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Bargaining structure and economic performance in the open economy
European Economic Review 38 (1994) 403-415. North-Holland
Bargaining structure and economic performance in the open economy Martin Rama* World Bank, Washington DC, USA and Centro de Investigaciones Econdmicas (CINVE), Montevideo, Uruguay
Received August 1990, tinal version received July 1992
It seems nowadays accepted that both centralized wage bargaining and negotiation at the firm level perform better than sectoral wage bargaining. This is because sectoral unions have enough market power to raise wages, but do not internalize all the effects of their actions. However, the ranking may be different in an open economy facing a less than inlinitely elastic foreign demand, because raising wages improves the country’s terms of trade, as in the optimal tarilT argument. As a result, welfare is higher in the centralized setting, while sectoral bargaining is better than full decentralization when imported goods represent a large share of total consumption.
1. Introduction
The relationship between wage bargaining and economic performance had been tackled from two opposite views. For the neoclassical approach, competition in the labor market was to be preferred to collective bargaining, since trade unions represented a monopoly of the labor supply. For the corporatist approach, on the contrary, negotiation was better than competition, because it made economic agents internalize the external effects of wage setting. Between these two extreme views, Calmfors and Driffill (1988) have convincingly argued that the impact of wage bargaining on macroeconomic equilibrium depends on how much coordinated trade unions’ decisions are. Their analysis points out that the best economic performance is associated with both centralized wage bargaining and negotiations at the firm level, whereas the worst outcomes correspond to sectoral settings. This is because sectoral unions are powerful enough to raise wages significantly, but not encompassing enough to take into account all the Correspondence to: Martin Rama, The World Bank, 1818 H Street NW, Washington, DC 20433, USA. *Financial support from the Swedish Agency for Research Cooperation with Developing Countries (SAREC) is gratefully acknowledged. Participants in seminars at the Banco Central de1 Uruguay and the universities of Aarhus (Denmark), Louvain-La-Neuve (Belgium) and Paris I (France) provided helpful comments and suggestions.
0014-2921/94/f07.00 0 1994-Elsevier SSDI 0014-2921(93) 00077-H
Science B.V. All rights reserved
404
XI. Rama, Bargaining structure and economic performance
implications. Consider the simple case in which prices are a mark-up over labor costs: by raising nominal wages, sectoral unions reduce real wages in the rest of the economy. A central trade union, on the contrary, is aware of its inability to modify the real wage (the latter is just the inverse of the markup ratio), so that it chooses a nominal wage compatible with full employment. However, the equivalence between centralized wage bargaining and perfect competition does not necessarily hold in the open economy. If foreign demand is less than infinitely elastic, higher wages give rise to unemployment but they also push export prices up, much the same as a tax on exports in the optimal tariff literature. Put differently, the domestic price of imports is not necessarily proportional to labor costs, so that there is room to increase real consumption wages even if real product wages remain unchanged. The aim of this paper is to reconsider the relationship between economic performance and the wage bargaining structure in the context of an open economy. Unlike most of the literature on trade unions and macroeconomic equilibrium, the focus of the paper is not on the effects of economic policies, or on the policy game between unions and the government.’ Rather, it sets aside government interventions and concentrates on the welfare implications of different negotiation settings. Section 2 presents the basic argument of the paper in as transparent a manner as possible. By means of a heuristic model, it shows that in the open economy, sectoral wage bargaining is always worse than complete centralization, yet it may be better than full decentralization. Sections 3 and 4 reconsider the issue within a general equilibrium model. Although restrictive assumptions are needed to obtain unambiguous results, this simple case suggests that sectoral wage bargaining is better than decentralized negotiation when imports represent a significant share of domestic consumption. Section 5 concludes. 2. The argument Consider an economy composed of I identical individuals (with I being a very large number) who all have an indivisible labor unit per period. The utility function of individual i is given by
u._rsiLi Iv-
6L.
1)
i-1 -
)...)
1
.
In this expression, Li is null if the individual remains inactive, and equal to one if he works. In this case, he receives the nominal wage Si and suffers the ‘See, for instance, the papers by Winckler and Amann (1986). Van Wijnbeqen and Persson (1988), Yip (1988) and Dixon (1990).
(1987), Horn
M. Rama. Bargaining
structure
and economic
performance
405
disutility 6. I/ represents the general price level, so that S,/V= K is the real consumption wage. Eq. (1) allows to determine the reservation wage D, i.e. the value of w for which either working or remaining inactive is indifferent to the individual. It follows that D = d/l-.
(2)
This would be the real wage if the labor market were competitive. However, if wages result from negotiation, trade unions try to set Wi so as to maximize the expected utility of their representative member [Oswald (1985)]. In order to account for a wide range of wage bargaining structures, assume that there are H trade unions in the economy. When negotiation is centralized, H= 1. When it is fully decentralized, there is one union in each of the J firms of the economy, so that H =J (with J being a very large number). Finally, between these two extreme settings, workers may be organized in unions by groups of firms (2 4 H 1 be the elasticity of Liwith respect to Si when there are H trade unions. This elasticity should increase with H. In the limit, if goods were produced with labor only and technology were linear, any single firm paying wages above its competitors would be out of the market. Therefore, eL+ + co as H+J. The general price level depends on nominal wages too. Let E"(H)be the elasticity of I’ with respect to Si. In a fully decentralized negotiation, ~~‘0, since actions by a union organized at the firm level have almost no impact on aggregate prices. However, this elasticity should increase as H decreases. In the limit, if firms set prices as a mark-up over labor costs, a general wage increase would lead to a proportional increase in I! Therefore, ey= 1 for H= 1.
