when period 2 comes along. In technical terms, the optimal policy for the union is dynamically inconsistent. The reason why the firm does not believe that the union will set the wage at W2 in period 2 is easy to demonstrate. Suppose that the firm did believe the union, and decided its investment plans according to (8.52)-(8.53)

with w2 substituted (call this investment level II). At the beginning of period 2, the firm has invested a lot and has a total capital stock of K1 + I;, and demands labour according to (8.51) with K1 + Ii substituted. The union, however, observes this demand for labour, knows that the capital stock cannot be shifted any more, and makes its decision on the optimal wage in the second period on the basis of the