The case for further liberalising labour markets

Economists seek economic efficiency by utilising the effectiveness of free markets. They do this because they want markets to maximise the value of net outputs produced - to maximise the size of the social pie. The idea is not to ignore ‘fairness’ or ‘equity’ concerns but to realise these objectives in quite different ways using the maximised value of output, achieved as a consequence of pursuing efficiency, as the best basis for achieving these other objectives. The rough idea - if you have got more you can do more.

This is true in all markets but particularly in labour markets. Here net value will be maximised if the specific skills possessed by workers go into their highest-valued uses. This will be so if highly skilled workers go into jobs that require high skills and less skilled workers do less skilled alternative tasks. Having skilled people doing unskilled tasks is wasteful as is trying to get unskilled people to master jobs that require skills. Setting wage or employment standards that apply across heterogeneous groups of workers, with differing productivities, creates inefficiencies either because those with above average talents are given insufficient incentives to contribute or those with lower than average skills are paid too much.

The best way of matching up skills with tasks to be done is via a free and competitive labour where no one (no union, no government agency) interferes with the ability of an individual worker to do the best deal they can do with an individual employer who has similar motivations. This best facilitates the process by which the worker can sell his skills and the employer can realise his or her profit objectives. Society’s total advantage is maximised with this arrangement.

The only requirement here is that the market be competitive so that there are plenty of job opportunities out there for a worker with any given set of skills. Then, in the bargaining process that occurs between worker and employer, the worker has a fallback option that yields close to his or her market value. If an employer does not offer a fair wage that reflects the fallback for this skill mix the worker will take an alternative offer. Similarly if the worker demands beyond what is fair remuneration for the skills the employer will select another applicant.

The best way of ensuring competition is to have good information about job offers, low barriers to switching between jobs and close to full employment. Low unemployment of any skill class of workers means that employers do not have undue bargaining power.

Skilled workers are generally in scarcer supply than unskilled workers yet the demand for their services in a modern economy is higher. Hence wages for the high skilled will tend to be high. This means that the distribution of income might be ‘biased’ with freer labour markets towards rewards favoring those with skills – perhaps those who, originally, had strong family support or an exceptional education. There is, furthermore, no guarantee than unskilled workers will only be demanded at a wage that provides only a very low standard of living. In short, a free labour market does not ensure what some would say is ‘social justice’ in the sense of ensuring a reasonable minimum standard of living.

The answer to meeting this social objective (if you believe in it) is not to distort the wages paid in labour markets. Setting minimum wages only creates unemployment if the value of an unskilled worker is less than the wage a government legislates must be paid. A rational employer in this situation will not give this worker a job since the employer will be worse off if they do. The solution instead is to tax well-paid workers and to pay these taxes to workers who earn low incomes as transfer payments. This realises equity objectives by the state acting to supplement the low income workers’ wages. This solution clearly outperforms having the unskilled worker unemployed and paying them unemployment benefits since – even ignoring issues of enhanced self-worth - society gains the value of the unskilled worker’s output when they are employed.

The notion that you can separate out issues of equity from those of efficiency is known as the ‘Second Theorem of Welfare Economics’. Strictly speaking this theorem requires that taxes and transfers be lump-sum (and hence independent of what workers choose to do) since otherwise, when one employs them, the incentives of economic agents are influenced so that in general efficiency need not be achieved. For example it can be argued that taking income from high income workers might conceivably reduce their incentives to work hard. Then funding salary supplementation for low income workers by taxing the well-off might reduce economic efficiency by reducing overall levels of skilled effort in an economy.

There are two reasons I think these types of effects are unimportant.

(i) High income workers have relatively strong income effects when their wages are reduced. Ignoring externalities this means that taking income away from a high income worker is likely to encourage the worker to work harder rather than to enjoy more leisure. The price of leisure is reduced which you might think provides incentives to take more leisure – this is the substitution effect of the net wage reduction - but the strong income effects here mean that wealthy workers will tend to regard their leisure as less valuable because they have less income to enjoy it with.

(ii) In so far as there are important effort-related externalities in this type of market they tend to take the form of ‘other-regarding’, relative income effects of the ‘rat-race’ type. Higher income workers sometimes supply excessive work effort because of a desire to ‘keep up with the Jones’. Even hefty progressive taxes on such workers reduce adverse ‘over-work’ effects. Most of us earning middle or high incomes could live without that new flat screen TV or that second house extension - limiting the opportunities of our wealthier neighbours to do this encourages a greater degree of socially desirable sloth by us.

The ‘Second Theorem’ is widely seen as an argument for social democracy. The ‘First Theorem of Welfare Economics’ says that competitive markets deliver efficiency while the ‘Second Theorem’ provides a restricted case for government intervention via the tax-transfer mechanism to deliver equity and social justice.

While the political left should probably be appreciative of intelligent minds (Kenneth Arrow and Gerard Debreu were the originators) trying to add a bit of logic to leftist ‘bubble-and-squeak’ theories - in general the left show no gratitude. Recognising the intellectual force of the ‘Second Theorem’ involves abandoning attempts to treat firms as social welfare agencies and rigorously delimits the role of the state to taxing and to transferring. This is problematic to those on the left. So too is the fact that there is no suggestion of any regulatory role for government in labour markets and none at all for trade unions.

Is this a reasonable position? In my view, ‘yes’. The counterarguments that are always brought up are things such as child labour laws and laws governing occupational health and safety. There is a reasonable debate that one can have over the role of such laws although it is one that I do not wish to enter into here – some of these laws reflect past historical circumstances and some reflect information failures that probably should be addressed by State action. But the case for governments intervening to secure pay or other reward-related issues to drive a social agenda seems to me weak.

The basic philosophy is to discourage unions and State intervention and to let the forces of self-interest and competition drive labour market outcomes. If society has social objectives in relation to the wages people are paid pursue this via the tax transfer mechanism not by erecting barriers between employers and those wanting jobs.

To be frank many leftwing critics of labour market reforms do not get to the point where they ever entertain the ‘Second Theorem’ logic. Instead, although they will hotly deny it, they operate with an entirely defective antique theory of wages and conditions which they see determined by a variant of old-fashioned class struggle theories rather than by worker productivity. According to this view wages are something like a charitable contribution to worker welfare which needs to be goaded and prodded by trade union action and legislation. In extreme versions of this ratbag theory they have little to do with productivity.

The recent electoral defeat of the Howard government largely on the basis of criticisms of its flawed attempts to increase the role of individual work contracts free from pre-set award conditions has set back labour market reform years if not decades. The overwhelming criticism of the WorkChoices reforms is that they disadvantaged poorer workers. There was no appreciation of their structural impact of attempting to better match individuals with jobs and to maximise the opportunities of all those with something to contribute to our society in terms of work to do so. The criticisms of those with a leftwing political bent were understandable even if they were clearly misinformed. Moreover, the reform package was overly complex and conditional because such nonsense as the ‘no disadvantage’ test was forced on it.

But no mercy or forgiveness should be shown to economists who preach the value of free trade in all markets but make a crucial exception of labour markets. It was this group who helped sealed the fate of WorkChoices by not pointing out the structural advantages it provided. Left wing ideology drove economic interpretation to the point where the implicit economic theory advanced by the left in Australia became internally inconsistent and operated to the disadvantage of ordinary Australians.