‘This makes a difference with the models by Cahnfors and Driflill (1988) and by Cahuc and Zylberberg (1991), in which a different good is considered to account for each sector.
406
hf. Rama, Bargaining
structure
and economic
performance
The real wage w= W, which is optimal from the viewpoint trade union is obtained by maximizing Ui: W,=
EL
of a single
D.
Et+Ey-l
In assessing elasticities EL and E”, each of the H unions takes as given what the others do, despite the fact that they all behave in the same way. This is the coordination failure associated with Cournot equilibrium, which implies that the real wage in eq. (3) is not socially optimal. The coordination failure is avoided only in the centralized setting, in which the optimal real wage is WI= D. Fully decentralized negotiation leads to the same outcome, since unions organized at the firm level are prevented from raising wages by excessively large job losses. But in the sectoral bargaining case, the optimal real wage from unions’ viewpoint is higher than the socially optimal reservation wage D.3 This reproduces in a simple manner the analysis by Calmfors and Drifill (1988). However, parameter values are different in an open economy, and so are the model results. First of all, sL is probably higher than in the closed economy, because of tough competition on international markets. In the limit, the ‘small country’ assumption would imply Ed-+ + co for all H, so that the real wage could not differ from D whatever the bargaining structure. But it seems more realistic to assume that sL is finite even for low values of H, since foreign demand for traded goods is usually less than infinitely elastic. The second difference between the closed and the open economies concerns sy. If there are imported goods in the consumption basket, and their domestic price is not strictly proportional to the nominal wage level, then E”< 1 even in the centralized setting. Intuitively, this possibility depends crucially on how the equilibrium exchange rate reacts to the increase of labor costs. In spite of these two changes in elasticities, the optimal real wage for unions organized at the firm level is still W,= D. But this is not the social optimum anymore. The latter is attained in the fully centralized structure only, and verifies WI > D. Concerning sectoral wage bargaining, the optimal real wage from unions’ viewpoint is necessarily higher than D, but may be either higher or lower than the socially optimum real wage. This heuristic model suggests that in the open economy, centralized wage bargaining is better than negotiation at the fn-rn level, while the ranking is ambiguous for intermediate settings. However, consumption appears as a function of wage payments only, while actually it also increases with real 31nfact, if prices are a mark-up over labor costs, sectoral unions may not succeed in raising real wages. Yet by bidding higher on nominal wages they lead to a price level V which is ‘excessive’ compared to the money supply, thus reducing aggregate employment.
M. Rama. Bargaining
structure
and economic
performance
407
money balances and real profits, which both depend on the wage bargaining outcome. Hence, the next step is to replicate the analysis in a general equilibrium model.
3. The model Consider a Ricardian economy with two different consumption goods. One of them, called the domestic good, is only produced at home, whereas the other one (the foreign good) is only produced abroad. The amounts of these goods consumed by individual i are indicated as CDi and CF, respectively. The corresponding prices (expressed in domestic currency) are P and P*E, with E being the nominal exchange rate. Utility Ui is given by 1-a-p
- SLi
with a+b< 1 [see Blanchard and Kiyotaki (1987)]. In this expression, Zi stands for money balances at the end of the period. The budget constraint, in turn, is Mi+Bi+SiLi=PCDi+
P*ECFi+Zi,
where Mi is the initial monetary endowment and Bi represents profits distributed to individual i. Maximizing Ui with respect to CDi, CF, and Zi, subject to the budget constraint indicated above, leads to the following demands for goods: Mi + Bi + SiLi
cD,=aMi+Bi+SiLi
1
P
’
CFi=8
P*E
*
Therefore, the relevant price level V is 1/=pa/(u+8)[p*E]B/(u++b)
(5)
The reservation wage is D = 6/r, with I’= a’/?( 1 -a -8)’ -b-8, the same as in the previous section [see eq. (2)]. Finally, adding CDi and CF, over the I individuals yields the following consumption functions: CD=a
with CD=cCDi,
~YP+M P ’
CF=p-,
CF=xCF,,
YPiM P*E YP=C(Bi+SiLi)
and M=CMi.
Eq. (6)
408
.%I. Rama, Bargaining
structure
and economic
pe$mnance
implicitly assumes that profits are distributed to individuals within the same period. Let CD* be the foreign consumption of domestic goods, so that Y = CD+ CD*. If the exchange rate is flexible and there are no capital movements, the balance of trade is in equilibrium: CD*P = CFP*E.
