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This paper develops a dynamic general equilibrium model in which the public and the private sector interact in the labor market. Previous studies that analyze the labor market effects of public sector employment and wages have mostly assumed exogenous rules for public wage and public employment. The authors show that theories that equalize wages with marginal products in the private sector can rationalize the interaction of public and private sector wages when extended to accommodate a nontrivial government sector/public sector union that endogenously determines public employment and wages. The model suggests a positive correlation between public and private sector wages. Any increase in tax revenues, coupled with the existence of a positive public-private sector wage gap, makes working in the public sector an attractive option.
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