Labor unions: Basic issues
What do unions do?
1.Determine/influence wages, other compensation (fringe
benefits, layoff/unemployment compensation, pensions,
insurance)
2.Influence on employment
3.Influence on worker effort or effort requirements, hours etc.
4.Influence on work conditions, safety, take up welfare issues
important for workers
5.Influence on work rules, rules of hiring and firing (e.g. LIFO),
may serve to enforce agreed rules versus employers
6.Influence on legislation and policy issues, in society generally
(mainly relevant for “encompassing unions” only)
7.Coordinate activities with aim to further its goals, such as
strikes or strike threats, go-slow or work-to-rule actions
Points 1-2 and 7 are the “traditional” roles of labor unions,
which imply that unions may act as monopolists in influencing
wages and employment levels. Much of the lectures will deal
with these issues.
Points 3-6 represent the “voice” role of labor unions, which is a
role stressed by Richard Freeman and James Medoff in an
influential book from 1984.
Two ways of organization are “closed shop” and
“open shop”
Closed shop: There is a common vote or decision whether or not
a given firm is to be unionised. If it is unionised, all workers in
the firm must belong to the union. If not, typically no worker is
unionised. This is a typical organization in the U.S., and to some
extent in the U.K, in particular in manufacturing, construction
etc.
Open shop: There is no requirement that the individual worker is
unionised.
Open shop is common in most of Europe.
At what levels do unions operate?
1.At the plant or firm level, union organized locally
2.At the industry level, common policy set for all firms in a
given industry
3.At the national level, “encompassing unions”, which may
organize all unionised workers and have more general effects on
society.
There is an observed tendency for unions to be more“
aggressive” (in particular in terms of wage demands), at the
industry level, than at either the local level, or at the national
level with encompassing unions.
Local unions: May often have reduced bargaining power
because an aggressive wage policy would hurt the local firm
badly. But generally do not have incentives to think about
national issues (such as holding back wages so as not to trigger
inflation).
Industry-level unions: May have considerable effective
monopoly power and power to effectively set high wages, and
firms often do not have great incentives to oppose these
demands (because high wages largely lead firms to set high
prices in that industry, thus recuperating profits).
The difference in strategic behavior of these two types of unions
will be illustrated in class, later in the lectures on unions.
Encompassing unions: In principle these have even greater
“monopoly power” than industry unions, in the sense that they
can coordinate the wages of more firms and in principle bid up
wages. But they may on the other hand have greater incentive to
act with restraint, because it realize that aggressive wage
demands will lead to unwanted inflation and sub-optimal overall
employment levels. This may lead to “peace agreements”
between encompassing union and employer organizations (as
has been standard in Norway, and partly and Sweden).
Note that in several European countries (such as France and
Germany) unions organize a small part of workers, but still
influence wages for many more. This is illustrated in two the
following table.
Table 1: Collective bargaining coverage and density (share of
labor force that is unionised), various OECD countries, selected
years
Country
Coverage,
1960
Austria
Na
Australia
85
Belgium
80
Canada
35
Denmark
67
Finland
95
France
Na
Germany
90
Ireland
Na
Italy
91
Japan
Na
Netherlands 100
New
Na
Zealand
Norway
65
Portugal
Na
Spain
Na
Sweden
Na
Switzerland Na
UK
67
US
29
Coverage,
1980
Na
85
90
40
72
95
85
91
Na
85
28
76
Na
Coverage,
1994
99
80
90
36
69
95
95
92
Na
82
21
85
31
Density,
1960-64
59
48
40
27
60
35
20
34
47
25
33
41
36
Density,
1980-87
51
49
52
37
79
69
16
34
56
45
27
30
37
Density,
1996-98
39
35
Na
36
76
80
10
27
43
37
22
24
21
70
70
Na
Na
Na
70
21
70
71
78
89
53
40
17
52
61
9
64
35
44
27
55
57
11
83
29
53
20
55
25
18
87
23
35
14
General allocation effects of unions
Allocation effects of unions depend on how widespread
unionism is, on what variables are actually set by unions, and on
how the union behaves with respect to these variables. In
addition it depends on what the alternative is, i.e. what would
have been the situation in the absence of unions.
Traditional view of unions, that was prevalent in the
professional literature up until around 1980:
The main effects of labor unions is to impose allocation losses
on society, as they impose a degree of monopolism in the supply
of labor, on the firms and the economy, thereby raising general
wages and lowering employment.