(7)
Replacing CD* in the analytical account, this condition yields
expression
of Y and taking eq. (6) into
It follows from eqs. (6) and (8) that CD is proportional to M/P while CF is proportional to M/( P*E). Suppose that preferences by individuals abroad are similar to those of domestic individuals. If both foreign output Y* and foreign money supply M* are given, then the price P* of imported goods is constant [see eq. (8)J. Similarly, consumption CD* of the domestic good by foreigners is proportional to (M*E)/P [eq. (6)]. The balance-of-trade equilibrium implies that the nominal exchange rate E is constant too [eq. (7)]. Consequently, P*E can be treated as given, and any changes in P reflect changes in the country’s terms of trade. Domestic output is produced with labor only, under constant returns to scale: l$=$Lj,
j= l,..., J,
with 1 q= Y and c Lj=C Lie Each firm maximizes its current profits taking as given the output level of the remaining firms. This means that the goods market is characterized by Cournot equilibrium. Moreover, since unions set wages unilaterally, firms also take as given the nominal wage Sj they have to pay to their workers. Using eq. (8), current profits Bj (with c B,=c Bi=B) can be written as
where Lj is the control first-order condition:
variable of the firm. This leads to the following
M. Rama, Bargaining
structure
and economic
Since Y=bx Lj, adding up this equation equilibrium price P, P= 2
J-l
S with C$
S=i
,i Sj. 1 1
performance
409
over the J firms yields, for the
(9)
Hence, the price of the domestic good is a constant mark-up over the average labor cost. The latter is represented by the ratio between the average nominal wage S and labor productivity 4. The mark-up ratio is higher the lower the number of firms J which produce the domestic good. Finally, the labor demand of firm i is obtained by replacing eqs. (S) and (9) in the first-order condition:
According to this expression, Lj increases with aggregate liquidity measured in wage units (M/S), and decreases with the firm’s relative wage (Sj/S). Notice that if the labor market were competitive, the nominal wage Sj would be the same for all firms (Sj=S=S,) and there would be full employment (1 Lj = JLj= I). For the sake of simplicity, let us assume that the equilibrium real wage is equal to the reservation wage D.4 Then, the price level associated with a competitive labor market is V,=S,/D, so that eq. (10) implies V_J-l O--J
m
a+p
M or’
(11)
4. Bargaining and welfare The utility of union member i is obtained by replacing eqs. (4) and (5) into (1’); it depends on whether he has a job (Li= 1) or remains inactive t&=0). The objective function q of union h is the average utility of its members:’
M~t+&+s&h V”
_DL
h f 1
Tonsidering the general case in which the equilibrium real wage is above D, as in Rama (1990) does not modify the basic results of the model, while leading to heavier calculations 51t is implicitly assumed that trade unions have all the same ‘size’, so that each of them has I/H members and operates over J/H firms. For simplicity, such ratios are treated as integers, although this is not necessarily the case.
410
M. Rama. Bargaining slructure and economic performance
In this expression, Sh is the nominal wage paid by the firm(s) in which trade union h operates, while L, represents employment at the level of the firm, the sector or the whole economy, depending on the centralization degree of negotiations. M,, and B, result from adding up Mi and Bi over the I/H union members. Finally, V, is the aggregate price level when there are H trade unions. The number of individuals 1 being large compared to the number of trade unions H, it can be accepted that M,= M/H and B,= B/H.6 Aggregate profits B, in turn, can be written as B= YP--SjLj=p i
‘+’
1-a-B
M-&L,,-
c
SkLk
k#h
[see eq. (8)], with c ‘.+,,S&=O if H = 1. Replacing B/H in the analytical expression of T, yields [M/(1-a-B)l+(H-1)ShLh-Ck+hSkLk
h’fh by M/H and B, by
_DHL
1 (1”) _
h v,
Notice that this equation is significantly different from standard unions’ objective functions. Usually, the rent specification is chosen, so that trade union h would maximize r[(S,/V,)-D] Lh [as in eq. (l)]. Such a specification provides an accurate approximation to the expected utility of union members in a context of highly decentralized wage bargaining.’ But this is no longer true in sectoral or centralized settings, since each of the unions has an incidence on the real value of both profits and money balances. Trade union h chooses the wage level Sh so as to maximize q. subject to the labor-demand schedule Lh [drawn from eq. (lo), by aggregation] and to price equations (5) and (9). Taking into account that Sh =Sk= SH in equilibrium, long and tedious calculations yield for the optimal real wage wH=s,/vH: &I = f(a, P, J, HP
(3’)
with
This result allows to discuss the outcomes of a wide variety of institutional ‘In equilibrium,all trade unions set the same nominal wage and have the same employment level. Hence, all individuals have the same ‘average history’, no matter the trade union they belong to. ‘In that case, V, can be taken as given, while H/(H - 1) = 1.
