Pissing Down Your Leg

Thoughts on Economics and Economic Policy

What Do Unions Do?

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Public unions have been taking a lot of heat from the right recently, while private sector unions continue to diminish in importance in the United States. I think it’s useful to think about what unions actually do in order to think about whether they are harmful or beneficial (or neutral) to economic performance. In order to do that, I want to do a little thought experiment.

Imagine an employer and a potential employee. While there is some doubt about how productive the worker will be at this particular job, the expectation is that there will be some value created by the match. That is, for every employer-employee combination, the worker creates a certain amount of value added for the firm. If the firm decides to hire this worker, the next step is to figure out how much to pay her.

The firm will not pay more than the value of that the worker can provide. If it did, it would lose money every day. The worker, on the other hand, will have some reservation wage below which she will choose not to take the job. It could be equal to the value she places on leisure or it could be the value of her next best job offer. If the firm offers to pay her less than this reservation wage, she will politely decline and go to her next best option.

So let’s call the reservation wage r and the value that the job creates v. In a search type model (a la Mortenson-Pissarides) we throw these numbers into a Nash-bargaining black box and come up with some equilibrium wage. But there could be a large number of possible equilibria. It depends on the bargaining power of both the firm and the employee which in turn depends on the tightness of the labor market for the employee’s particular skills.

In general, most workers have significantly less bargaining power than the firms that want to hire them. Therefore wages tend to much closer to r than to v. There are, of course, exceptions. NFL quarterbacks, CEOs, and airline pilots spring to mind. But for factory workers, clerical workers, retail workers, and most of the rest of us, the firm generally has the upper hand in bargaining over wages and can make take-it-or-leave-it offers. While some industries may pay efficiency wages above their workers reservation wages in order to reduce efficiency, many do not.

Firms then, are often able to capture much of the surplus that is created by each employer-employee match. When we see corporate profits increasing while labor income is stagnating or decreasing, this is evidence that firms have been successful in reducing the amount of the surplus that goes to labor. That we have seen this recently in the United States is no surprise because we have also seen the power of labor unions fall.

For what do labor unions do? At least when it comes to wages, they are able to increase the bargaining power of labor. This allows workers to capture more of the surplus created by these employer-employee matches and push wages closer to v. This will reduce corporate profits and increase the share of revenue that goes to labor. This is what we saw in the 1940s and 1950s, the heyday of union growth in the U.S.

But the question remains whether this is good or bad. We have seen a number of industries that seem to have given away too much to labor. leading to a loss of profitability and competitiveness and even bankruptcy. The answer to this question is, unfortunately, far from clear. First of all, increasing the bargaining power of labor is definitely good for (currently-employed) workers in the short term. It will increase their wages (and other forms of compensation). Of course, by raising the cost of labor, it will likely lead to fewer jobs in that particular firm/industry. Firms have a downward sloping demand curve for labor, so when the price goes up, they will employ fewer workers.

That doesn’t necessarily mean that it is bad for the economy. Increasing the share of income that goes to labor (as opposed to profits), leads to increased consumer spending and higher demand for firms. In the end, it may lead to more total employment in the economy or it may simply be neutral. Certainly the economy of the 1940s-60s was no worse than the economy of the last 20 years and it may have been healthier.

But what of the long-term consequences? If firms that are profitable now give away too much to the unions, they may find themselves uncompetitive in the future, needing to cut jobs or even declare bankruptcy. Certainly the U.S. auto industry seems to be in this position and unions have had to give back a fair amount of what it won in the past in order to keep the big three auto companies afloat.

Here, I believe, unions need to think more like the owners of the firms than as representing the interests of the firms’ most important input. The surplus value created by each employer-employee match is not fixed in stone. It will vary over the business cycle and it will vary over time as the competitive landscape of industries change. If labor unions understand this, they can bargain for contracts that accept this fact and that increase pay to labor when the firm is doing well and decrease it when the firm is struggling. This is often how the pay is structured for those workers that have more bargaining power to begin with (think CEOs).

The obvious solution, which has been proposed again and again in the history of labor economics, is some form of profit sharing and/or employee ownership. A Ford that has lower base pay for workers but that regularly shares its profits across the board will be a much more competitive firm than a Ford that faces a UAW intent on extracting as large a share of guaranteed pay as possible. Of course, in a world in which workers own a large percentage of each firm, it would be inappropriate to have industry-wide unions like the UAW which might see it in the interests of its members to reduce competition in order to increase profits and pay.

Public unions, in this scenario, represent a problem. After all, they do not exist in a competitive world trying to maximize profits. If they work for anybody it is the citizens of the country, state, city, or town. These citizens have an interest in having high quality service at a low cost so that taxes are held in check. Politicians, on the other hand, elected to negotiate with these workers often have their own agenda. They may be more willing to make concessions in the interest of labor peace, especially if the bill for those concessions won’t come due until they have been out of office for a long time (think defined-benefit public pensions now bankrupting states and municipalities across the country). Or they may be intent on breaking the unions for ideological reasons especially if they have been sent to office by business interests intent on lowering their own labor bill.

It is therefore very important that public-sector negotiations take place in as public and open a format as possible. For the most part, voters and taxpayers want to see their teachers, police officers, firefighters, and other public servants paid fairly. What they don’t want is to see promises made that are much more generous than the compensation they themselves receive, as the taxpayers will eventually end up footing the bill.

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Written by Liam C Malloy

October 21, 2011 at 10:36 am

Posted in Uncategorized

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