Traditionally recognized views of unions are in addition:
- that they work hard to attain wages that are similar across
employed workers within the given firm or sector that they
organize, implying that wages tend to vary “too little” with
productivity. This may lead to allocation losses e.g.
because of too little incentive to put up effort, or to take
education.
- That they push up wages for the workers that they
organize, leading to “unjust” union-nonunion wage
differentials (i.e. those workers who are not unionised,
earn relatively too little). This was a view early exposed by
Milton Friedman.
Arguments that may imply that unions have favourable (or
less unfavourable) allocation effects:
1. The “voice” aspect. The idea here is that a union, more easily
than individual workers, is able to raise issues with
management, which are of common concern to workers, and
which would lower worker welfare if not dealt with. The
union may serve as an information channel for complaints,
e.g. about work conditions, contractual issues etc.
2. Productivity effects. It is possible that the “voice” aspect may
have countervailing and positive effects on productivity
(counteracting the negative effects mentioned above), leading
to more satisfied, and productive, workers under unions.
3. Contract enforcement issues. Contracts offered by firms to
individual workers (in particular if they are mainly “implicit”
as will be discussed in the lectures on that topic) may be
reneged or defaulted by firms, and unions may serve as
guarantist that the contracts will be abided by.
4. The countervailing power argument. This is particularly
relevant when firms have considerable monopoly power
which is exercised versus workers. The union may then have
force to “balance” the distribution of power, between workers
and firms, in ways that individual workers cannot.
5. Reduction of bargaining costs. The union is an efficient
instrument for conducting bargaining versus the firm, in
particular when the alternative is a situation with individual
bargains, between each worker and firm.
6. Saving of monitoring and enforcement costs. This issue is
particularly relevant when workers differ in productivity and
there, in the absence of unions, would be individual wage
setting. Wages would then vary by productivity across
workers, and firms would need (and workers themselves
require) that individual workers output is measured. Unions
by contrast tend to demand more or less equal wages for
workers with given seniority and education. Then a situation
without unions does not necessarily require that individual
workers’ outputs be measured, and the amount of costly
monitoring would be reduced. The union solution only
requires that aggregate output be measured, which requires
no individual monitoring.
7. Macroeconomic effects. These effects will under unions
depend strongly on the level at which unions operate.
Encompassing unions may provide macroeconomic benefits
even when compared to a competitive solution, by often
making possible a lower inflation rate and higher overall
employment as a result of union restraint (when the union
realizes that high wage claims “mainly” results in high
inflation and/or low employment).
The monopoly union model
We will now consider a few standard analytical models of union
behavior, and the effect of such behavior on the economy. We
start with the most basic analytical model of the labor market,
namely the simple monopoly union model. In this model, the
union is assumed to determine the wage, and the firm then sets
employment.
We make the following assumptions:
-Homogeneous labor, all N workers in a firm are organized in
one union, where N is exogenously given (in the short run).
-Firms are price takers and profit maximizers, have production
functions f(L) were L is the number of workers employed in
production, f’ > 0 f’’’ < 0.
-L<N, i.e., not all workers in the local union will actually be
employed, N-L = U will be unemployed.
-The union has a utility function of the form (aggregating up the
utilities of all N workers belonging to the union):
(1)
u(w)L + u(b)(N-L), u’ C 0, u’’  0
(u’’ = 0 here implies worker risk neutrality, u’’< 0 implies
worker risk aversion), where b express unemployment benefits
if a given worker is not going to be employed in a period. This
function is based on an assumption that all workers have the
same probability L/N of being employed, and a probability (NL)/N of being unemployed in the period.
The firm’s profit function is
(2)
R = pf(L) – wL – e(N-L),
where p is the output price, w the wage, and e is the part of b
paid by the firm (such that the government pays b-e).
The firm takes w, e and p as given in maximizing R with respect
to L, yielding
(3)
dR
 pf ' ( L)  w  e  0 .
dL
Thus the employment level L is affected by w in the following
way (found differentiating (3):
(4)
dL
1

