An Economic Perspective on Wage-Setting in the Private and Public Sector

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An Economic Perspective on Wage-Setting in the
Private and Public Sector

• Montana Arbitrators' Association
• Training Session
• Barry Bluestone
• Northeastern University
• September 22, 2004

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Sessions

1. Marginal Productivity Theory, Human Capital
   Theory, and Competitive Labor Markets
2. Institutional Factors Discrimination, Labor
   Market Regulation, and Trade Unions
3. Impact on Wage Determination of International
   Trade, Technology, and Labor Rights
4. Impact of Labor Theory on Arbitrator Decisions

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Session I

• Traditional Labor Market Theory
• Marginal Productivity Theory
• Human Capital Theory

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Marginal Productivity Theory

• Workers are paid according to how much they
  contribute to marginal increases in output
• If increasing the number of employees in a firm
  by one worker would increase output by 25,000,
  workers should be paid 25,000.

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Assumptions of MP Theory

• No barriers to labor mobility
• Homogeneous labor force
• Product market is competitive
• Firms attempt to maximize profit
• Competition among workers keeps wage no higher
  than marginal product
• Competition among firms for workers keeps wage
  no lower than marginal product
• All similar workers receive exactly the same
  wage, regardless of the firm for whom they work

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Relationship between Prices, Productivity, and
Wages

• Equation 1
• ?Price ?Wage - ?Productivity
• Equation 2
• ?Wage ?Price ?Productivity

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Implications of Equation

• Equation 1
• If wages increase no more than productivity, then
  firms can maintain normal profits without raising
  prices
• If wages increase MORE than productivity, then
  firms must raise prices to maintain normal
  profits.
• If a firm raises price to cover higher wages in
  excess of productivity gains in a competitive
  industry, then firm loses market share workers
  will be laid off

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Implications of Equation, cont

• Equation 2
• If productivity goes up by X and firm is able to
  raise prices by Y, then wages can go up by XY
• If wages rise by less than productivity, firm
  should be able to lower prices and become more
  competitive
• If wages rise by less than productivity and
  prices do not fall, profits increase

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Heterogeneous Labor

• If labor differs by skill, then workers will be
  paid differently, but each worker will be paid
  his or her marginal product
• Wage differences will simply reflect different
  worker productivities
• Again, this assumes perfect labor mobility and
  competitive product markets

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Impact of Capital and Technology

• Increase in the use of physical capital (e.g. new
  machines or new processes) increases the marginal
  productivity of workers and therefore wages
• Improvements in technology - that add to labor
  productivity increase wages as well

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Human Capital Theory

• Retains assumption of perfect labor mobility, but
  expands on differences among worker skills
• Human capital models single out individual
  investment behavior as a basic factor explaining
  differences in wages
• Wage Differences f (Differences in individual
  investments in skill)

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Types of Human Capital Investment

• Formal Education
• On-the-job Training
• Vocational Education
• Health Status
• Access to labor market information
• Migration

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Basic Human Capital Equation

• Earnings(i) a0 b1 x Education(i)
• b2 x OJT(i)
• b3 x Vocational Educ(i)
• b4 x Health Status(i)
• b5 x Labor Market Info(i)
• b6 x Migration(i)

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Earnings Distribution

• The market determines the b for each human
  capital attribute. It will be the same for all
  workers given labor mobility and perfect
  competition
• This b is the rate of return to each human
  capital factor
• Earnings differ simply because individuals make
  different human capital investments in themselves.

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Wage Implication

• Wages are set exclusively by the market
• Wage differences are exclusively due to
  differences in worker investments in human
  capital
• These wage rates are fair and just because they
  represent the workers own investments in human
  capital, the state of capital investment, and the
  state of technology

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Market Implication

• Any firm in a competitive industry forced to pay
  a wage higher than the market wage will no longer
  be competitive and will have to lay off workers
  or go out of business
• Trade Unions, Arbitrators, minimum wage
  legislation can raise wages if their influence
  covers an entire industry ... but at the expense
  of reducing employment to the point that wages
  marginal product

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Market Implications, cont

• If trade unions, arbitrator decisions, or minimum
  wage affects only some firms in a perfectly
  competitive industry, these firms will no longer
  be competitive and will go out of business.

