Why Labor Market Institutions Are Important

29 Sep 2016 11:32 AM | Mike Lillich (Administrator)

(First published online by the Yonkers Tribune.)

By Oren Levin-Waldman

It would appear that neither of our political candidates really gets it. For Donald Trump all we need to do is grow the economy by 4 percent and if workers could be more flexible in their wage demands, then all will be good. And of course, Hillary Clinton tells us that measures that enable more to go to college free of debt will ultimately help the middle class. This is the answer to stagnant wages? Both overlook the obvious that labor market institutions matter, and it is because of their decline that the middle class has been suffering.

Both appear to subscribe to the neoclassical argument that inequality has grown and the middle class has shrunk because of an oversupply of unskilled labor. For Trump growing the economy will generate more opportunity thereby pushing up wages. And for Clinton, educating workers will in theory enable them to command higher wages. It isn’t clear that an oversupply of more skilled and educated workers won’t also exert a downward pressure on wages. And yet, the issue isn’t an oversupply of unskilled workers, but an oversupply of workers lacking market power.

The fundamental difference between the neoclassical school and the institutional school is that the latter recognize that in the market place the balance of power between workers and employers is asymmetrical. The neoclassical model assumes that workers bargain with their employers equally. The institutional model makes no such assumptions. And yet the distinction between an oversupply of unskilled workers and workers lacking market power may appear to some a very subtle distinction. Why? Because the lack of skills may be the reason for the lack of market power. This may be partly true, but it misses the role that labor market institutions play in achieving a more fair and equitable economy.

Let’s rehearse the neoclassical model. An equilibrium wage or market clearing wage is when the demand for labor intersects the supply of labor. As the prices of labor decreases, more employers will demand labor services, thereby employing more. Of course, each worker presumably has a wage, known as a reservation wage, beneath which s/he will not work. So how much of their supply of labor services is contingent on the wage being offered? Should there be an oversupply of workers lacking skills, we would expect to see a shifting out of the supply curve, thereby resulting in an even lower equilibrium wage. Only if the demand curve were to shift out would we see that equilibrium wage returns to where it was.

In this model, then, there cannot be unemployment because workers can always lower their wage demands until their labor services are demanded. Hence the argument that it is wage rigidity, i.e. the refusal of workers to accept lower wages, that results in them being unemployed. Moreover, institutions that artificially raise wages like unions and minimum wages only prevent workers from accepting lower wages.

Much of economic policy in the U.S. has been predicated on the assumption that this model is in fact correct. And yet, there are serious flaws. First of all, it really matters not how low workers’ wage demands are. If there is no aggregate demand for goods and services, then workers can lower their wage demands to zero and there will still be no demand for their labor. Moreover, if workers were to all accept lower wages during economic downturns, then they would lack the wherewithal to purchase goods and services, thereby resulting in less aggregate demand, which would make more unemployment a foregone conclusion. Of course, the neoclassical model assumes firms will similarly lower prices, but there is a limit to how much price adjustment there can be given that there are fixed costs.

The second major flaw is that the model assumes that workers negotiate as equals with their employers the terms of their employment. Obviously those with more skills can command higher wages. But in the real world the only real negotiation that occurs is that workers are offered jobs and told what they will be paid. They are then free to either accept or not accept the offer. If after a while wages don’t increase, the only option that workers have is to leave in search of something better unless all the workers can stand together, backed up with the threat of a strike, and demand more.

What is often missed is that employers are “wants traders” while workers are “needs traders”. Employers, after all, have resources which enable them to wait it out until workers accept their terms of employment. Workers are “needs traders” who often have no choice but to accept what is being offered if they don’t want to starve. In short, employers have market power; workers do not. Hence the need for market power.

When the National Labor Relations Act, otherwise known as the Wagner Act, was enacted in 1935, the effect was to give workers market power, or what some would refer to as a degree of monopoly power. By legalizing collective bargaining and giving workers the strike weapon, workers effectively achieved voice through their new market power. This was not such a revolutionary concept. Even Adam Smith in his “Wealth of Nations” recognized the need for workers to band together in the face of employers colluding with one another to drive down wages. The minimum wage, then, only extended that market power to those workers who weren’t covered by unions.

Do these institutions artificially raise wages? Yes. But so does the market power of employers in artificially suppressing them. In other words, there is no such thing as the “natural” market place. If we accept the neoclassical premise that only if workers have skills, i.e. something employers need, can they demand higher wages, we have to accept that similarly if they have market power they can also demand higher wages. After all, without either, employers will use their market power to drive wages down because the fundamental axiom of economics is maximization of profit and minimization of costs.

Here is where the candidates seem to miss the point. Workers need neither to be more flexible nor to receive more programs. They need institutions in place that will boost wages. Only by raising wages can we grow the economy because the greater purchasing power that accompanies them will result in greater aggregate demand for goods and services. Restoring the middle class requires restoring institutions. Until our candidates begin speaking about institutions, we will have one more election where the candidates succeed in nothing more than speaking past one another. And while they continue speaking past each other the middle class continues to decline even more.

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