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Unions and the Fallacy of Composition

Responding to  this post by Adam Ozimek , I left the following long comment:

I’m gone a month and you’re back to union-bashing. Do I really need to keep pointing out the obvious? Economists don’t agree on the efficiency issues related to unions, and for good reason. Let me quote the offending paragraph:

“On the other hand, fairness and welfare can also be at odds. For instance, many people may find it unfair when businesses to not share quasi-rents with their employers, and may encourage, both through market and non-market means ranging from protests, to private demand for goods from “fair” goods, to demanding outright regulation or labor cartelization. However, those quasi-rents may be the incentives that businesses need in order to start up the business in the first place, so that the demand that businesses share them (again, this can be market or non-market) may lead to less business creation in the long-run. Here, people’s sense of fairness produces inefficient outcomes: workers capturing quasi-rents may be made better off, but the business owners lose that transfer and future business owners and workers are hurt by less business creation. In short, wealth is destroyed.”

This paragraph is wrong; the ol’ fallacy of composition, once again. First off, the union action literally can’t destroy the incentive to start a business; the business doesn’t exist yet. While the union should only lay claim to part of the surplus; a strategy to lay claim to all or more than all the surplus would not be incentive compatible. In fact ANY strategy which would drop the firm below the owner’s level of reservation profits would not be incentive compatible for the union. An efficient union would thus drive its share right up to this boundary. Workers themselves would also need to be compensated for being in the union; if everyone’s reservation wages/profits are being driven by the “market” – perhaps imagine unions bidding for workers – so that the marginal worker’s value is their marginal improvement to bargaining position – and the owners their reservation profits equal their market wages. In this case, everyone is earning their shapley value – it takes a lot of assumptions to get this, but I don’t care if its true in the real world, I have a point to make.

Now, read Rajan/Zingales (one of my favorites). The point which is important here is that RZ assume that everyone in a firm is earning their shapley value. This is a little strange for them, since the coalition is only equal to the firm in equilibrium; otherwise the coalitions are just “cliques” in which access to the firm’s capital is being granted to the workers, or not. The point is that when workers receive their shapley value, they will maximize their relationship specific investment (in the data of course, relationship specific investment wouldn’t show up as “investment”, but as “technology” – because it includes things like developing… anything… that makes an individual worker more efficient at a given level of capital).

There are a couple of points which any economist should recognize:
1) The firm has less financial capital for investment – it’s investment will fall – this means that the firm will eventually “die” or “die” sooner, more likely. This is, I believe, part of your point.
2) The pace of technological progress should be higher from the higher level of relationship specific investment.
3) The economy’s total savings falls only to the extent that workers save less than the firm.
4) Since firms are generally borrowers and workers savers – the savings rate for the economy might actually rise.
5) So, there is nearly as much, or perhaps more financial capital in the economy available for investment – as I said, fallacy of composition.
6) So, wealth accumulation is just as fast, or faster under the efficient union equilibrium.

This is only comparing the “efficient union” equilibrium to the non-union equilibrium. So this is all true in theory, but how do you get to the efficient union equilibrium? The efficient union has to be a cartel when dealing with management, but is competitive when dealing with workers. Meh, I’m a theorist, so don’t bother me with practical questions. The point is only that you may have the wrong sign for the effect. In defense of my little model, though, every prediction it makes has come true since the era of deunionization began: fall in technological progress? check. rise in business saving/investment? check. fall in personal saving? check. fall in wages? check. No, I don’t think this is the correct explanation for any of these, but I do get all the right signs.

Now, to add “fairness” back into the mix; to the extent that workers are interested in (and accurately perceive) fairness, they will, on the margin, be more willing to accept lower wages than the “efficient union” equilibrium I assumed above. This will mean that the firm (individually) would have a higher level of investment. To make a long story short: this is a bad example of fairness causing inefficiency. Also, as an aside, this is one more reason that “be nice to business” makes for really bad macroeconomic policy – I’m talking to you, Republicans!

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