Richard Epstein: Best Efficiency Gains Flow from Hands-off Approach

Richard A. Epstein
New Zealand herald
March 1, 2005

The phrase inequality of bargaining power has been constantly invoked to justify the supposed need for extensive government regulation of the wages and conditions in ordinary labour markets. But if that fatal term had never been coined, how would we analyse their operation? Pessimists might say that a competitive labour market demonstrates a high level of social efficiency because it is characterised by misery on both sides of the transaction. Employers and employees both complain.

Looked at from the perspective of either group, this situation appears pathological and perhaps even unsustainable. But these appearances mislead.

From a broader societal perspective, the optimists should prevail because this arrangement is enormously positive. Neither side has any degree of market power; at the margin nobody can change wages or other terms of employment and retain the worker or the job.

In effect, there is a normal market equilibrium.

It is a sign of social health when transaction costs are low relative to the number of transactions consummated. A delusion that has afflicted many progressive writers is to think that haggling over the price of a cow across the farmyard fence represents some economic Shangri-La. Not so: high friction and few transactions is a recipe for stagnation.

The single most important thing to understand about the operation of a standard labour market in the world today is that it is immensely boring. It should be thought of in terms of the traditional intersection of supply and demand. It does not present any difficult transactional problems or generate negative externalities that require government control.

Compared with network industries or intellectual property, dealing with labour markets appears a piece of cake so long, at least, as we have the courage to leave well enough alone.

The great threat here is co-ordination by either employers or workers who are intent on moving wages away from the competitive equilibrium. Generally, people are rightly suspicious of monopolies because they recognise that the equilibrium reached in a typical case is inferior to that reached through competition.

In a labour market, workers fortunate enough to organise a monopoly will constrain the supply of labour and seek higher wages. The private gain from pushing wages above competitive levels would be smaller than the social losses suffered by employers and third parties, such as unemployed job-seekers and consumers who use the products of the firm.

A low transaction cost model well describes a competitive market, but not if a monopoly is present. There may be political jockeying to decide who is accepted as a member of a union and who will be excluded. To maintain its monopoly, the union must appeal to the state to block new entry by excluded workers, whose uncontrolled actions would return wages to the competitive level.

Parallel results would occur if employers were organised and workers were not. An effort to lower wages would cause a reduction in labour supply. There would be constant manoeuvring and cheating by employers.

If both sides are allowed to establish strong bargaining power by combining forces, we get the worst case scenario - a bilateral monopoly situation. There is then no determinate wage or quantity of work to be done, a huge amount of negotiating will take place, but relatively few stable bargains will emerge.

If the social goal is to maximise productivity with minimum transaction costs, the competitive situation will work best. So why is inequality of bargaining power even worthy of serious discussion? Some believe that, in a competitive situation, the employer blessed with size, net worth, experience or some other apparent advantage can push wages so low that workers are badly hurt. This hypothesis is closely associated with the Marxist notion of exploitation.

Descriptively, this is false. If employers held such bargaining power, they would surely continue exercising it to the point where the other side had abjectly to surrender.

The only conceivable equilibrium position would allow employers to receive an infinite amount of labour for a zero wage. Why would any employer, with this inexhaustible bargaining advantage, settle for anything less? Yet a pattern of zero wages (or zero time off work) exists in no labour market. The classical rules of supply and demand are descriptively far more accurate.

A common tactic of those who search for inequality in the labour market is to focus on the particular terms of a particular contract and declare they are so one-sided that improper use of market power was needed to obtain them.

This query animates a popular line of inquiry: whether, in dealing with labour relations, we ought to have any affection for the traditional contract at will. This arrangement posits perfect legal symmetry between the two sides. An employer may hire, fire or retain a worker for good reason (which is, of course, virtuous), bad reason (which is, of course, reprehensible), or no reason at all (which turns out to be a little bit crazy). Likewise, the worker may take, leave or retain a job for good reason, bad reason or no reason at all.

Knowledge of transaction cost economics makes it most unwise to regard such a contract as presumptively off-limits, or to even hint that the protections of tenured arrangements or unjust dismissal laws are needed to redress some mythical imbalance.

Many employees exercise their right to quit. They would be affronted (and astonished) at the idea of having to appear before a public agency to prove they had good cause for taking another job.

If that showing were required, the law would invite enormous administrative rigidities and a whole series of fanciful stories.

All this is not to say that the at-will rule always works best, even at the option of employees. The absence of a for-cause requirement on the employee side may sometimes give rise to a certain kind of opportunism.

Looking at the full range of voluntary employment arrangements including the contract at will, I do not think that any of them systematically gives rise to obvious forms of inefficiency.

Behavioural economists like to point out, often to the point of numbness, that not all people are good at making the calculations necessary to enter into agreements that make them better off. The principle of mutual advantage cannot work, it is said, when people involved in these transactions are subject to a variety of biases that lead to systematic flaws in their decision making.

If this theory is true, it is true for people on both sides of the market. Moreover, although people certainly make mistakes when they enter into employment relationships, they are at least cognisant of their ignorance about how things will work out.
And what's the best way to protect themselves? Of course, by obtaining a contract at will.

In sum, competitive markets, which operate well for goods and services, work just as well for employment relationships. There will be mistakes in individual cases under any system.

However, we must focus on the main point which is that the additional churning and transaction costs created by protectionist employment law will result in divisive behaviour, not in productive gains that can be socially shared.

The late Nobel laureate George Stigler was fond of saying that efficiency gains will, in the long run, swamp redistributive victories if markets are allowed to operate. That holds as true in labour markets as anywhere else.

Richard Epstein is the James Parker Hall Distinguished Service Professor of Law at the University of Chicago and the Peter and Kirsten Bedford Senior Fellow, the Hoover Institution. This article is based on a talk he gave in Wellington in August 2004 on a visit hosted by the New Zealand Business Roundtable.

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Richard A. Epstein