GLASGOW CALEDONIAN UNIVERSITY
DEPARTMENT OF ECONOMICS
Labour Market Theories – Competition and Segmentation
(Concepts and Methods in Economic Analysis coursework)
Victoria Iliassova
BA Honours Business Economics
Level 4
Module Leader: Geoff Riddington
February 2000
Introduction
Labour markets are extremely important for majority of individuals and aggregate
economy as a whole. Operations of labour market determine standard of living and
welfare of individuals as well as efficiency of the aggregate economy. Some argue
that of the many markets that exist in a modern economy the market for labour is the
most important (Elliot, 1991).
Due to a special character and human dimension of labour services (e.g., “free
will”, morale and motivation of workforce), the nature and operations of labour
markets are very different from markets for other factors of production.
Analysis of labour markets is further complicated by the fact that there is no such
thing as a pre-defined labour market and it may often have quite a vague reference.
Labour market is essentially what one defines it to be for a particular case. Labour
markets are usually defined on a geographical, skill/occupation or industry basis.
Aggregate markets are formed from individual sub-markets and degree of movement
between them is an important factor in defining what a labour market is.
Labour economics comprises numerous interrelated and overlapping theories that
attempt to explain how labour markets operate. Conventionally the theories are
analysed within the scope of School of thought, which developed them such as Neoclassical, Institutionalist or Radical-Marxian. However, with time, even within these
theories, particularly within Neo-classical approach, there developed such an
enormous range of opinions and theories that to refer to them in conventional way
appears no longer to be very useful as a means of specifying a particular belief or
approach (Adnett, 1996). A dichotomy between competitive and non-competitive or
segmentation models of the labour markets is sometimes suggested to be more useful,
particularly for consideration of labour market policies.
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Competition models
Orthodox Neo-classical approach to labour markets is essentially a competitive
model. It starts with several quite restrictive and unrealistic assumptions of perfect
competition, homogeneity of workers, perfect information and labour mobility.
Orthodox theories have internal differences of their own, but there is general
agreement on the following points.
First is the central role of maximising behaviour on the part of economic agents –
individuals, households and firms – subject to well-defined technological and budget
constraints. In particular, individuals are assumed to be striving to maximise their
utility from consumption of goods and leisure subject to time and wage rate
constraints. Labour supply is determined by individual’s choice between work and
leisure and is a function of real wage, non-labour income and tastes. The slope of the
labour supply curve is determined by the relative degrees of income and substitution
effects but is normally assumed to be positive. On the other hand, competitive model
assumes that firms aim at maximising profits and therefore employ labour up to the
point where marginal cost of labour is equal to its marginal revenue product. Demand
for labour is a derived demand from a demand for goods that the labour produces.
The price that the buyer of labour is willing to pay is related to the market value of an
employee’s output (the revenue that the firm obtains from selling the output of
labour). Labour demand is a function of technology, price of the good produced and
the wage rate, and is downward sloping. Supply of and demand for labour interact,
determining the static and dynamic wages and employment outcomes.
Utility-
maximisation by workers/consumers and profit-maximisation by firms are very
important competitive conditions.
Second is the principle of substitution. Individuals and households are assumed to
choose from a wide range of commodities and to allocate their time between many
different activities. Firms select techniques of production and levels of input usage
from the large number, which are available, while workers optimise in their choice of
jobs, work and leisure.
In competitive theory of labour, choice is the “basic
behavioural mode” (Harrison et al., 1979), and the whole labour process is said to
consist of the working out of essentially harmonious interests between worker/
consumer and producers.
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Third is a strong tendency for markets to clear. Economic agents are assumed to
be in, or rapidly approaching equilibrium. The emphasis of competitive theories is on
labour markets responding to market forces. Whilst the auction market is recognised
as an over-simplification, wages, according to competitive theory, do move to
equilibrium levels and do produce market-clearing adjustments in labour supply.
Though some rigidity in absolute and relative wage levels in the very short-run is
recognised, for policy purposes labour markets are viewed as flexible-price markets.
Fourth is a deep suspicion of explanations, which run in terms of habit and
custom, collective against individual decision-making, or the idiosyncrasies of human
institutions.
