comparative advantage and the welfare effects of uniform wage policies

Comparative Advantage and the Welfare Effects of Uniform Wage Policies STUART DORSEY Western Illinois University

This paper analyzes the theoretical impact o f a commonly cited union goal - - the elimination or reduction of wage differentials within occupations. By dropping the usual assumption of homogeneous labor, we show how, and under what market conditions, workers will receive rents due to individual comparative advantage. In competitive labor markets a union-imposed uniform wage may lower the earnings o f workers holding a productive advantage, causing a reduction in employment and a welfare loss o f comparative advantage rents. The implications o f a strict uniform wage rule imply that unions may be forced to adapt their wage policy to allow more productive workers to receive wage differentials. This consideration helps explain some common trade union institutions.

I. Introduction

The theoretical impact of unionization on wages and employment is well- established in standard economic analysis. If the union is successful in raising wages, either by restricting entry or direct negotiation, employment in the affected industry is reduced. A welfare loss is incurred as workers who lose their jobs in the unionized industry move to areas where they are less productive. A simplifying assumption employed in this analysis is that workers are homogeneous and wages are equal within the industry or occupation. Often, however, productivity will vary across workers in similar jobs. The homogeneity assumption is a useful abstraction for predicting the impact of union-negotiated wage increases, but only by relaxing this assumption can one similarly analyze another result of collective bargaining - - the narrowing of personal wage differentials within occupations. This has been an important goal of trade unions, and they appear to have made considerable progress in this direction.

This paper is not an empirical investigation of the impact of unions on personal wage differentials, although this is an important issue and some evidence will be cited. The issue here is the predicted impact of a union's successful uniform wage policy in labor markets where wage differentials otherwise would result from individual differences in productivity. An implication of the analysis is that, similar to an increase in the general wage level, imposition of a uniform wage reduces employment with a resultant welfare loss, when workers holding a comparative advantage leave the union sector and are unable to obtain similar employment. First, it is necessary to show how, and under what market conditions, rents arise from individual comparative advantage.

JOURNAL OF LABOR RESEARCH Volume I1, Number 1 Spring, 1981

148 J O U R N A L O F L A B O R R E S E A R C H

II. The Origin of Comparative Advantage Rents

Differences in tastes and in abilities for given types of work generally are considered to be similar in how they generate inframarginal labor market rents (Friedman, 1962, pp. 218-220). Actually, rents arise from these two factors under different, and potentially conflicting, conditions. Differences in tastes result in higher or lower reservation wages for entering an occupation. Those with a comparative taste for an occupation will receive a rent if all workers are paid the same wage, that necessary to attract entrants who do not share this preference. However, workers with a comparative advantage, in that their marginal product in a given occupation is higher than in all others, receive rents only if wages vary across individuals according to the value of marginal product (VMP) of each.

The presence of comparative advantage implies that the market price of output required to compensate workers at a given reservation wage will vary, and thus the supply to the occupation as a function of output price is positively sloped. Figure 1 illustrates a labor market where all workers have similar tastes for the activity, therefore the same reservation wage, W, .' While the supply as a function of the wage is perfectly elastic, differences in ability among potential entrants imply that the product price necessary to attract additional workers will increase, given that each is paid equal to his VMP. At a market price of P,, the N2 worker is attracted, because his productivity is such that at this price his reservation wage, ~ = P, x MPP., is met. Those below N , are more productive in this occupation and can earn W, at lower product prices. At P, their wage exceeds IV,, yielding a comparative advantage rent. 2

Workers will receive rents from comparative advantage only if wages vary by marginal product. This condition is met for self-employed labor and workers employed in competitive labor markets.' Competition among employers will equate the wage of each worker to his VMP, ensuring that comparative advantage rents are captured by the worker.

Employees will not, however, receive comparative advantage rents under conditions of monopsony. By definition, there are no competitors forcing the monopsonist to pay each worker his VMP. Rather the discriminating monopsonist pays each worker according to his reservation wage. When wages vary in this fashion, the employer captures all inframarginal rents, due either to comparative advantage or differences in tastes for the activity.

~The reservation wage is the m i n i m u m that workers will accept in the occupation. If there were no differences in nonpecuniary aspects of jobs, the reservation wage would equal the worker 's wage in his next most productive employment,

2For simplicity, all have the same reservation wage in this example, so that comparat ive advantage reflects absolute differences in productivity.