 0.
dw pf ' ' ( L)
Thus a higher wage will reduce employment, something that
must be recognized by the union in setting the wage.
The union can be assumed to maximize (1) with respect to w,
taking into consideration the relationship (4) (i.e., the union
knows that after it has set the wage, the firm will respond by
setting L in such a way that (4) holds). We then simply set L =
L(w) (where L(w) fulfils (4)) in (1), and maximize (1) with
respect to w. This yields:
(5)
dU
1
 u ' ( w) L  u ( w)  u (b)
 0.
dw
pf ' ' ( L)
This condition says that the slope of the firm’s demand curve,
dL/dw, is to equal the slope of the union’s equivalent tradeoff
between L and w, along an indifference curve for the union,
which is found differentiating (1), as follows:
(6)
dL
u ' ( w) L

.
dw
u ( w)  u (b)
Thus the union indifference curve should be tangent to the
firm’s demand function for labor, which is the highest utility
level the union can achieve. This is illustrated in a figure in
class.
It is easy to show that the monopoly union model leads to
inefficiently low employment. Departing from the monopoly
union solution, the union and the firm could in principle bargain
and reach a new solution that is better for both parties. The
monopoly union solution thus is a sort of prisoners’ dilemma
case. This will be illustrated in class, in a simple figure, and
through the wage-employment bargaining solution to be
discussed later (and which resolves this dilemma).
.
The wage bargaining (“right-to-manage”) model
A more realistic alternative to the monopoly union model is the
“right-to-manage” model, where the union and the firm bargain
over the wage, and the firm subsequently sets employment. The
employment rule is then the same as in
The game played under this model is strategically very similar
to that under the monopoly union model. In the first stage, there
is bargaining between the union and firm over the wage of all
employed workers (while those who do not obtain employment
receive a fixed pre-set compensation). In the second stage, the
firm sets employment (at a level below full employment).
Consider now a simplified case where e = 0 and the firm thus
pays nothing of unemployed workers’ unemployment benefits.
Then we may define the maximand for this problem as follows:
(7) N  u(w) L  u(b)( N  L)  pf ( L)  wL    pf '( L)  w ,

1 
where the first of the two main expression on the right-hand side
is the socalled Nash product, where β and 1-β are the relative
bargaining strengths of the union and the firm. The Nash
bargaining solution is found maximizing the Nash product under
the constraint of firm profit maximization with respect to L, i.e.
condition (3) (with e = 0), corresponding to maximizing N with
respect to the two variables w and L, where λ is a Lagrange
multiplier associated with the latter constraint.
The first-order conditions for the Nash maximization problem
are
(8)
N
  u '( w) LU  11   (1   ) LU        0
w
(9)
N
  u ( w)  u (b) U  11   pf ''( L)  0 ,
L
where union net utility and firm profits are U and Π
respectively, and where we in the last expression use that pf’-w
= 0.
The solution can be written on the form
(10)
u '( w) L  u ( w)  u (b) 
1
(1   )U

L.
pf ''( L)

The expression (10) can be compared to (5), the corresponding
expression in the monopoly union case. The left-hand side of (5)
was the derivative of the union’s objective function along the
firm’s demand curve for labor, and it has the same interpretation
here.
In (5), this derivative was zero, as the union could choose its
preferred wage. Here by contrast, the union must bargain with
the firm over the wage, and cannot in general reach its preferred
solution along the firm’s demand curve. This is expressed by the
right-hand side of (10) being positive, in the general case where
β is between zero and unity (implying that the union ideally
would have preferred a higher wage). We see also that as a
special case, when β→1, we are again in the monopoly union
model as the union then has all the bargaining power in the
union-firm relationship (and can again dictate the wage). This
will be represented graphically in class.