1. An Economic Perspective on Wage-Setting in the Private and Public Sector Montana Arbitrators' Association Training Session Barry Bluestone Northeastern University September 22, 2004

2. Sessions 1. 1. Marginal Productivity Theory, Human Capital Theory, and Competitive Labor Markets 2. 2. Institutional Factors: Discrimination, Labor Market Regulation, and Trade Unions 3. 3. Impact on Wage Determination of International Trade, Technology, and Labor Rights 4. 4. Impact of Labor Theory on Arbitrator Decisions

3. Session I Traditional Labor Market Theory Marginal Productivity Theory Human Capital Theory

4. Marginal Productivity Theory Workers are paid according to how much they contribute to marginal increases in output Workers are paid according to how much they contribute to marginal increases in output If increasing the number of employees in a firm by one worker would increase output by $25,000, workers should be paid $25,000. If increasing the number of employees in a firm by one worker would increase output by $25,000, workers should be paid $25,000.

5. Assumptions of MP Theory No barriers to labor mobility No barriers to labor mobility Homogeneous labor force Homogeneous labor force Product market is competitive Product market is competitive Firms attempt to maximize profit Firms attempt to maximize profit Competition among workers keeps wage no higher than marginal product Competition among firms for workers keeps wage no lower than marginal product All similar workers receive exactly the same wage, regardless of the firm for whom they work

6. Relationship between Prices, Productivity, and Wages Equation 1 %  Price = %  Wage - %  Productivity Equation 2 %  Wage = %  Price + %  Productivity

7. Implications of Equation Equation 1 If wages increase no more than productivity, then firms can maintain normal profits without raising prices If wages increase no more than productivity, then firms can maintain normal profits without raising prices If wages increase MORE than productivity, then firms must raise prices to maintain normal profits. If wages increase MORE than productivity, then firms must raise prices to maintain normal profits. If a firm raises price to cover higher wages in excess of productivity gains in a competitive industry, then firm loses market share – workers will be laid off If a firm raises price to cover higher wages in excess of productivity gains in a competitive industry, then firm loses market share – workers will be laid off

8. Implications of Equation, con’t Equation 2 If productivity goes up by X% and firm is able to raise prices by Y%, then wages can go up by X%+Y% If productivity goes up by X% and firm is able to raise prices by Y%, then wages can go up by X%+Y% If wages rise by less than productivity, firm should be able to lower prices and become more competitive If wages rise by less than productivity, firm should be able to lower prices and become more competitive If wages rise by less than productivity and prices do not fall, profits increase If wages rise by less than productivity and prices do not fall, profits increase

9. Heterogeneous Labor If labor differs by skill, then workers will be paid differently, but each worker will be paid his or her marginal product If labor differs by skill, then workers will be paid differently, but each worker will be paid his or her marginal product Wage differences will simply reflect different worker productivities Wage differences will simply reflect different worker productivities Again, this assumes perfect labor mobility and competitive product markets Again, this assumes perfect labor mobility and competitive product markets

10. Impact of Capital and Technology Increase in the use of physical capital (e.g. new machines or new processes) increases the marginal productivity of workers and therefore wages Increase in the use of physical capital (e.g. new machines or new processes) increases the marginal productivity of workers and therefore wages Improvements in technology - that add to labor productivity – increase wages as well Improvements in technology - that add to labor productivity – increase wages as well

11. Human Capital Theory Retains assumption of perfect labor mobility, but expands on differences among worker skills Human capital models single out individual investment behavior as a basic factor explaining differences in wages Wage Differences = f (Differences in individual investments in skill)

12. Types of Human Capital Investment Formal Education Formal Education On-the-job Training On-the-job Training Vocational Education Vocational Education Health Status Health Status Access to labor market information Access to labor market information Migration Migration

13. Basic Human Capital Equation Earnings Earnings (i) = a 0 + b 1 x Education (i) + b 2 x OJT (i) + b 3 x Vocational Educ (i) + b 4 x Health Status (i) + b 5 x Labor Market Info (i) + b 6 x Migration (i)

14. Earnings Distribution The market determines the “b” for each human capital attribute. It will be the same for all workers given labor mobility and perfect competition The market determines the “b” for each human capital attribute. It will be the same for all workers given labor mobility and perfect competition This “b” is the “rate of return” to each human capital factor This “b” is the “rate of return” to each human capital factor Earnings differ simply because individuals make different human capital investments in themselves. Earnings differ simply because individuals make different human capital investments in themselves.