M. Rama, Bargaining structure and economic performance
411
arrangements, ranging from wage bargaining at the firm level (H =J) to centralized negotiation (H= l), and including multiple intermediate settings. The discussion is carried out under the assumption that the number J of domestic firms is large enough to allow taking limits in eq. (3’). Thus, for HZ 2, f(e) = H/(H - 1). In the particular case of a fully decentralized negotiation, H( = J) is also large, so that f( .) = 1 and the real wage W, equals the reservation wage ti. Therefore, bargaining at the firm level leads to the same outcome as perfect competition in the labor market, the real wage being higher in sectoral settings, as suggested by Calmfors and Driftill (1988). However, the real wage may be even higher in the fully centralized setting. If H = 1, then f(.) =(a+/I)2/a, so that the relationship between W, and W, ( =20) depends on parameters a and 8. Let X= /I/(a +/I) be the openness coefficient of the economy, i.e. the ratio between imports and total consumption. This coefficient is constant because of the Cobb-Douglas specification for preferences at home and abroad, which implies that the price elasticity of the demand for goods is equal to one. Eq. (3’) implies that WI is higher the higher X. Particularly, WI > W, if X > 1-,/(a/2). Hence, there is a hump-shaped pattern for real wages only in economies which are barely or moderately open. Indeed, W2> W, >D if 1 -J(a/2) > X > 1 -da. Besides, according to eq. (3’) W, would fall below the reservation wage for X< 1 -,/a. Since nobody would work in these circumstances, the central trade union has to choose the corner solution WI = D, the same as in the closed economy. The main difference with the closed-economy analysis comes from the fact that now the real wage pattern may not convey enough information concerning economic performance. This is because higher wages have two opposite effects on welfare. On the one hand they lead to unemployment, thus reflecting an inefficient resource allocation. But on the other hand they raise the price of the domestic good, thus improving the country’s terms of trade. The final impact on welfare depends on the relative weight of these two effects. Consider the welfare function U, defined as the sum of utility Ui over the I individuals.8 Under the assumptions of the model, the objective function Ti of the central trade union is nothing but U/Z (see eq. (l”)]. Hence, the maximum welfare level corresponds always to centralized wage bargaining. Notice that in moderately or highly open economies, such a maximum is associated with a real wage W, above its market-clearing level D. More generally, the welfare function U is I times the utility G of the representative union member. Since all trade unions set the same wage, S,, and St can be replaced by SH = W,V,, in eq. (l”), whereas Lh and Lk can be *This welfare function is chosen based on the Hicks-Kaldor individuals’ utility is a linear function of individuals’ real wealth.
compensation
criterion,
since
412
,Vf. Rama, Bargaining
structure
and economic
performance
replaced by JL,/H. Taking eqs. (2), (5), (9), (10) and (11) into account, the welfare level UH can be written as
(1-a For H 22, and provided that the number of firms J is large enough to take limits, eqs. (3’) and (12) imply
du, sign dH -[
1
_ -sign{[a-(a+/?)2]H+(a+/l)2).
(13)
This result allows to distinguish three different cases depending on the value of the openness coefficient. When the share of imports in total consumption is low (Xc 1 -,/a), then dUJdH >O, so that negotiation at the firm level is better than sectoral wage bargaining. In addition, the former leads to the same outcome as centralized wage bargaining (W,= W, =D). Hence, extreme settings are equivalent in barely open economies. The equivalence does not hold anymore for large values of the openness coefficient. Indeed, if the economy is highly open [X> 1 -,/(r/2)], then dUJdH ~0. The best performance being always associated with H= 1, the relationship U, 2 U, is necessarily fulfilled. Therefore, welfare is an upward function of the centralization degree of negotiation, the worst outcome corresponding to negotiation at the firm level. Finally, for intermediate values of the openness coefficient eq. (13) implies that there exists a number of trade unions H =(a +j?)2/[(a + j?)2 - x] > 1, such that dU,,/dH = 0. Hence, welfare increases alongside the centralization degree of negotiation, until reaching a local maximum for some sectoral setting. Since the highest welfare level is attained in the centralized setting, the existence of a local maximum suggested that moderately open economies may be characterized by a ‘sectoral bargaining trap’. Figs. 1, 2 and 3 represent the relationship between the welfare level and the number of trade unions depending on whether the domestic economy is barely open, moderately open or highly open, respectively.
5. Concluding remarks Although it seems nowadays accepted that both centralized wage bargaining and negotiation at the firm level perform better than sectoral wage bargaining, the ranking may be quite different in an open economy. This is because higher wages push up the price of the domestic good, thus improving the terms of trade, much the same as a tax on exports in the
M. Rama. Bargaining structure and
Welfare
economic
performance
413
level
1 Intermediate
Negotiation
settings
by firms
Centralized negotiation
Fig. 1. Barely open economy.
Welfare
level
_;:
Negotiation by firms
Intermediate settings
Centralized negotiation
Fig. 2. Moderately open economy.
optimal tariff literature.’ The difference lies on the nature of deadweight costs: going through the labor market gives rise to unemployment, whereas some consumer surplus is lost when levying taxes on foreign trade. In the ‘The idea is not new: Latin-American economic thought traditionally pointed out the role of labour market institutions in the ‘centre’ as a source of unfavourable terms of trade for the ‘periphery’ [Rodriguez (1980)].
hf. Rams, Bargaining structure and economic performance
414
Welfare
Negottalion by firms
level
lntermedtate settings
Fig. 3. Highly
Centralized negottatlon
open economy,
general case, the first of these two costs is likely to be higher, since Harberger triangles are seldom significant. Yet union activities are not subject to retaliation by foreign governments, as may be the case with trade policies. ’ O Needless to say, the discussion in this paper is based on a simple case, so that the results may not generalize. In order to get an analytically tractable setting, very simple specifications were chosen for the individuals’ utility function and the lirms’ production function. Besides, there are obvious criticisms to the equilibrium concepts used for both the goods market and the labor market. However, the model provides interesting insights into the relationship between the bargaining structure and economic performance in the open economy. It suggests, particularly, that the relationship does not depend on the centralization degree of negotiation only, but also on the ‘quality’ of the external insertion of the economy. Indeed, in order to improve welfare by raising wages, foreign demand must be less than infinitely elastic. In addition, there must be a productivity gap with the rest of the world, because otherwise the latter would start producing the domestic good. Finally, imports must represent a significant share of domestic consumption. The
“‘Similarly, the effects of a higher centralization of wage bargaining could be compared to those of firms’ collusion. In this case, an important issue is whether agreements involving a large number of firms can be actually enforced. By contrast, cooperation among workers in the context of trade unions has proved sustainable.
