Revised Chapter 15 Notes (June 4, 2007)

Chapter 15: Wage and Employment Determination under Collective Bargaining

Theory of Union Behaviour

the theory of union behaviour has long been a subject of debate
most economists have taken an 'economic' approach assuming that the union maximizes an objective function subject to labour market constraints, such as the firm's demand for labour
but other economists, political scientists and industrial relations specialists have criticized the 'economic' approach for not paying enough attention to the union as a 'political' institution
the modern approach to union behaviour recognizes some merit in both positions in that the union is modelled as attempting to maximize a well-defined utility function subject to labour market constraints, but attention is paid to the political nature of union decision-making, especially the relationship between the preferences of individual members and those pursued by union leaders

Union Objectives

the union's objective function (the union's objectives when it bargains with management) is assumed to reflect the aggregate labour market preferences of union members
we assume that workers are well informed about various labour market options and that union leaders are democratically elected and wish to remain in office (if union leaders try to implement an agenda which does not represent a majority of union members, we assume that they will be voted out of office and replaced by new leaders who do represent union members)
the two key elements in a union objective function are compensation and employment (job security)
while the compensation package includes fringe benefits, such as vacation pay and pension plans, we assume that wages are the key compensation objective
what matters to union members is their real wage (W/P), the nominal wage (W) rate relative to the cost of living (represented by the price level, P)
the benefits of belonging to a union depend on the union wage relative to the best alternative wage; most workers will be unwilling to bear the cost of union membership (dues) if the union wage is less than they can earn elsewhere for comparable work
unions also bargain over a host of other issues, such as working conditions, grievance procedures, seniority clauses, and severance pay, which are ignored in the following analysis
the union utility (objective) function is assumed to depend on the union wage (expressed in real terms), total employment of union members, and the alternative wage
the union attempts to maximize wages and job security for its members, but must trade-off gains in wages against losses in employment for its members
Textbook Figure 15.1 depicts a set of union (U) indifference curves in W/P, E space

the Uo indifference curve represents all combinations of the real wage (W/P) and employment (E) which provide union members with the same Uo amount of utility;higher indifference curves, such as U1 and U2, represent higher levels of utility
the curvature of the indifference curve reflects the union's preferences for real wages (W/P) versus employment (E) or job security
if the union prefers high wages over job security (i.e., is willing to give up many jobs to gain a small increase in wages), then the indifference curves will be relatively flat
the union's indifference curves lie above the alternative wage Wa that union members could earn elsewhere; if the wage obtained by the union falls below Wa, union members will leave the union and the firm

some special cases of this union utility function that have been proposed include:

maximize the (real) wage, which implies that no weight is placed on employment (job security) in union preferences; as shown in Textbook Figure 15.2(a), this special case is represented by a map of horizontal indifference curves
maximize employment, which implies that no weight is placed on the wage in union preferences; as shown in Figure 15.2(b), this special case is represented by a map of vertical indifference curves
maximize the wage bill (the product of employment and the wage rate), ignoring the alternative wage; as shown in Figure 15.2(c), this special case is represented by a set of indifference curves which are rectangular hyperbolas lying above the employment E axis
maximize the economic rent of union members given what they could earn elsewhere (the product of employment and the difference between the union wage and the alternative wage); as shown in Figure 15.2(d), this special case is represented by a set of indifference curves which are rectangular hyperbolas lying above the alternative wage
this latter special case is the most plausible and is analogous to the union acting as a monopoly seller of labour to the firm and maximizing the 'total return' to its members

Union Preferences: Some Additional Considerations

the task of deriving union objectives from the underlying preferences of individual members is easiest when individual members' preferences are relatively homogeneous
when individual members' preferences are heterogeneous (for example, older members may want to place more weight on pensions and less on current wages than younger members), the median voter model may be a good way to represent union preferences
in the median voter model, which can be derived under certain conditions from a political model of union decision-making, the preferences of the organization as a whole are represented by the median member (for example, a member of the median age if preferences differ according to the age of the member)
because union utility depends on the preferences of individual members, changes over time in union membership may lead to changes in union objectives
for example, an increase in product demand may lead to an influx of new and possibly younger members, reducing the age and seniority of the median member

Union Constraints

assuming that the union maximizes its objective function and the firm maximizes profits, two different bargaining cases are considered:
the firm and union only negotiate the wage rate and the firm retains discretion over the level of employment (the labour demand curve, 'right to manage' model)
the firm and union negotiate both the wage rate and the employment level (the 'efficient' contracts model)