The competitive model described above is a wage competition model. Wages are
assumed to be determined competitively by the forces of supply and demand and to
respond readily to shortages or surpluses of labour in the various markets. Wages
tend to adjust to equilibrium level. The pay structure within a firm is expected to
contract or widen accordingly as the relative balance of supply and demand for the
jobs in the market as a whole changes. According to the competitive theory, it is the
price that adjusts to bring supply and demand into balance. Yet, in the real labour
market it is very difficult to see this presumed adjustment process at work. There are
many criticisms of the orthodox competitive labour market theory, which stem to a
large extent from its unrealistic assumptions. It fails to explain many important
phenomena of real world labour markets. There have been several attempts in the
form of other additional theories to adjust and improve competitive model and to
reconcile it with real world observations. At the heart of the standard competitive
view of labour markets there are many theories that are consistent with each other.
Theory of Equalising Differences is fundamental to the competitive theory and
was first formulated by A. Smith. It states that intense competition for better-paid
jobs (i.e. increased demand for more advantageous jobs) should in the long run result
in the lowering of their advantages as wages fall and, conversely, continuous quitting
of lower-paid or less desirable jobs in search of better ones (i.e. decreased demand for
less advantageous jobs) should in the longer term result in employers having to raise
wages to retain or attract labour. This process is expected to continue until the
advantages and disadvantages of different jobs are equal. It follows then that if all
other conditions of employment are the same across the jobs, wages should tend to
equality. As many of the conditions of different employments are not the same, wage
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differentials are observed.
The long-run movement towards equalising wage-
differentials means that any persisting differentials, after adjustment for the nonpecuniary aspects of the employment, reflect differences in employee productivity,
due to uneven investments in education, training and experience.
Efficiency Wage theory states that employers may pay wages in excess of market
clearing rates because it results in good incentives and beneficial productivity effects.
Shirking model, Turnover model, Superior Job Applicant model and “Fair” Wages
model can all be grouped under the heading of Efficiency wage Theory.
Human Capital theory is another development of the competitive theory. Human
Capital is skills and knowledge, embodied in the workforce.
This concept is
extensively used in both competitive and segmentation theories. Human Capital
theory allows for the assumption that the workers are homogeneous to be relaxed.
The theory focuses on compensation for the cost of investments in education and
training. Under this theory, the structure of earnings is highly dependent on the costs
of these investments, including the foregone earnings associated with time spent in
education and training. Wages and productivities adhere to the jobs themselves, not
to the capacities of individual workers per se. On-the-job training is argued to be the
cheapest method of training in most cases, and access to primary sector jobs becomes
a prerequisite for enhancing human capital. Therefore, most job skills, general or
specific, are acquired either formally or informally through on-the-job training after a
worker finds an entry job and associated “promotion ladder”.
Education and training are seen as investments into Human Capital. The theory
states that firm’s decision to train its workers is an investment decision and is based
on a “rate of return” concept. Firms provide on-the-job training if the discounted
benefits from that investment cover the costs of training and compare favourably with
returns from alternatives. The training is provided by the firm only if it is specific to
the firm and trained workers cannot subsequently be poached away.
The assumption of perfect information is relaxed within the Search theory, which
states that because of a variety of sub-labour markets, information is costly and firms
and workers search prior to job-matching causing unemployment and unfilled
vacancies.
Various attempts to reconcile competitive view with persistent unemployment and
sticky wages have been made in efficiency wage theory, job search theory, jobmatching theory and theories of implicit contract.
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Segmented Labour Market (SLM) theory
SLM theory is a more complicated explanation of operation of labour markets
since its main hypothesis is that labour market is a combination of a series of distinct
interconnected markets rather than one competitive market. This distinction arises as
a result of existence of barriers determined by geographical, occupational and
institutional factors as well as social attitudes to gender, race and age.
Segmented Labour Market (SLM) theories were developed as an attempt to
explain inequality of opportunity and persistence of poverty that remain as prominent
features of modern economies and which orthodox forces of competition failed to
eliminate. Segmented labour market theory states that competitive forces in many
real world firms are to a great extent “muted” or “shut out” at least in the short run,
and have little impact on firms’ wage and employment structure. Such “imperfect”
operations remain typical characteristics of many real world labour markets. SLM
theory attempts to provide better explanations for them.
SLM theory is now used as an umbrella term for alternative theory developments
in labour economics and segmentationist school of thought.
It is based on the
Institutionalist approach and comprises many diverse and overlapping models of
labour markets including dual (primary, secondary), tripartite (core, peripheral,
irregular), stratified, hierarchical and job competition model.