15. Wage Implication Wages are set exclusively by the market Wages are set exclusively by the market Wage differences are exclusively due to differences in worker investments in human capital Wage differences are exclusively due to differences in worker investments in human capital These wage rates are “fair and just” because they represent the worker’s own investments in human capital, the state of capital investment, and the state of technology These wage rates are “fair and just” because they represent the worker’s own investments in human capital, the state of capital investment, and the state of technology

16. Market Implication Any firm in a competitive industry forced to pay a wage higher than the market wage will no longer be competitive and will have to lay off workers or go out of business Any firm in a competitive industry forced to pay a wage higher than the market wage will no longer be competitive and will have to lay off workers or go out of business Trade Unions, Arbitrators, minimum wage legislation can raise wages if their influence covers an entire industry... but at the expense of reducing employment to the point that wages = marginal product Trade Unions, Arbitrators, minimum wage legislation can raise wages if their influence covers an entire industry... but at the expense of reducing employment to the point that wages = marginal product

17. Market Implications, con’t If trade unions, arbitrator decisions, or minimum wage affects only some firms in a perfectly competitive industry, these firms will no longer be competitive and will go out of business. If trade unions, arbitrator decisions, or minimum wage affects only some firms in a perfectly competitive industry, these firms will no longer be competitive and will go out of business.

18. Monopoly and Oligopoly Markets Relaxing the assumption of perfectly competitive labor markets changes these dynamics dramatically Firms that have monopoly or oligopoly advantage earn “monopoly profits” Firms and workers can negotiate how these monopoly profits will be shared

19. Implications Trade Unions, Arbitrators, and minimum wage legislation can raise wages without forcing firms into bankruptcy. Trade Unions, Arbitrators, and minimum wage legislation can raise wages without forcing firms into bankruptcy. Still, wages higher than initial marginal product will encourage firms to reduce workforce until wages = marginal product... in order to maximize profit Still, wages higher than initial marginal product will encourage firms to reduce workforce until wages = marginal product... in order to maximize profit

20. Session II Institutional Labor Market Theory Labor Market Discrimination, Trade Unions, and Labor Market Regulation

21. Labor Market Discrimination Once there is labor market discrimination against any group of workers, the assumption of perfect mobility no longer holds Once there is labor market discrimination against any group of workers, the assumption of perfect mobility no longer holds Workers with identical human capital can end up with very different wages... even if wages = marginal product for each worker. Workers with identical human capital can end up with very different wages... even if wages = marginal product for each worker.

22. Firm B only employs white men; Firm A employs anyone Firm B pays a premium to its white male workforce Firm A need not pay this premium to attract all the workers it needs Wage Gap

23. Human Capital Equation with Labor Market Discrimination Earnings Earnings (i) = a 0 + b 1(i) x Education (i) + b 2(i) x OJT (i) + b 3(i) x Vocational Educ (i) + b 4(i) x Health Status (i) + b 5(i) x Labor Market Info (i) + b 6(i) x Migration (i) Now, earnings differ as a result of differences in human capital investment PLUS differential returns to investment

24. Impact of Labor Market Discrimination For every unit of human capital, group discriminated against receives a lower return on its investment For example, an extra year of college is worth less to a black female than a white male Workers with identical human capital earn different wages

25. Impact of Unions To the extent that craft unions limit entry into an occupation, they establish wage differentials for their members relative to those who cannot enter the occupation To the extent that craft unions limit entry into an occupation, they establish wage differentials for their members relative to those who cannot enter the occupation These barriers to occupational mobility create “non-competing” groups of labor These barriers to occupational mobility create “non-competing” groups of labor These barriers create a “balkanized” labor market where individual wages depend on the access individual workers have to these sub-markets. These barriers create a “balkanized” labor market where individual wages depend on the access individual workers have to these sub-markets.

