Skills, Wages, and Employment in East and West Germany

Skills, Wages, and Employment in Eastern and
Western Germany by Felix FitzRoy and Michael Funke

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