A fundamental
dichotomy between “internal” and “external” labour markets is related to dual and
tripartite theories
Clark Kerr divided the labour markets into two groups: “Structureless markets”,
which function like Neo-classical competitive markets and where the only attachment
between employer and worker is the wage rate, and “Structured markets”, where those
on the inside enjoy more favourable treatment than those on the outside. Internal and
external labour markets are an example of a structured market. Internal Labour
Market (ILM) is “an administrative unit” (workplace or a firm), where pricing and
allocation of labour are determined by administrative rules and procedures. Internal
Labour Markets can be either horizontal or vertical. The concept of ILM can be
traced back to the work of Kerr (1954) and Dunlop (1957), and was fully articulated
by Doeringer and Piore (1971) (Adnett, 1996). Internal Labour market is opposed to
External Labour market, where pricing and allocation of labour are determined by
supply and demand. The two markets are linked by “ports of entry and exit” (i.e.
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lower paid jobs that are needed to be entered in order to enter ILM and start climbing
the promotion ladder). However, the promotion or transfer of workers, who have
already gained entry, fills the majority of jobs within ILM. ILM jobs are shielded
from the direct influences of competitive forces in the external unstructured market.
The mobility between internal and external labour markets is very limited.
According to SLM theory, internal labour markets are generated by several factors
not envisioned in conventional economic theory. They include skill specificity, which
often arises from the requirements of the technology employed in many firms and the
uniqueness of the job that individuals perform; information imperfections and
resulting substantial costs associated with obtaining and processing information about
potential employees’ productivity; and on-the-job training.
Dual Labour Market theory developed by Doeringer and Piore (1980) is the
simplest form of segmentation theory. The theory assumes that the labour market
could be viewed as being composed of two sectors: Primary sector and Secondary
sector. Primary sector is characterised by consisting of good jobs with good wages,
promotional opportunities, good working conditions, job security, powerful trade
unions and consultancy style management. The secondary sector, on the contrary, is
characterised by having bad insecure jobs, low wages, non-involvement of workers in
the decision-making process, poor working conditions and ununionised firms.
Mobility between the two sectors is very limited, resulting in a queue for primary
sector jobs. Whilst competitive forces may dominate the secondary labour market
they are not completely absent from the primary sector. Primary labour markets need
to attract entrants and firms in this segment face competition in the product market.
These forces may be weak in the short run but cannot be ignored in the long run.
The sharp dichotomy between “good” and “bad” jobs in the dual labour market
model appears too simple, and the distribution of the quality of jobs is more likely to
be multi-modal rather than bi-modal. The emphasis upon the social foundation of
internal labour markets, as opposed to human capital, price incentives and technical
efficiency foundations, has produced additional insights into labour market behaviour.
Some argue that the main contributions of SLM approach to our understanding of
the operation of labour markets are theoretical modifications and additions to
orthodox theory rather than an introduction of an alternative to it (Cain, 1976). As
Cain put it, segmented labour market theories are “continuations of older debates”
(Cain, 1976).
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Contributions of SLM theories stem from their alternative Institutionalist
approach to viewing the labour markets. SLM theories do not treat firms and other
organisations, representing demand side of labour markets, in conventional orthodox
way of dealing with “black boxes”, completely ignoring what is happening inside
them.
On the contrary, SLM theories provide their explanations by looking at
organisational structure, social relationships, custom and power, and by emphasising
the importance of firm-specific, internal factors of wage determination and
employment. The segmentation theories attempt to explain the development of the
institutions themselves as a result of interactions of groups or classes of individuals
with objectively different interests. SLM theories concentrate upon the demand for
labour as a restrictive force upon earnings of lower class workers and minorities.
SLM theories are interested in the market for labour within a particular firm and the
structure of pay that emerges as a result.
If in competitive theories it is the
characteristics of an individual that are important, in SLM theories it is the
characteristics of jobs that matter.
Job Competition Model
Job Competition model developed by Lester Thurow (1976) continues the above
argument. In this theory Thurow emphasises the attributes of individuals and role of
training. He argues that the marginal product resides in the job and not in the man, as
it was conventional to believe. Individuals are trained into the productivity of the job
they hold.
Therefore, the job allocation procedure assumes a much greater
importance than it does in wage competition, where an individual’s skills
automatically place him or her in some particular job market. The function of the
labour market in such a theory is the allocation of “training slots”.
On-the-job
training is assumed to be the cheapest, most efficient method of training. Employers’
objective is minimisation of training costs, which is consistent with competitive
theory assumption of profit maximising behaviour of firms. Distribution of earnings
is dependent on the distribution of training slots. Distribution of training slots in its
turn, is a function of labour queue and actual distribution of job/training opportunities
in the economy. Labour queue is determined by employers. Workers’ background
characteristics affect the cost of their training. Potential workers are ranked in queue
according to the costs required to train them into the job. The higher the training
slots, the lower the position in the queue.