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Monopoly and Oligopoly Markets

• Relaxing the assumption of perfectly competitive
  labor markets changes these dynamics dramatically
• Firms that have monopoly or oligopoly advantage
  earn monopoly profits
• Firms and workers can negotiate how these
  monopoly profits will be shared

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Implications

• Trade Unions, Arbitrators, and minimum wage
  legislation can raise wages without forcing firms
  into bankruptcy.
• Still, wages higher than initial marginal product
  will encourage firms to reduce workforce until
  wages marginal product ... in order to maximize
  profit

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Session II

• Institutional Labor Market Theory
• Labor Market Discrimination, Trade Unions, and
  Labor Market Regulation

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Labor Market Discrimination

• Once there is labor market discrimination against
  any group of workers, the assumption of perfect
  mobility no longer holds
• Workers with identical human capital can end up
  with very different wages ... even if wages
  marginal product for each worker.

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Wage Gap
Firm B only employs white men Firm A employs
anyone Firm B pays a premium to its white male
workforce Firm A need not pay this premium to
attract all the workers it needs
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Human Capital Equation with Labor Market
Discrimination

• Earnings(i) a0 b1(i) x Education(i)
• b2(i) x OJT(i)
• b3(i) x Vocational Educ(i)
• b4(i) x Health Status(i)
• b5(i) x Labor Market Info(i)
• b6(i) x Migration(i)
• Now, earnings differ as a result of differences
  in human capital investment PLUS differential
  returns to investment

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Impact of Labor Market Discrimination

• For every unit of human capital, group
  discriminated against receives a lower return on
  its investment
• For example, an extra year of college is worth
  less to a black female than a white male
• Workers with identical human capital earn
  different wages

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Impact of Unions

• To the extent that craft unions limit entry into
  an occupation, they establish wage differentials
  for their members relative to those who cannot
  enter the occupation
• These barriers to occupational mobility create
  non-competing groups of labor
• These barriers create a balkanized labor market
  where individual wages depend on the access
  individual workers have to these sub-markets.

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Balkanized Labor Markets

• Due to
• Racial or Gender Discrimination
• Strong trade unions
• Barriers to geographic mobility
• Lock-in Effects of Seniority
• Civil Service Channels

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Ability to Pay

• Within balkanized labor markets, wages reflect
  the ability to pay of individual firms
• Firms with monopoly or oligopoly advantage can
  pay higher wages
• Workers who gain access to these advantaged firms
  can negotiate higher wages through their unions,
  through arbitration, or through industry or
  occupational regulation

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Institutionalized Labor Market

• Wages in institutionalized labor markets reflect
• Differences in human capital attributes of
  individual work groups
• Differences in race, gender, access to union
  membership
• Differences in firms ability to pay

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1950s-1970s Institutionalized Labor Market Heyday

• In the first three decades following World War
  II, the U.S. labor market was in its
  institutionalized heyday
• Large oligopolies dominated the American
  landscape GM, Ford, Chrysler, U.S. Steel,
  Bethlehem Steel, General Electric, Westinghouse,
  ATT, Boeing, McDonnell Douglas, IBM, Textron,
  etc., etc. etc.

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1950s-1970s Institutionalized Labor Market Heyday

• Union Density reached its zenith in the mid-
  1950s with 36 of the U.S. workforce members of
  unions or covered by collective bargaining
  contracts
• Rise of regulated labor market with OSHA, Equal
  Employment Opportunity Act, minimum wage etc.
• Growth in public sector at federal, state, and
  local level
• Rise of public sector unions

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Session III

• Globalization Deindustrialization
• New Technology
• Unionism

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Impact of Global Economy on Wage Determination

• Growth of International Competition in key
  industries auto, steel, machinery, electrical
  goods
• Leads to large increase in import share of GDP
• Key industries lose Oligopoly Status subject to
  intense international competition

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Impact of Technological Change on Key Industries

• Under intense international competition, key
  industries move aggressively to substitute
  computer-based technology for workers
• Combination of imports productivity-enhancing
  technology reduces employment in manufacturing
  dramatically