26. “Balkanized” Labor Markets Due to: Due to: Racial or Gender Discrimination Racial or Gender Discrimination Strong trade unions Strong trade unions Barriers to geographic mobility Barriers to geographic mobility “Lock-in” Effects of Seniority “Lock-in” Effects of Seniority Civil Service Channels Civil Service Channels

27. “Ability to Pay” Within “balkanized” labor markets, wages reflect the “ability to pay” of individual firms Within “balkanized” labor markets, wages reflect the “ability to pay” of individual firms Firms with monopoly or oligopoly advantage can pay higher wages Firms with monopoly or oligopoly advantage can pay higher wages Workers who gain access to these advantaged firms can negotiate higher wages through their unions, through arbitration, or through industry or occupational regulation Workers who gain access to these advantaged firms can negotiate higher wages through their unions, through arbitration, or through industry or occupational regulation

28. Institutionalized Labor Market Wages in institutionalized labor markets reflect: Wages in institutionalized labor markets reflect: Differences in human capital attributes of individual work groups Differences in human capital attributes of individual work groups Differences in race, gender, access to union membership Differences in race, gender, access to union membership Differences in firm’s ability to pay Differences in firm’s ability to pay

29. 1950s-1970s: Institutionalized Labor Market Heyday In the first three decades following World War II, the U.S. labor market was in its institutionalized heyday In the first three decades following World War II, the U.S. labor market was in its institutionalized heyday Large oligopolies dominated the American landscape: GM, Ford, Chrysler, U.S. Steel, Bethlehem Steel, General Electric, Westinghouse, AT&T, Boeing, McDonnell Douglas, IBM, Textron, etc., etc. etc. Large oligopolies dominated the American landscape: GM, Ford, Chrysler, U.S. Steel, Bethlehem Steel, General Electric, Westinghouse, AT&T, Boeing, McDonnell Douglas, IBM, Textron, etc., etc. etc.

30. 1950s-1970s: Institutionalized Labor Market Heyday Union Density reached its zenith in the mid- 1950s with 36% of the U.S. workforce members of unions or covered by collective bargaining contracts Union Density reached its zenith in the mid- 1950s with 36% of the U.S. workforce members of unions or covered by collective bargaining contracts Rise of regulated labor market with OSHA, Equal Employment Opportunity Act, minimum wage etc. Rise of regulated labor market with OSHA, Equal Employment Opportunity Act, minimum wage etc. Growth in public sector at federal, state, and local level Growth in public sector at federal, state, and local level Rise of public sector unions Rise of public sector unions

31. Session III Globalization Deindustrialization New Technology Unionism

32. Impact of Global Economy on Wage Determination Growth of International Competition in key industries – auto, steel, machinery, electrical goods Growth of International Competition in key industries – auto, steel, machinery, electrical goods Leads to large increase in import share of GDP Leads to large increase in import share of GDP Key industries lose Oligopoly Status – subject to intense international competition Key industries lose Oligopoly Status – subject to intense international competition

34. Impact of Technological Change on Key Industries Under intense international competition, key industries move aggressively to substitute computer-based technology for workers Under intense international competition, key industries move aggressively to substitute computer-based technology for workers Combination of imports + productivity- enhancing technology reduces employment in manufacturing dramatically Combination of imports + productivity- enhancing technology reduces employment in manufacturing dramatically

35. Deindustrialization (1969-1976) Good News: Good News: 25 million jobs created in brand new factories, offices, and stores 25 million jobs created in brand new factories, offices, and stores 19 million jobs created in existing businesses 19 million jobs created in existing businesses Bad News: Bad News: 22 million jobs lost due to plant closings and relocations to other states or abroad 22 million jobs lost due to plant closings and relocations to other states or abroad 13 million jobs lost due to downsizing of existing businesses 13 million jobs lost due to downsizing of existing businesses

37. Rise of the Public Sector Employment YearFederalStateLocal 19592,342,0001,484,0004,366,000 19692,893,0002,533,0006,904,000 19792,894,0003,541,0009,633,000 19893,136,0004,182,00010,609,000 19992,769,0004,709,00012,829,000 Dec.20032,710,0004,951,00013,807,000 Source: Council of Economic Advisers, Economic Report of the President, 2004, Table B-46

38. The Trend in Unionism

41. Age Composition of Union Members in the U.S. 2002 Percent of Employed Age Group Workforce Total, Age 16+13.3% Age 16-24 5.2% Age 25-34 11.2% Age 35-44 14.3% Age 45-54 18.6% Age 55-64 17.4%