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SLM theory was developed by Institutionalists, whose focus was initially on the
inside and outside operation of organisations. Therefore the theory tends to add
explanations of institutional matters inside the organisations. The very important
contribution of SLM theory to the mixture of analysis and policy debates is their
attention to the interests and behaviour of classes and groups and to the historical
basis of their collective actions. Moreover, the SLM theories evolve from detailed
data that are often richer in historical, institutional, and qualitative aspects than is
customary among the econometrically-oriented competitive orthodox theories.
SLM theories provide a good description of the income distribution, a claim about
the absence of market clearing and a radical departure from the standard neoclassical
assumption of fully rational actors and exogenously determined preferences (Dickens
et al., 1988).
Many argue that Segmentation models together with Institutionalist approach are
not yet at the stage where they offer a fully convincing and comprehensive challenge
to orthodox labour economics. Segmentation theory is often said to be less coherent,
less rigorous, less fully elaborated than orthodox competitive theory is. It remains
open to accusation that the practices described by SLM theories are nothing other than
Neoclassical maximising behaviour in disguise. Segmented labour market models
suffer from their inability to define operationally the “distinct segments”, a problem
compounded by the popularity of the simplest variant of this approach, Dual Labour
Market model.
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Conclusion
The degree of competition versus segmentation of labour markets is a matter of
degree. Each market can be analysed from one prospective or the other. Critically
these two approaches are not really substitutes for each other since they incorporate
over-lapping concepts and analysis and labour market behaviour consistent with both
approaches can be observed in the economy.
It is often argued that at present there is no obvious successor to the competitive
analysis of the labour market and that Neo-classical competitive theory has a prime
position but other theories, like Segmented Labour Market theory develop the
arguments (Adnett, 1996).
The following summarises and highlights the key points.

Mobility
Relative mobility or immobility of labour is one of the main points of
contradiction between competitive and segmentation theories.
Perfect mobility is one of the assumptions of competitive model. Labour is
assumed to be able to move between jobs freely and at no substantial costs. The
mobility of labour between markets ensures that wage differentials are competed
away, with temporarily high or low wages producing a movement of workers and
firms. Segmentation theories contradict the Neo-classical competitive theory. One of
the main aspects of dualism and segmentation is immobility of labour. Workers can
be trapped in bad jobs of a secondary sector.

Market Structure
Market structure is one of the most important differences between competitive and
segmented labour markets theories. Competitive theory states that labour market is
one competitive aggregate market for labour. Wages and employment levels are
determined by the interactions of demand and supply.
Conversely, Segmented
Labour Market theory states that labour markets contain multiple segments. Markets
of labour are segmented, therefore wages are not corresponding market prices for
labour and do not reflect the relative surplus or scarcity of aggregate labour, as
predicted by competitive orthodox theory.
Labour markets do not clear in
conventional competitive way. A firm can adjust to labour market imbalances in a
number of ways, by varying job allocations, recruitment standards, the training of
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workers, overtime and subcontracting, etc. These adjustment instruments largely
substitute for wage changes leaving little role for wages in the adjustment process.
Firms are reluctant to change wage structures when labour and product market
conditions alter, and any adjustment is slow and largely through previously
determined rules for changes in working patterns. Wage increases are a result of a
bargaining process and tend to be applied across the board.
The size of wage
increases reflects the firm-specific factors such as financial performance, rather than
just the external market forces, which drive wage changes in the competitive model.
Education and training can assist workers’ acceptance into internal labour markets but
luck is important, with wages reflecting the job’s not worker’s characteristics.

Human Capital
In competitive theory investments in Human Capital play a very important role in
determining the earnings and employment opportunities of individuals because it is
assumed that individual’s earnings power increases with improvements in his/her
human capital endowments, even if wage does not always reflect individual’s
marginal revenue product. Competitive theory assumes that individuals are at least
hired on the basis of their Human Capital endowments and then are paid their
marginal revenue products.
Segmentation theory, on the contrary, states that Human Capital is not so important.
At least in some sectors jobs are rationed. Therefore luck and access to good jobs
play a much more significant role. Market value of labour accrues through on-the-job
training. Education received out of job is important but not sufficient as it is just a
screening device for attributes employers want.