3Self-employment may be partially a result of workers a t tempting to ensure that they receive the benefits of their comparative advantage. If so, we would predict that se l f -employment is more common in occupations where abilities vary widely.

Wage

rV,

P,

Supply (W)

Quantity

Output Price

i I i

STUART DORSEY 149

Supply (P)

Quantity N~

Figure 1

Supply o f workers to an occupation as a function o f wage, output price

150 JOURNAL OF LABOR RESEARCH

III. The Impact o f a Uniform Wage Rule in a Competitive Market

If institutional factors prevent employers from paying different wage rates within the same job, workers with a comparative advantage may lose rents. One such insitution is employee resistance to wage differentials for similar work. Workers historically have preferred a uniform wage to incentive systems or to allowing employers power to arbitrarily set each worker's compensation. The latter can lead to monopsonistic exploitation if the employer is able to base wage rates upon the individual's reservation wage rather than productivity. If workers can insist upon a uniform wage, the firm cannot discriminate, but also will be unable to vary wage rates by productivity. However, each worker still may receive a wage equal to his marginal product, and those with a comparative advantage will gain rents if the labor market is competitive.

Each firm will choose a wage rate, Wj, and utilize only workers whose VMP= Wj. The j,h firm will lose those whose VMP> Wj to employers who believe they can lower efficiency-wages by offering a higher wage and attracting higher quality labor. Still other firms will minimize labor costs by paying a lower wage to workers who are rejected by firms that choose a high wage and labor quality. An equilibrium would be reached with each firm paying a single wage corresponding to the ability of employees they have selected, efficiency- wages equalized across all firms and each worker employed by the firm which pays a wage equal to his VMP.' Thus workers with a comparative advantage ~vould still receive rents.

The uniform wage protects the inframarginal rents of workers who have a comparative taste for the trade from a discriminating monopsonist. However, it would be much more difficult to prevent the monopsonist from capturing comparative advantage rents. It is one thing to insist that all are paid the same wage, but quite another to force an employer who faces little competition in hiring to pay each worker his marginal product. In any event, it would seem that workers who are suspicious of monopsonistic wage discrimination would be unwilling to allow such an employer the power to vary wage rates, which is a necessary condition for workers to receive comparative advantage rents.

The Union Impact. One way by which employee sentiment for uniform wages would manifest itself is by organization of a trade union. An important goal of many unions has been the elimination or reduction of wage differentials for similar jobs (Kerr, 1957, pp. 173-193 and Reynolds and Taft, 1956, pp. 175-180). In fact, the union presence appears to have narrowed personal wage differentials within similar occupations. Kerr (1957, p. 181) reported that differences in compensation for the same job had been largely eliminated or controlled in unionized sectors. Some empirical evidence consistent with unions

This result assumes that productivity of workers of a given ability class is unaffected when they are segregated. We may not expect this if there are interdependencies between co-workers in the production process. For example, less able workers may learn from working alongside those who are more efficient. On the other hand, highly productive workers may tend to work less intensely in order to " con fo rm" to group standards. Finally, if the production function changes when ability classes are separated, workers ' productivity also may change.

STUART DORSEY 151

reducing the earnings of more productive workers was recently reported by Borjas (1979). The implications of this effect are considered next.

Suppose a union organizes a competitive labor market, and that the union contract will cover all firms hiring for a particular occupation. This situation would be approximated by a craft union, or an industrial union where an occupation is specific to that industry. Examples of the latter would be occupations specific to the auto industry. Where there are personal wage differentials based upon ability, the union's decision is not how much to raise a single competitive wage, but at what level to standardize wages in the occupation. Recall that employee opposition to variable wages within a firm did not affect the outcome of the competitive market, because each firm would choose a different combina- tion of wage and labor quality. The effect of the union will be different because it attempts to standardize wages across a wider range of firms or industries.

Let the union bargain for a uniform wage, W~, that is above the competitive wage for each worker in this occupation. The consequences are similar to the standard analysis of a union in a homogeneous labor market. Initially, the VMP of all workers is below W~. But as less productive workers are laid off, the VMP of remaining workers rises because of diminishing marginal productivity. Employment is reduced at the margin until the VMP of the last worker retained reaches W~. All those who retain their jobs are receiving higher wages.