M. Rmm. Bargaining structure and economic performance
question remains to what extent different bargaining structures downgrade such a ‘quality’ in the long run.
415
improve or
References Blanchard, 0. and N. Kiyotaki, 1987, Monopolistic competition and the effects of aggregate demand, American Economic Review 77, no. 4, 647-666. Cahuc, P. and A. Zylberberg. 1991, Niveaux de ntgociation salariale et performances macroeconomiques. Annales d’Economie et de Statistique 23, I-12. Calmfors, L. and J. Dritlill, 1988, Bargaining structure, corporatism and macroeconomic performance, Economic Policy 6, 16-61. Dixon, H., 1990, Macroeconomic policy with a floating exchange rate and a unionised nontraded sector. Economic Journal 100, Supplement, 78-90. Horn, H. and T. Persson, 1988, Exchange rate policy, wage formation and credibility. European Economic Review 32, 1621-1636. McDonald, 1. and R. Solow, 1981, Wage bargaining and employment, American Economic Review 71, 896-908. Oswald, A., 1985, The economic theory of trade unions: An introductory survey. Scandinavian Journal of Economics 87. no. 2, 160-193. Rama, M., 1990, Wage bargaining and economic performance in the open economy, Mimeo. (CINVE, Montevideo). Rodriguez, O., 1980, La teoria de1 subdesarrollo de la CEPAL. Siglo XXI, Mexico. Van Wijnbergen, S., 1987, Tariffs, employment and the current account: real wage resistance and the macroeconomics of protectionism. International Economic Review 28, no. 3, 691-706. Winckler, G. and E. Amann. 1986, Exchange rate policy in the presence of a strong trade union. Journal of Economics, Supplementum 5, 259-280. Yip, C., 1988, The employment effects of tariffs in an efficient bargain model. Journal of Macroeconomics 10, no. 3 477-485.
Bargaining structure and economic performance in the open economy Martin Rama* World Bank, Washington DC, USA and Centro de Investigaciones Econdmicas (CINVE), Montevideo, Uruguay
Received August 1990, tinal version received July 1992
It seems nowadays accepted that both centralized wage bargaining and negotiation at the firm level perform better than sectoral wage bargaining. This is because sectoral unions have enough market power to raise wages, but do not internalize all the effects of their actions. However, the ranking may be different in an open economy facing a less than inlinitely elastic foreign demand, because raising wages improves the country’s terms of trade, as in the optimal tarilT argument. As a result, welfare is higher in the centralized setting, while sectoral bargaining is better than full decentralization when imported goods represent a large share of total consumption.
1. Introduction
The relationship between wage bargaining and economic performance had been tackled from two opposite views. For the neoclassical approach, competition in the labor market was to be preferred to collective bargaining, since trade unions represented a monopoly of the labor supply. For the corporatist approach, on the contrary, negotiation was better than competition, because it made economic agents internalize the external effects of wage setting. Between these two extreme views, Calmfors and Driffill (1988) have convincingly argued that the impact of wage bargaining on macroeconomic equilibrium depends on how much coordinated trade unions’ decisions are. Their analysis points out that the best economic performance is associated with both centralized wage bargaining and negotiations at the firm level, whereas the worst outcomes correspond to sectoral settings. This is because sectoral unions are powerful enough to raise wages significantly, but not encompassing enough to take into account all the Correspondence to: Martin Rama, The World Bank, 1818 H Street NW, Washington, DC 20433, USA. *Financial support from the Swedish Agency for Research Cooperation with Developing Countries (SAREC) is gratefully acknowledged. Participants in seminars at the Banco Central de1 Uruguay and the universities of Aarhus (Denmark), Louvain-La-Neuve (Belgium) and Paris I (France) provided helpful comments and suggestions.