42. Union Membership by Occupation in 2003 Occupation Union Membership as % of Employment Sales and related occupations 4.0% Food preparation and serving related occupations 4.1% Legal Occupations 4.8% Computer and mathematical occupations 5.2% Business and financial operations occupations 6.1% Art, design, entertainment, sports, and media occupations 7.5% Architecture and engineering occupations 7.8% Life, physical, and social science occupations 9.0% Healthcare practitioner and technical occupations 12.3% Production occupations 17.5% Installation, maintenance, and repair occupations 18.9% Transportation and material moving occupations 20.1% Construction and extraction occupations 21.7% Protective service occupations 36.1% Education, training, and library occupations 37.7%

43. Summing Up The 21 st Century Labor Market is characterized by: The 21 st Century Labor Market is characterized by: Dramatic Increase in International Competition Dramatic Increase in International Competition New Labor-Saving Technology New Labor-Saving Technology Sharp decline in Manufacturing Employment Sharp decline in Manufacturing Employment Rapid increase in Public Sector Employment Rapid increase in Public Sector Employment Sharp decline in Union Membership Sharp decline in Union Membership HOW DOES THIS AFFECT WAGE SETTING?

44. Session IV Implications of Economic Trends on Wage Determination and Arbitration Decisions

45. Globalization With greater global competition, U.S. firms increasingly consider foreign sourcing as an alternative to domestic production With greater global competition, U.S. firms increasingly consider foreign sourcing as an alternative to domestic production Union wage demands, increased labor market regulation, and arbitrated wage increases can induce firms to increase the level of foreign sourcing Union wage demands, increased labor market regulation, and arbitrated wage increases can induce firms to increase the level of foreign sourcing Result: Higher Wages; BUT Result: Higher Wages; BUT Lower Employment Lower Employment

46. Information Technology Access to new technology increases firm’s ability to adopt labor-saving processes Access to new technology increases firm’s ability to adopt labor-saving processes Union wage demands, increased labor market regulation, and arbitrated wage increases can increase the pace at which labor-saving technology is adopted Union wage demands, increased labor market regulation, and arbitrated wage increases can increase the pace at which labor-saving technology is adopted Result: Higher Wages; BUT Result: Higher Wages; BUT Lower Employment Lower Employment

47. Declining Union Density With falling union density in many industries as well as across industries, union wage premiums are more difficult to sustain With falling union density in many industries as well as across industries, union wage premiums are more difficult to sustain Result: Arbitrated wages that maintain a sizeable union-nonunion gap are likely to result in lower employment levels Result: Arbitrated wages that maintain a sizeable union-nonunion gap are likely to result in lower employment levels

48. Public Sector Wages With many states and local communities in fiscal crisis, state and municipal government leaders increasingly seek ways of limiting union wage gains With many states and local communities in fiscal crisis, state and municipal government leaders increasingly seek ways of limiting union wage gains Result: Stronger public support for privatization of municipal services, charter schools, school voucher programs Result: Stronger public support for privatization of municipal services, charter schools, school voucher programs

49. Questions for Arbitrators Given this new Economic Environment, what must arbitrators consider? Given this new Economic Environment, what must arbitrators consider? Which wage comps should be used? Which wage comps should be used? Union wage increases in other regions? Union wage increases in other regions? Union wage increases in other industries? Union wage increases in other industries? Tie wage increases to productivity gains in firm? Tie wage increases to productivity gains in firm? Tie wage increases to productivity gains in entire industry? Tie wage increases to productivity gains in entire industry? How much should arbitrators concern themselves with employment effects? How much should arbitrators concern themselves with employment effects?

50. An Economist’s Thoughts In private sector contracts, wage increases should be tied more closely to productivity increases in relevant industry to maintain price competitiveness in global markets In private sector contracts, wage increases should be tied more closely to productivity increases in relevant industry to maintain price competitiveness in global markets In the public sector, wage increases should be tied to cost-of-living plus all- economy productivity increase to keep public sector wages more in line with private sector In the public sector, wage increases should be tied to cost-of-living plus all- economy productivity increase to keep public sector wages more in line with private sector

51. Assumptions Global competition, new technology, weaker unions, and public sector fiscal constraints are important in relevant industry Global competition, new technology, weaker unions, and public sector fiscal constraints are important in relevant industry Arbitrators should consider possible employment effects of wage settlements Arbitrators should consider possible employment effects of wage settlements Still, within reason, unionized sector should lead economy to higher standard of living Still, within reason, unionized sector should lead economy to higher standard of living

52. Your Thoughts? Your Comments?