But the union may not try to raise everyone's wage if unacceptable employment losses are entailed. The wider is the range of abilities within an occupation, the lower the union will attempt to set the uniform wage, given its employment goals. Consider the median worker of a distribution of employees by productivity. The broader the distribution of abilities, the greater the distance between the median worker's VMP and W~. Given the rate of diminishing marginal productivity of workers, a larger reduction in employment is required to raise the median's VMP equal to W~. The probability that the median or any other worker will be dismissed is, therefore, greater. If the union does trade off employment with wage goals, it may choose to set the wage below the marginal product of the most productive worker. Let this wage be Wb.

In this more interesting case some workers' earnings are raised, but others' are lowered. Employment declines for two reasons. Workers whose VMP initially is below Wb are released. But those whose marginal productivity exceeds Wb could have earned more in the absence of the union. The response of this latter group depends upon their alternatives. If their opportunity wage is below W~, they will remain in the occupation. In the absence of the uniform wage rule, they were earning comparative advantage rents. These rents are transferred to the employer. All employees whose opportunity wage is above Wb leave the occupation voluntarily, and employment is further reduced. If there is no comparative advantage among those leaving, such that VMP,--opportunity wage (O W,) for each of those for whom O W~ > Wb, the welfare loss would be only that resulting from their diminished marginal product caused by adding more workers in the nonunion sector. But if some of these workers have a comparative advantage, such that VMP, > O W,> Wb, there is an additional dead-weight loss of their comparative advantage rents. No financial incentive exists for them to exercise their special abilities.


For completeness, consider the unlikely case of the union negotiating a uniform wage, W,, equal to the VMP of the least productive worker. No one is laid off, but employment declines as some have their earnings reduced below their opportunity wage. As above, rents of workers with a comparative advantage and whose wages are reduced are either transferred to the employer or become a dead-weight loss.

To summarize, dropping the postulate of homogeneous labor in the analysis of unions yields three new results. One is that a uniform wage may transfer some comparative advantage rents to employers. If the firm is able to retain its more productive employees, this benefits the competitive employer by offsetting to some degree the increase in labor costs of workers whose wages are raised. An interesting question for further consideration is under what conditions, if any, a union might bargain for a uniform wage such that the net effect is to benefit the competitive firm. Presumably this would hinge upon the political structure of the union, since it would require that the less productive members, who are in a position to benefit from wage standardization, gain control.

Second, imposing a uniform wage lowers employment, even i f no worker ' s wage is raised. When the wage is set at W~, those who could earn more elsewhere voluntarily leave. Their loss may be offset by new entrants who were unable to earn W~ under competitive conditions, but whose VMP rises to W~ with the decline in employment, given diminishing marginal productivity. If for every worker who elects to leave, there is another whose productivity rises to W, as a result (and this is sufficient to induce him to incur the costs of changing jobs), employment does not decline. But employment must fall if a reduction in employment of at least two workers is required to raise the VMP of the last attracted worker to I4~. This replacement o f workers who quit assumes that those attracted by the uniform wage will be free to enter. The union is less likely to erect entry barriers when the wage is set low, because those attracted will be less productive and pose no threat to the jobs of the existing union members. However, a higher uniform wage may induce the entry of workers who are more productive than some of the original workers. In this case we would expect the union to use traditional methods to restrict entry into the occupation and otherwise protect the job rights of its membership. The most effective tool is the closed shop. s Short of this, membership in craft unions has been effectively cur- tailed by long and limited admission to apprenticeships. In many crafts, such as barbering, plumbing, or electrical work, entry can be controlled by influencing the licensing process. In noncraft unions the seniority principle would protect the original members ' job rights f rom competit ion f rom new, more able workers. To the extent that the union is able to restrict entry in these manners, the employment loss from imposing the uni form wage will be greater.

Finally, the uniform wage causes a misallocation o f labor resources. The welfare loss of union-nonunion wage differentials has been analyzed and estimated (Rees, 1963, pp. 69-78). But we have shown that standardizing wages

SAlthough ostensibly prohibited under Taft-Hartley, many union contracts effectively specify a closed shop. See R. L. Miller, "Right-to-Work Laws and Compulsory Union Membership in the United States," British Journal of Industrial Relations, (July, 1976), pp. 186-193.

STUART DORSEY 153

will also cause employment to fall, and the comparative advantage rents of workers who leave the occupation are an additional dead-weight loss. If unable to move to similar jobs in competitive labor markets, they experience a decline in productivity which is more than just a function of diminishing marginal product in the expanding nonunion sector. This suggests that previous estimates of the welfare loss of unionization are on the low side.

