widening of the wage distribution, particularly at the low end. By contrast, in Europe, the same factors, together with a more compressed wage structure, appear to have resulted in higher unemployment and less labor force participation (that is, an increase in the number of discouraged workers), particularly among the unskilled.