0014-2921/94/f07.00 0 1994-Elsevier SSDI 0014-2921(93) 00077-H
Science B.V. All rights reserved
404
XI. Rama, Bargaining structure and economic performance
implications. Consider the simple case in which prices are a mark-up over labor costs: by raising nominal wages, sectoral unions reduce real wages in the rest of the economy. A central trade union, on the contrary, is aware of its inability to modify the real wage (the latter is just the inverse of the markup ratio), so that it chooses a nominal wage compatible with full employment. However, the equivalence between centralized wage bargaining and perfect competition does not necessarily hold in the open economy. If foreign demand is less than infinitely elastic, higher wages give rise to unemployment but they also push export prices up, much the same as a tax on exports in the optimal tariff literature. Put differently, the domestic price of imports is not necessarily proportional to labor costs, so that there is room to increase real consumption wages even if real product wages remain unchanged. The aim of this paper is to reconsider the relationship between economic performance and the wage bargaining structure in the context of an open economy. Unlike most of the literature on trade unions and macroeconomic equilibrium, the focus of the paper is not on the effects of economic policies, or on the policy game between unions and the government.’ Rather, it sets aside government interventions and concentrates on the welfare implications of different negotiation settings. Section 2 presents the basic argument of the paper in as transparent a manner as possible. By means of a heuristic model, it shows that in the open economy, sectoral wage bargaining is always worse than complete centralization, yet it may be better than full decentralization. Sections 3 and 4 reconsider the issue within a general equilibrium model. Although restrictive assumptions are needed to obtain unambiguous results, this simple case suggests that sectoral wage bargaining is better than decentralized negotiation when imports represent a significant share of domestic consumption. Section 5 concludes. 2. The argument Consider an economy composed of I identical individuals (with I being a very large number) who all have an indivisible labor unit per period. The utility function of individual i is given by
u._rsiLi Iv-
6L.
1)
i-1 -
)...)
1
.
In this expression, Li is null if the individual remains inactive, and equal to one if he works. In this case, he receives the nominal wage Si and suffers the ‘See, for instance, the papers by Winckler and Amann (1986). Van Wijnbeqen and Persson (1988), Yip (1988) and Dixon (1990).
(1987), Horn
M. Rama. Bargaining
structure
and economic
performance
405
disutility 6. I/ represents the general price level, so that S,/V= K is the real consumption wage. Eq. (1) allows to determine the reservation wage D, i.e. the value of w for which either working or remaining inactive is indifferent to the individual. It follows that D = d/l-.
(2)
This would be the real wage if the labor market were competitive. However, if wages result from negotiation, trade unions try to set Wi so as to maximize the expected utility of their representative member [Oswald (1985)]. In order to account for a wide range of wage bargaining structures, assume that there are H trade unions in the economy. When negotiation is centralized, H= 1. When it is fully decentralized, there is one union in each of the J firms of the economy, so that H =J (with J being a very large number). Finally, between these two extreme settings, workers may be organized in unions by groups of firms (2 4 H
‘This makes a difference with the models by Cahnfors and Driflill (1988) and by Cahuc and Zylberberg (1991), in which a different good is considered to account for each sector.
406
hf. Rama, Bargaining
structure
and economic
performance
The real wage w= W, which is optimal from the viewpoint trade union is obtained by maximizing Ui: W,=
EL
of a single
D.
Et+Ey-l
In assessing elasticities EL and E”, each of the H unions takes as given what the others do, despite the fact that they all behave in the same way. This is the coordination failure associated with Cournot equilibrium, which implies that the real wage in eq. (3) is not socially optimal. The coordination failure is avoided only in the centralized setting, in which the optimal real wage is WI= D. Fully decentralized negotiation leads to the same outcome, since unions organized at the firm level are prevented from raising wages by excessively large job losses. But in the sectoral bargaining case, the optimal real wage from unions’ viewpoint is higher than the socially optimal reservation wage D.3 This reproduces in a simple manner the analysis by Calmfors and Drifill (1988). However, parameter values are different in an open economy, and so are the model results. First of all, sL is probably higher than in the closed economy, because of tough competition on international markets. In the limit, the ‘small country’ assumption would imply Ed-+ + co for all H, so that the real wage could not differ from D whatever the bargaining structure. But it seems more realistic to assume that sL is finite even for low values of H, since foreign demand for traded goods is usually less than infinitely elastic. The second difference between the closed and the open economies concerns sy. If there are imported goods in the consumption basket, and their domestic price is not strictly proportional to the nominal wage level, then E”< 1 even in the centralized setting. Intuitively, this possibility depends crucially on how the equilibrium exchange rate reacts to the increase of labor costs. In spite of these two changes in elasticities, the optimal real wage for unions organized at the firm level is still W,= D. But this is not the social optimum anymore. The latter is attained in the fully centralized structure only, and verifies WI > D. Concerning sectoral wage bargaining, the optimal real wage from unions’ viewpoint is necessarily higher than D, but may be either higher or lower than the socially optimum real wage. This heuristic model suggests that in the open economy, centralized wage bargaining is better than negotiation at the fn-rn level, while the ranking is ambiguous for intermediate settings. However, consumption appears as a function of wage payments only, while actually it also increases with real 31nfact, if prices are a mark-up over labor costs, sectoral unions may not succeed in raising real wages. Yet by bidding higher on nominal wages they lead to a price level V which is ‘excessive’ compared to the money supply, thus reducing aggregate employment.
M. Rama. Bargaining
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407
money balances and real profits, which both depend on the wage bargaining outcome. Hence, the next step is to replicate the analysis in a general equilibrium model.