The Labour Demand Curve Model: The Firm and Union Only Negotiate the Wage Rate

the union wants to maximize its objective function but is constrained by the firm's labour demand curve; once the wage rate is negotiated, the firm will decide on the profit-maximizing level of employment (according to the labour demand curve)
we assume that the union knows the firm's labour demand curve (how much labour it will hire at various wage rates) and takes this into account in negotiating the wage rate
given the labour demand curve DL and set of union indifference curves in Textbook Figure 15.1, the union maximizes its objective function at point a0 where the DL curve is tangent to the highest possible indifference curve U1
given the firm's DL curve, the union can not reach a higher indifference curve than U1 and if the union were to move away from point a0 on the DL curve in either direction (such as points a1 and a2) union members would have a lower utility
the firm's labour demand curve DL in Figure 15.1 represents the value of the marginal product of labour and the area under the DL curve above the negotiated wage represents the amount of profits the firm makes from hiring labour; as the firm moves down the DL curve, profits increase
assuming that the firm can not hire any employees if it pays less than the alternative wage Wa, the firm's optimal bargaining point is the alternative wage Wa
the range of bargaining outcomes is represented by points on the labour demand curve between the union's optimal bargaining position (point a0) and the firm's optimal bargaining position (Wa)
both parties lose if they move up the labour demand curve to a point higher than a0
depending on the respective bargaining strength (power) of the firm and the union, the negotiated wage will end up somewhere between point a0 and the alternative wage Wa
as the union moves from point a0 towards the alternative wage Wa it loses utility and as the firm moves from alternative wage Wa towards point a0 it loses profits
a powerful union, such as the Canadian Automobile Workers (CAW), can obtain a negotiated wage rate close to its optimal position a0, whereas a weak union may be forced to accept a wage much closer to the alternative wage Wa
unions may be able to enhance their available wage-employment outcomes by relaxing the demand constraint, either by increasing labour demand or by making the labour demand curve more inelastic (as discussed in Chapter 5, the elasticity of labour demand depends on the elasticity of product demand and the ease of substituting other inputs for labour)
union activity is often directed at restricting substitution possibilities by employers in the labour market (for example, opposing automation and out-sourcing) and by restricting substitution possibilities by consumers in the product market (for example, opposing Free Trade and government de-regulation policies which increase competition in the marketplace)

The 'Efficient' Contracts Model: The Firm and UnionNegotiate Both the Wage Rate and the Employment Level

the firm and union can each benefit from negotiating a contract covering both wages and employment
outcomes on the labour demand curve imply unexploited 'gains from trade' that can be attained by exchanging a lower wage rate for increased employment such that both firm profits and union utility increase
if the firm and union only negotiate wage rates (and not employment levels), the outcome will not be Pareto efficient
if resources are allocated in such a way that no re-allocation of resources can make anyone better off without making someone else worse off, the allocation of resources is Pareto efficient or Pareto optimal; Pareto was an Italian economist (1843–1923) who conducted pioneering research in the field of welfare economics
if the firm and union bargain over both wage rates and employment levels, one party can be made better off without hurting the other party (a Pareto improvement) and it is possible to make both parties better off
to demonstrate the Pareto improvement possible by negotiating both wage rates and employment levels, we make use of firm isoprofit curves (see Textbook Figure 15.3)

an isoprofit curve plots combinations of wages and employment that yield equal profits
since the firm reaps more profits as it moves down the labour demand curve, higher profit levels are represented by lower isoprofit curves (0, 1, 2, and 3)
each isoprofit curve achieves maximum height where it intersects the labour demand curve; for any given wage rate, moving left or right from the labour demand curve will result in a lower profit level (and correspond to a higher isoprofit curve)
for example, at the wage rate W* in Figure 15.3, the firm will earn less profits if it hires fewer employees (points e and f) than E* (the profit-maximizing point b) or if it hires more employees (points g and h) than E*; compared to point b on the isoprofit curve 2, points e, f, g, and h all lie on the higher isoprofit curves 0 and 1 representing lower profit levels

A Pareto Improvement

point A in Textbook Figure 15.5represents the union's optimal position if the union and firm only negotiate the wage rate

point A is the tangency point between the labour demand curve and the highest possible union indifference curve
any point above and to the right of A would represents increased utility for union members

the isoprofit curve passing through point A is also included in Figure 15.5; any point below this isoprofit curve represents increased profits for the firm
suppose that the firm and union were to negotiate a contract which sets the employment level as well as the wage rate
points along the isoprofit curve to the right of A (down to the second intersection of the of union indifference curve and the isoprofit curve) represent a Pareto improvement for the union; the union is better off (can reach a higher indifference curve) without making the firm worse off (profit levels remain constant along the isoprofit curve)
similarly, all points along the union indifference curve to the right of A (down to the second intersection of the of union indifference curve and the isoprofit curve) represent a Pareto improvement for the firm; the firm is better off (on a lower isoprofit curve and has higher profits) without making the union worse off (union utility levels remain constant along the indifference curve)
all points inside the shaded elliptic area in Figure 15.5 (bounded by the union indifference curve and the isoprofit curve passing through point A) represent a Pareto improvement for both the firm and the union
all points in this shaded area represent a higher union utility level (correspond to higher indifference curves) and a higher level of firm profits (correspond to lower isoprofit curves)