Segmentation theory states that
individuals get hired on whatever basis, luck of a draw, etc. and then trained into the
job. Therefore the ultimate determinant of labour market success is luck of a draw.

Negative Feedback Hypothesis
Competitive theories assume that tastes for education and acquiring productive
characteristics are exogenous. They have little interest in the determination of
individuals’ tastes or attitudes.
Segmented theories of labour, on the contrary, propose that tastes and attitudinal
variables of workers are endogenously determined. The hypothesis that productivity
and stability increase as wages increase is embedded in the dual and segmented labour
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market theories. Thus at the low wages prevalent in the secondary segment, low
productivity and lack of motivation are expected. As a result, part of the difference in
human capital that is observed in the labour market is itself a consequence of the
existence of a dual or segmented labour market. Therefore dual and segmented labour
markets explain part of the inequalities in educational attainment that exist in real
world labour markets.
Negative Feedback Hypothesis states that negative experiences of workers may
feed back into their performance or that of their offspring. For example, those who
expect to be consigned to the secondary sector will be discouraged from investing in
human capital.
Motivation and worker behaviour are formed in response to
confinement. In acclimatising themselves to local work arrangements, some workers
may find it psychologically as well as technically difficult to move from one sector of
the economy to another. It is related to the psychological impact of “discouraged
worker”. Segmented theories are explicitly historical and focus on systematic forces,
which restrict the options available to members of the labour force. The primary unit
of analysis is no longer the individual and his (her) free choices, but rather groups or
classes who face objectively different labour market situations which systematically
condition their “tastes”, and restrict their range of effective choices (Carnoy and
Rumberger, 1977, cited in Harrison et al., 1979).

Efficiency, equity and policy considerations
The basic perfectly competitive model of labour market assumes that equilibrium
outcome is efficient.
Profit-maximising firms and utility-maximising households
acting purely on the basis of their own interests are expected to produce outcomes
where additional societal wealth is produced at minimum cost.
Segmentation
theories, however, emphasise that enterprise-specific rents are often paid to workers,
and this together with their individual bargaining power leads to highly stable work
groups in many sectors of the labour market. These stable groups develop norms
concerning the fairness of work effort and distribution of those rents. It is social
cohesion, rather than efficiency, which underlies the development of relative wage
rigidity and seniority-determined pay scales in internal labour markets. Firms in
many sectors of the economy have structured their labour markets in order to produce
motivated and loyal employees. Under-employment and unemployment are partly a
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consequence of this quantity-adjustment, rather than price-adjustment in the labour
market, with unemployment being unequally shared by the workforce. Much greater
emphasis is placed on the determinants of labour demand in this approach, with
employers usually being the dominant decision-makers in the hiring process. Since
the productivity characteristics of the worker no longer determine their present
employment, and X-inefficiency is always present, employment levels no longer
indicate efficiency in the economy. Efficiency is no longer an absolute concept and
can only be assessed once a social welfare function has been specified.
Competitive theories also imply that the competitive outcomes are equitable. That
is because wages paid to workers are assumed to be equal to their marginal revenue
products and reflect their human capital endowments.
Segmentation theories state that human capital endowments do not play the major
role. But luck of a draw does. Also the employers’ power and existence of particular
firm structures result in unemployment and under-employment, discrimination,
persistence of income inequality and poverty. Discrimination is an important inquiry
of segmentationists, who argue that inequality and hierarchy are inherent in the job
structure. Segmentation theory predicts discrimination and states that groups that get
into “bad” segments of the labour market are there, at least partly, because of
discrimination against them. Ascriptive traits such as age, race and gender are easily
used to assign workers to segments.
The policy implications of segmentation theories are entirely different from those of
competitive model. According to segmentation theories, rather than concentrating
upon increasing the skills of certain groups, policy should be aimed at job
distribution. Therefore SLM representatives are policy-oriented, advocating major
changes in the economic system in a left-liberal or socialistic direction.
theories take structural and/or demand side approach.
SLM
They suggest a need to
concentrate on the creation of better jobs. Human capital is not a problem, access to
good jobs is. Market value of labour accrues through on-the-job training, outside-job
education is important but not sufficient. Ultimately, the value of labour in the market
depends on the opportunity one gets.
Competition theory states that workers are hired on the basis of their human
capital endowments. SLM theory, in contrast, assumes that workers are hired on
whatever basis, luck of a draw, and then trained on the job. Therefore, ultimate
determinant of labour market success depends on one’s luck.
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