IV. The Impact o f the Uniform Wage Rule in a Monopsonistic Market

The effect of the union's uniform wage policy is quite different in a monopsonistic labor market. We have seen that the competitive employer may capture rents of more productive workers whose earnings are lowered by the uniform wage. However, the monopsonist has no such offset. He already captures some comparative advantage rents by paying a uniform wage, or if able, discriminating on the basis of opportunity wage. The union prevents the monopsonist from discriminating, and represents an attempt to raise the wage paid to all. A given wage policy will tend to impact the monopsonist more strongly than the competitive employer. This suggests that, other factors the same, a monopsonist would present stronger opposition to union organization than a group of competitive employers, particularly in markets where the potential for capturing comparative advantage is high.

However, this consideration does not predict that unions would be more likely to be organized in competitive labor markets. For one, worker support for the union would be more solid under monopsony, where no worker stands to lose. If the labor market is competitive, some workers expect to be worse off and will oppose unionization. In theory employer opposition is neutralized by collective bargaining legislation. While this surely is not completely true, it implies that a monopsonistic employer would be more likely to be organized, as the outcome would depend upon employee preferences only. Another factor is that wage policies pursued by the union may differ according to market organization. In competitive markets it may be forced to allow some wage differentials, in order to satisfy the more productive workers. This point is dis- cussed below in detail.

V. Summary and Applications

This paper has analyzed the impact of a uniform wage rule in labor markets where abilities vary across workers. The major result is that a uniform wage policy will, like general wage increases, lead to reduced employment in the affected industries and a welfare loss of comparative advantage rents. These effects will be more important the wider abilities are distributed across workers.

In order to demonstrate these results, we have assumed the union policy of wage equalization to be exogenous. However, a union has many objectives and it is misleading to characterize unions as maximizers of any one to the exclusion of the others. Significantly narrowing wage differentials might cause unacceptable losses of employment and union membership. Given these consequences, one would expect the union to adapt its wage policy to allow wage differentials


for its more productive membership - - in effect trading off wage equality for employment and membership goals. On the basis of improving this trade-off, our analysis predicts the appearance of some common trade union institutions which allow wage differentials, while inflicting less damage to the "equal pay for equal work" principle.

The seniority system, for example, has been explained in terms of political control of the union by older members or by the importance workers attach to job security. But this system can also be seen as a mechanism which allows firms to pay higher wages to workers who generally are more productive, yet in a way that is less likely to be perceived as inequitable by others. The union may have to accept some wage inequality in order to satisfy its more productive membership, but it does not want the employer to arbitrarily set each worker's compensation. If a general rule were to be established which would regulate wage differentials, it would be efficient to base the system on experience. More experienced workers have a greater accumulation of firm-specific investments, and on average are more productive. Under seniority systems they have priority in pro- motion to higher-paying jobs, and also receive greater nonwage benefits, including preferential treatment in layoffs and recalls. Thus, however impre- cisely, higher compensation is awarded to those who are more productive, but more importantly, in a way that seems equitable and orderly compared to if the firm set each worker's wage separately.

A factor complementary to the seniority system is the job ladder. The equity-employment trade-off also helps explain its evolution. Unions often are associated with a larger number of precisely defined job classifications and corresponding wage rates. Even finer gradation can be achieved by establishing different pay levels within a job category, for example A, B, and C drill press operators (example from Cohen, 1975, p. 164). Progression up the job ladder is based in part upon length of service. But given that longer-tenured workers tend to be more productive, and that employers usually can justify promoting highly able junior employees, the system tends to reward productivity. Yet damage to perceptions of equity again is minimized. Variations in pay correspond to offi- cially different jobs, and so violations of the "equal pay for equal work" principle are less likely to be seen. Most important for equity considerations is that movement along the job ladder be orderly and not solely at the discretion of the employer. Let me emphasize that such a job ladder may appear even where there are no appreciable technical differences in the work being performed. The union and firm have an incentive to establish artificial job distinctions which would allow greater compensation for more productive workers. Thus we would predict that finer job classification systems would evolve in union than in nonunion industries.

To the extent that the union accomodates differences in productivity, the competitive market will be more closely approximated and employment and efficiency distortions correspondingly reduced. Yet despite the appearance of institutions which allow systematic wage differentials, we would expect the wage structure to be more compressed in the union sector. The principal consequence of this result is that more productive workers may find their earnings reduced by collective bargaining and, if they can earn more elsewhere, move to another job.