Pareto Optimal Points and the Efficient Contract Curve

a Pareto optimal point occurs when one party can not be made better off without making the other party worse off
when the union and firm negotiate both wage rates and employment levels, a Pareto optimal point occurs where a union indifference curve is tangent to a firm isoprofit curve
consider point A" in Figure 15.5, which is the tangency point of a union indifference curve and a firm isoprofit curve; if the firm and the union move in any direction from point A", one or both parties will be worse off
if they move north of point A" (above the union indifference curve), the union will be better off but the firm will be worse off (have lower profits)
if they move south of point A" (below the isoprofit curve), the firm will be better off but the union will be worse off (on a lower indifference curve)
if they move northwest or southeast of point A" (between the union indifference curve and the isoprofit curve), both parties will be worse off
point A", the tangency of a union indifference curve and an isoprofit curve, is a Pareto optimal point; one party can not be made better off without making the other party worse off
in Figure 15.5, the CC' line going through point A" and other tangency points between indifference curves and isoprofit curves is called the contract curve, the locus of all Pareto-efficient contracts
if the union attaches any weight to job security in its objective function, the union indifference curves will be downward-sloping and the contract curve (the set of tangencies between the indifference curves and the isoprofit curves) must lie to the right of the labour demand curve where the firm's isoprofit curves are also downward sloping
the two parties have an incentive to negotiate a wage-employment arrangement that appears wasteful (i.e., the firm appears to have hired too much labour at the negotiated wage rate) but such 'featherbedding' employment practices may be advantageous for both the employer and the union
the efficient contract curve may be downward-sloping, vertical, or upward-sloping, depending on the strength of the union's preference for job security
higher wages that generally accompany unionization may not be associated with reduced employment (if the union has a strong preference for job security and union indifference curves are very steep)
unions and firms negotiating a Pareto-efficient contract which sets both the wage rate and the employment level will bargain along the contract curve; depending on the respective bargaining strength (power) of the firm and the union, the negotiated wage, and employment level will lie somewhere on the contract curve
the upper limit of the bargaining range is determined by the zero isoprofit curve and the lower limit is determined by the alternative wage; moving down the contract curve increases firm profits and decreases union utility
a powerful union may be able to negotiate a contract settlement further up the contract curve than a relatively weak union (which may be forced to accept a settlement on the lower end of the contract curve)

Obstacles to Reaching an Efficient Contract

although in principle both the employer and the union can be made better off by negotiating both wage and employment levels, in practice there are several obstacles to reaching an efficient contract
to sign a Pareto-efficient contract, both parties must know each other's objective function; without full information about each other's objective function it is difficult to know whether a Pareto improvement is possible (whether you are on or off the contract curve)
in non-cooperative bargaining, each side typically tries to conceal (or misrepresent) information about its objective function (for example, firms are reluctant to open the books and reveal profit relationships to unions)
because demand may shift during the term of the agreement altering the contract curve, the contract must stipulate the efficient levels of wages and employment for a variety of different possible economic conditions; it is very difficult and expensive to negotiate and enforce a 'contingent' agreement, which depends on different economic conditions that may prevail
one has to define all possible economic conditions in legally enforceable language and for each possible economic condition the firm and union have to negotiate a Pareto-efficient wage-employment contract
there is a need for costly monitoring because for any given contract the firm has an incentive to reduce employment back to the labour demand curve, where profits are maximized for a given wage rate; given the firm's incentive to cheat on employment levels, the union must be able to enforce (in a court of law) the specified employment level
while it is easy to enforce the wage provisions in a contract (any employee can use a pay stub as evidence of the wage paid by the employer), enforcing total employment levels in a contract is more difficult (for example, do you adjust for the number of hours worked per week)
the costs of negotiating, monitoring, and enforcing efficient 'contingent' contracts may be too high to make the effort worthwhile
while it may not be possible to specify an exact employment level in a contract, unions and firms may be able to approximate the employment level clause in a Pareto-efficient contract by tying employment to the output of the firm or to the use of other inputs
unions often negotiate work rules which restrict the firm's flexibility in reducing employment, say by specifying the minimum number of workers required for a particular task (for example, the minimum number of pilots per aircraft and the maximum class size for teachers); such restrictive employment practices allow employment levels to change in response to shifts in demand but constrain the employer to hire more workers than implied by the demand for labour curve
excess labour (workers watching other workers), restrictive work rules and featherbedding practices are consistent with a Pareto-efficient contract

Empirical Applications