3. The model Consider a Ricardian economy with two different consumption goods. One of them, called the domestic good, is only produced at home, whereas the other one (the foreign good) is only produced abroad. The amounts of these goods consumed by individual i are indicated as CDi and CF, respectively. The corresponding prices (expressed in domestic currency) are P and P*E, with E being the nominal exchange rate. Utility Ui is given by 1-a-p
- SLi
with a+b< 1 [see Blanchard and Kiyotaki (1987)]. In this expression, Zi stands for money balances at the end of the period. The budget constraint, in turn, is Mi+Bi+SiLi=PCDi+
P*ECFi+Zi,
where Mi is the initial monetary endowment and Bi represents profits distributed to individual i. Maximizing Ui with respect to CDi, CF, and Zi, subject to the budget constraint indicated above, leads to the following demands for goods: Mi + Bi + SiLi
cD,=aMi+Bi+SiLi
1
P
’
CFi=8
P*E
*
Therefore, the relevant price level V is 1/=pa/(u+8)[p*E]B/(u++b)
(5)
The reservation wage is D = 6/r, with I’= a’/?( 1 -a -8)’ -b-8, the same as in the previous section [see eq. (2)]. Finally, adding CDi and CF, over the I individuals yields the following consumption functions: CD=a
with CD=cCDi,
~YP+M P ’
CF=p-,
CF=xCF,,
YPiM P*E YP=C(Bi+SiLi)
and M=CMi.
Eq. (6)
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.%I. Rama, Bargaining
structure
and economic
pe$mnance
implicitly assumes that profits are distributed to individuals within the same period. Let CD* be the foreign consumption of domestic goods, so that Y = CD+ CD*. If the exchange rate is flexible and there are no capital movements, the balance of trade is in equilibrium: CD*P = CFP*E.
(7)
Replacing CD* in the analytical account, this condition yields
expression
of Y and taking eq. (6) into
It follows from eqs. (6) and (8) that CD is proportional to M/P while CF is proportional to M/( P*E). Suppose that preferences by individuals abroad are similar to those of domestic individuals. If both foreign output Y* and foreign money supply M* are given, then the price P* of imported goods is constant [see eq. (8)J. Similarly, consumption CD* of the domestic good by foreigners is proportional to (M*E)/P [eq. (6)]. The balance-of-trade equilibrium implies that the nominal exchange rate E is constant too [eq. (7)]. Consequently, P*E can be treated as given, and any changes in P reflect changes in the country’s terms of trade. Domestic output is produced with labor only, under constant returns to scale: l$=$Lj,
j= l,..., J,
with 1 q= Y and c Lj=C Lie Each firm maximizes its current profits taking as given the output level of the remaining firms. This means that the goods market is characterized by Cournot equilibrium. Moreover, since unions set wages unilaterally, firms also take as given the nominal wage Sj they have to pay to their workers. Using eq. (8), current profits Bj (with c B,=c Bi=B) can be written as
where Lj is the control first-order condition:
variable of the firm. This leads to the following
M. Rama, Bargaining
structure
and economic
Since Y=bx Lj, adding up this equation equilibrium price P, P= 2
J-l
S with C$
S=i
,i Sj. 1 1
performance
409
over the J firms yields, for the
(9)
Hence, the price of the domestic good is a constant mark-up over the average labor cost. The latter is represented by the ratio between the average nominal wage S and labor productivity 4. The mark-up ratio is higher the lower the number of firms J which produce the domestic good. Finally, the labor demand of firm i is obtained by replacing eqs. (S) and (9) in the first-order condition:
According to this expression, Lj increases with aggregate liquidity measured in wage units (M/S), and decreases with the firm’s relative wage (Sj/S). Notice that if the labor market were competitive, the nominal wage Sj would be the same for all firms (Sj=S=S,) and there would be full employment (1 Lj = JLj= I). For the sake of simplicity, let us assume that the equilibrium real wage is equal to the reservation wage D.4 Then, the price level associated with a competitive labor market is V,=S,/D, so that eq. (10) implies V_J-l O--J
m
a+p
M or’
(11)
4. Bargaining and welfare The utility of union member i is obtained by replacing eqs. (4) and (5) into (1’); it depends on whether he has a job (Li= 1) or remains inactive t&=0). The objective function q of union h is the average utility of its members:’
M~t+&+s&h V”
_DL
h f 1
Tonsidering the general case in which the equilibrium real wage is above D, as in Rama (1990) does not modify the basic results of the model, while leading to heavier calculations 51t is implicitly assumed that trade unions have all the same ‘size’, so that each of them has I/H members and operates over J/H firms. For simplicity, such ratios are treated as integers, although this is not necessarily the case.
410
M. Rama. Bargaining slructure and economic performance
In this expression, Sh is the nominal wage paid by the firm(s) in which trade union h operates, while L, represents employment at the level of the firm, the sector or the whole economy, depending on the centralization degree of negotiations. M,, and B, result from adding up Mi and Bi over the I/H union members. Finally, V, is the aggregate price level when there are H trade unions. The number of individuals 1 being large compared to the number of trade unions H, it can be accepted that M,= M/H and B,= B/H.6 Aggregate profits B, in turn, can be written as B= YP--SjLj=p i
‘+’
1-a-B
M-&L,,-
c
SkLk
k#h
[see eq. (8)], with c ‘.+,,S&=O if H = 1. Replacing B/H in the analytical expression of T, yields [M/(1-a-B)l+(H-1)ShLh-Ck+hSkLk
h’fh by M/H and B, by
_DHL
1 (1”) _
h v,
Notice that this equation is significantly different from standard unions’ objective functions. Usually, the rent specification is chosen, so that trade union h would maximize r[(S,/V,)-D] Lh [as in eq. (l)]. Such a specification provides an accurate approximation to the expected utility of union members in a context of highly decentralized wage bargaining.’ But this is no longer true in sectoral or centralized settings, since each of the unions has an incidence on the real value of both profits and money balances. Trade union h chooses the wage level Sh so as to maximize q. subject to the labor-demand schedule Lh [drawn from eq. (lo), by aggregation] and to price equations (5) and (9). Taking into account that Sh =Sk= SH in equilibrium, long and tedious calculations yield for the optimal real wage wH=s,/vH: &I = f(a, P, J, HP
(3’)
with
This result allows to discuss the outcomes of a wide variety of institutional ‘In equilibrium,all trade unions set the same nominal wage and have the same employment level. Hence, all individuals have the same ‘average history’, no matter the trade union they belong to. ‘In that case, V, can be taken as given, while H/(H - 1) = 1.