S T U A R T DORSEY 155

While evidence tends to show that unions lower quit rates (Burton and Parker, 1969 and Pencavel, 1969) our analysis predicts a greater frequency of quits among highly productive union employees. This is a proposition that could be tested by looking at older cohorts, given that productivity is an increasing function of job experience. If unions suppress wages of more productive workers, we should discover a flatter experience-earnings profile for union employees, perhaps causing more experienced union workers to earn less than their nonunion counterparts. This implies that the union impact on quits will be weaker among more experienced workers. These are precisely the results reported by Borjas (1979). He estimated that unions depress wages for workers with approx- imately twenty or more years of job tenure. As a result, while unions reduced quit rates among younger members, this effect diminished as experience increased, and that near the point where the union effect on wages becomes negative, union employees were more likely to quit. These results are predicted by our analysis.

University Faculty Unions. The university faculty union presents an interesting model of the effects of wage equalization. An important reason for the growth of these unions seems to be a desire of less well-paid faculty, particularly in the social sciences or on branch campuses, to reduce salary differentials within the university system. ~ Successful union policies probably have had the effect of lowering the earnings of highly active faculty, or those in fields which are in short supply. Common elements are substitution of across-the-board salary increases in place of individually negotiated raises, elimination of "meri t" bonuses, and restriction of the ability of administrators to make upward salary adjustment to retain more productive faculty. This policy can result in an inverted wage structure. The university must pay competitive salaries to attract new Ph.D.'s, but once hired they are locked into standard salary increases. In periods of tight supply competitive rates will be rising rapidly, raising the possibility that where salary adjustments are limited, new faculty may be paid more than more experienced professors.

An implication of such a wage inversion is that there will be greater turn- over at the associate and full professor levels. To the extent that senior faculty are mobile, they can move to other positions, losing only rents arising from locational preference or other nonmonetary aspects of their orginal position. The university, however, will be worse off if it is prevented from competing to retain its existing faculty. Not only will it lose its more productive professors, but their replacements may be more costly, since they will be hired at competitive market salaries. While total salary payments may be no lower, we should observe a greater proportion of assistant professors or instructors among the faculty.

'A survey by Ladd and Lipset (1973, pp. 25-40) found that 55% of faculty in the social sciences favored the extension of unionization of colleges and universities, compared with 28°/o of applied business faculty. In general, professors with less scholarly achievement and lower salaries gave greater support to collective bargaining.


O f course , these effects wou ld be t e m p e r e d i f sa lar ies cou ld be a d j u s t e d somehow. This suggests a g rea te r p r o p e n s i t y for l eave - t ak ing at un ion i zed universi t ies . A t some schools , res t r ic t ions on u p g r a d i n g salar ies are a v o i d e d by the facu l ty m e m b e r res igning and t ak ing a one -yea r a p p o i n t m e n t e lsewhere , wi th the unde r s t and ing tha t he or she will be r eh i red at a compe t i t i ve sa la ry the fo l lowing year .

R E F E R E N C E S

Borjas, George J. "Job Satisfaction, Wages, and Unions," Journal o f Human Resources, Volume 14, (Winter, 1979), pp. 21-40.

Burton, J. F., and Parker, J. E. "Interindustry Variations in Voluntary Labor Mobility," Industrial and Labor Relations Review, Volume 22 (January, 1969), pp. 199-216.

Cohen, Sanford. Labor in the United States. (Columbus, Ohio: Charles E. Merrill Co., 1975).

Friedman, Milton. Price Theory: A Provisional Text. Chicago: Aldine Publishing Co., 1966.

Kerr, Clark. "Wage Relationships - - The Comparative Impact of Market and Power Forces." The Theory o f Wage Determination. Edited by John Dunlop. London: Macmillan and Co., 1957.

Ladd, Everett C., and Lipset, Seymour M. Professors, Unions and American Higher Education. (Washington, D.C.: American Enterprise Institute for Public Policy Research, 1973).

Pencavel, J. H. "Interindustry Variations in Voluntary Labor Mobility: Comment ," Industrial and Labor Relations Review, Volume 23 (October, 1969), pp. 78-83.

Rees, Albert. "The Effects of Unions of Resource Allocation," Journal o f Law and Economics, Volume 6, (October, 1963), pp. 69-78.

Reynolds, Lloyd G., and Taft, Cynthia H. The Evolution o f the Wage Structure. (New Haven: Yale University Press, 1956).

comparative advantage and the welfare effects of uniform wage policies

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