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Deindustrialization(1969-1976)

• Good News
• 25 million jobs created in brand new factories,
  offices, and stores
• 19 million jobs created in existing businesses
• Bad News
• 22 million jobs lost due to plant closings and
  relocations to other states or abroad
• 13 million jobs lost due to downsizing of
  existing businesses

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Rise of the Public Sector Employment
Year Federal State Local
1959 2,342,000 1,484,000 4,366,000
1969 2,893,000 2,533,000 6,904,000
1979 2,894,000 3,541,000 9,633,000
1989 3,136,000 4,182,000 10,609,000
1999 2,769,000 4,709,000 12,829,000
Dec.2003 2,710,000 4,951,000 13,807,000

Source Council of Economic Advisers, Economic
Report of the President, 2004, Table B-46
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The Trend in Unionism
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Age Composition of Union Members in the U.S.
2002
Percent of Employed
Age Group
Workforce
Total, Age 16 13.3
Age 16-24 5.2
Age 25-34 11.2
Age 35-44 14.3
Age 45-54 18.6
Age 55-64 17.4
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Union Membership by Occupation in 2003
Occupation Union Membership as of Employment
Sales and related occupations 4.0
Food preparation and serving related occupations 4.1

Legal Occupations 4.8
Computer and mathematical occupations 5.2
Business and financial operations occupations 6.1
Art, design, entertainment, sports, and media occupations 7.5
Architecture and engineering occupations 7.8
Life, physical, and social science occupations 9.0
Healthcare practitioner and technical occupations 12.3

Production occupations 17.5
Installation, maintenance, and repair occupations 18.9
Transportation and material moving occupations 20.1
Construction and extraction occupations 21.7

Protective service occupations 36.1
Education, training, and library occupations 37.7
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Summing Up

• The 21st Century Labor Market is characterized
  by
• Dramatic Increase in International
  Competition
• New Labor-Saving Technology
• Sharp decline in Manufacturing Employment
• Rapid increase in Public Sector Employment
• Sharp decline in Union Membership
• HOW DOES THIS AFFECT WAGE SETTING?

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Session IV

• Implications of Economic Trends on Wage
  Determination and Arbitration Decisions

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Globalization

• With greater global competition, U.S. firms
  increasingly consider foreign sourcing as an
  alternative to domestic production
• Union wage demands, increased labor market
  regulation, and arbitrated wage increases can
  induce firms to increase the level of foreign
  sourcing
• Result Higher Wages BUT
• Lower Employment

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Information Technology

• Access to new technology increases firms ability
  to adopt labor-saving processes
• Union wage demands, increased labor market
  regulation, and arbitrated wage increases can
  increase the pace at which labor-saving
  technology is adopted
• Result Higher Wages BUT
• Lower Employment

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Declining Union Density

• With falling union density in many industries as
  well as across industries, union wage premiums
  are more difficult to sustain
• Result Arbitrated wages that maintain a
  sizeable union-nonunion gap are likely to result
  in lower employment levels

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Public Sector Wages

• With many states and local communities in fiscal
  crisis, state and municipal government leaders
  increasingly seek ways of limiting union wage
  gains
• Result Stronger public support for privatization
  of municipal services, charter schools, school
  voucher programs

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Questions for Arbitrators

• Given this new Economic Environment, what must
  arbitrators consider?
• Which wage comps should be used?
• Union wage increases in other regions?
• Union wage increases in other industries?
• Tie wage increases to productivity gains in firm?
• Tie wage increases to productivity gains in
  entire industry?
• How much should arbitrators concern themselves
  with employment effects?

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An Economists Thoughts

• In private sector contracts, wage increases
  should be tied more closely to productivity
  increases in relevant industry to maintain price
  competitiveness in global markets
• In the public sector, wage increases should be
  tied to cost-of-living plus all-economy
  productivity increase to keep public sector wages
  more in line with private sector

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Assumptions

• Global competition, new technology, weaker
  unions, and public sector fiscal constraints are
  important in relevant industry
• Arbitrators should consider possible employment
  effects of wage settlements
• Still, within reason, unionized sector should
  lead economy to higher standard of living

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Your Thoughts?Your Comments?