Wednesday, December 12, 2007

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.


Jan said...

I fully share your view on this one Harry - the labour market is not a place to pursue a social agenda.

Regarding the redistribution through the tax system, there has been some sensible proposal of negative income tax. Personally I like John Humphreys's Reform 30/30 - see this book:

The idea is that workers face the same effective marginal tax rate at ANY level of income, which ensures that incentives are not distorted.

Anonymous said...
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Anonymous said...


Why don’t didn’t you mention things like the marginal productivity theory that basically explains why labor will end up receiving the marginal product of its output. You also neglected to mention determinancy, which was the principal argument that union trog thugs used to bash Workchoices. Union trogs argued that workers would be ripped off without them because they would be able to determine their correct labor rate.

Slim said...

Harry - an informative description of the Second Theorem of Welfare Economics.

The solution instead is to tax well paid workers and to pay these taxes to workers who earn low incomes as transfer payments.

Does this not mean that the burden of funding equity measures for low income workers is carried solely by high income workers? By far the greatest wealth beneficiaries of a free market economy are the corporations. Should they not also be responsible for the burden of equity measures? Are there any mechanisms by which this could be achieved efficiently and effectively?

hc said...

Anonymous, JQ is one of the important figures in Australian economics. He is very hard-working and has made a host of contributions across many fields.

The marginal productivity theory shows how wages are related to productivity. An important theory - entirely consistent with what I have written.

Slim, I don't think corporations would be the biggest receipients of advantage - most would accrue to ordinary citizens.

There is no difficulty in levying neutral profits taxes as a redistributive measure. I'd want to think about this one and will.

With dividend imputation company taxes are equivalent to taxing dividends in the hands of shareholders which seems about right.

Bring Back CL's blog said...

Ahh the marginal productivity theeory.

Tell me JC what is the marginal productivty of capital and how do you measure it?

If Asutraalia wants to further de-regualte the market then simply adopt what NZ did in less than 100 pages of legislation. You will need to introudce family tax credits otherwise you will run into trouble re-welfare payments.

Harry I recomend you buy the 2005 Elderton Barossa shiraz.
Robert Parker says it is better than Grange and I agree with him and it is only $25 a bottle

Slim said...

Cheers Harry - you have identified some other measures for consideration. I guess what I was getting at is that not everyone is a worker and some of the greatest individual wealth derives from corporate activity and is it reasonable that equity measures themselves be as equitably distributed as possible.

Anonymous said...

Good one slim

Slim is looking to steal from someone else if there has to be a free labor market. Keep your envious eyes off other people's money and assets, slim. Try and earn some yourself- the hard way.

Homer, you economics dunce. See what happens when one raises wages above the clearing rate.


In 2004, Quiggin suggested that the Australian Green's economic policies were generally ok.

Do you agree with him?

Slim said...

As usual the anonymous troll is presuming to speak for others and has the wrong end of the stick yet again.

I have simply asked that if there are to be equity measures for low paid workers should they be only be subsidised by high paid workers.

I have a job and a small business, earn a salary and pay taxes.

Try to keep on topic.

Bring Back CL's blog said...

the troll can't aanswer the question.

It is a very rare case when a person has no interaction with other people.This is why it is really very stupid to engage in idividual agreements.

Workplaces are full of people working with each other.
That is the only way you can become more efficient, boost productivity andthus increase wages.

derrida derider said...

Costly information makes labour market fail (in the technical sense), and hence workers being paid their marginal product is the exception rather than the rule. What we can or should do about it is another question, but modern labour and organisational economists have moved way, way beyond this Econ 101 stuff.

But that's not my main point here. I've always had a beef with the line that "we should puruse allocative efficiency regardless of equity concerns because the losers can compensate the winners". Yes, they can - but for it to be an unambiguous welfare improvement we have to show that they will. That's the only way you get a Pareto improvement out of it. And it rarely happens.

And even in narrow efficiency terms, it's no gimme that the efficiency costs of redistribution through the tax/benefit system are less than those of technically inefficient labour market insititutions. After all, you righties complain about tax and welfare too.

hc said...

derrida derrida, You have not provided counterarguments to the basic claims being made here.

Gains-from-trade issues may be Economics 101 but they are some of the important arguments of economics and they apply in labour markets just as much as markets for internationally traded goods. I set the issues out here since recent posts at LP and elsewhere convince me many do not understand the issues.

There are failures in all markets but that in itself is not a case for intervention. What failures in labour markets with respect to pay and conditions are best dealt with by government bureaucrats or unions? I think the free market job ads and competition for workers at full employment do better than bureaucrats and bogan unionists.

The State does not act primarily as an information-provider in labour markets - it interferes with the terms under which deals can be done between workers and firms. It restricts the range of possible deals.

The redistribution argument here is not based on compensation ideas. The transfers are to effect an income distribution desired by social democrats.

There are deadweight losses associated with taxes and numerous instances of things such as welfare fraud. These problems can be reduced by a negative income tax.

Your claim here is fairly empty anyway - you don't actually assert which way of doing things results in lower costs. It is not an argument for retaining the current regulatory regime.

Mark U said...


This is a a good, thought provoking post.

I agree with most of the economics that you have outlined here. I also agree that the labour market is not the mechanism to address distributional issues. However, I consider that labour markets are different from other commodity markets because they involve very loose agreements between employers and employees about the conditions of exchange over an indefinite period of time and this makes the employer-employee relationship much more complicated than a mere exchange of money for a commodity. (More like a marriage than a supermarket purchase.)

I also consider that workers should be free to either individually or collectively negotiate their wages and conditions at the enterprise level and should be entitled to be assisted in this negotiation by an advocate (whether an open-shop union or some other form of specialist negotiator). I do not object to workers seeking individual agreements with their employer, which means I disagree with Labor's objection to AWAs (although it is possible that common law contracts may become an effective substitute). However, I disagree with the Coalition's Workchoices legislation because it enabled employers to force their workers onto AWAs, whether workers preferred them or not. In the case where workers have low work skills, and sometimes even lower negotiating skills, there can be serious information imbalances and a collective approach to wage setting can be a more effective way of ensuring that all individual workers are paid close to their marginal product. If an employer can legally pay less than a worker's marginal product then it is perfectly rational for them to do so.

hc said...

The points you raise are fair ones. In the main they relate to issues of information. But I question whether workers are unable to determine their value readily in a competitive labour market.

Most people have a pretty fair idea of salaries and conditions in their workplace.

I agree with you that all workers should have the right to negotiate an individual AWA.

Mark U said...


Do you agree that workers also have a right to choose to collectively bargain?

Collective bargaining can often be a valuable process because it gets the employees as a group to look at how they operate and identify opportunities to improve work practices in exchange for wage increases (ie. identify opportunities for productivity improvements). Individual contracts are not conducive to this as each worker negotiates in isolation from his co-workers and has limited knowledge of what conditions they are being employed under.

hc said...

Improvements in work practices do not require unions to act on behalf of employees - there should be internal review procedures within the firm.

Of course people should be able to seek advice on negotiating terms and conditions but I am uneasy about agreements negotiated collectively that cover large numbers of workers.

Mark U said...


Collective baragining does not necessarily require union involvement.

Surely your objection must be based on some more rigorous analysis and not just a feeling of "unease".

hc said...

I deleted the second comment which attacked a colleague. I will delete all such comments in future and will ban the person completely from this blog if he persists.

Please go elsewhere.