M. Rama, Bargaining structure and economic performance
411
arrangements, ranging from wage bargaining at the firm level (H =J) to centralized negotiation (H= l), and including multiple intermediate settings. The discussion is carried out under the assumption that the number J of domestic firms is large enough to allow taking limits in eq. (3’). Thus, for HZ 2, f(e) = H/(H - 1). In the particular case of a fully decentralized negotiation, H( = J) is also large, so that f( .) = 1 and the real wage W, equals the reservation wage ti. Therefore, bargaining at the firm level leads to the same outcome as perfect competition in the labor market, the real wage being higher in sectoral settings, as suggested by Calmfors and Driftill (1988). However, the real wage may be even higher in the fully centralized setting. If H = 1, then f(.) =(a+/I)2/a, so that the relationship between W, and W, ( =20) depends on parameters a and 8. Let X= /I/(a +/I) be the openness coefficient of the economy, i.e. the ratio between imports and total consumption. This coefficient is constant because of the Cobb-Douglas specification for preferences at home and abroad, which implies that the price elasticity of the demand for goods is equal to one. Eq. (3’) implies that WI is higher the higher X. Particularly, WI > W, if X > 1-,/(a/2). Hence, there is a hump-shaped pattern for real wages only in economies which are barely or moderately open. Indeed, W2> W, >D if 1 -J(a/2) > X > 1 -da. Besides, according to eq. (3’) W, would fall below the reservation wage for X< 1 -,/a. Since nobody would work in these circumstances, the central trade union has to choose the corner solution WI = D, the same as in the closed economy. The main difference with the closed-economy analysis comes from the fact that now the real wage pattern may not convey enough information concerning economic performance. This is because higher wages have two opposite effects on welfare. On the one hand they lead to unemployment, thus reflecting an inefficient resource allocation. But on the other hand they raise the price of the domestic good, thus improving the country’s terms of trade. The final impact on welfare depends on the relative weight of these two effects. Consider the welfare function U, defined as the sum of utility Ui over the I individuals.8 Under the assumptions of the model, the objective function Ti of the central trade union is nothing but U/Z (see eq. (l”)]. Hence, the maximum welfare level corresponds always to centralized wage bargaining. Notice that in moderately or highly open economies, such a maximum is associated with a real wage W, above its market-clearing level D. More generally, the welfare function U is I times the utility G of the representative union member. Since all trade unions set the same wage, S,, and St can be replaced by SH = W,V,, in eq. (l”), whereas Lh and Lk can be *This welfare function is chosen based on the Hicks-Kaldor individuals’ utility is a linear function of individuals’ real wealth.
compensation
criterion,
since
412
,Vf. Rama, Bargaining
structure
and economic
performance
replaced by JL,/H. Taking eqs. (2), (5), (9), (10) and (11) into account, the welfare level UH can be written as
(1-a For H 22, and provided that the number of firms J is large enough to take limits, eqs. (3’) and (12) imply
du, sign dH -[
1
_ -sign{[a-(a+/?)2]H+(a+/l)2).
(13)
This result allows to distinguish three different cases depending on the value of the openness coefficient. When the share of imports in total consumption is low (Xc 1 -,/a), then dUJdH >O, so that negotiation at the firm level is better than sectoral wage bargaining. In addition, the former leads to the same outcome as centralized wage bargaining (W,= W, =D). Hence, extreme settings are equivalent in barely open economies. The equivalence does not hold anymore for large values of the openness coefficient. Indeed, if the economy is highly open [X> 1 -,/(r/2)], then dUJdH ~0. The best performance being always associated with H= 1, the relationship U, 2 U, is necessarily fulfilled. Therefore, welfare is an upward function of the centralization degree of negotiation, the worst outcome corresponding to negotiation at the firm level. Finally, for intermediate values of the openness coefficient eq. (13) implies that there exists a number of trade unions H =(a +j?)2/[(a + j?)2 - x] > 1, such that dU,,/dH = 0. Hence, welfare increases alongside the centralization degree of negotiation, until reaching a local maximum for some sectoral setting. Since the highest welfare level is attained in the centralized setting, the existence of a local maximum suggested that moderately open economies may be characterized by a ‘sectoral bargaining trap’. Figs. 1, 2 and 3 represent the relationship between the welfare level and the number of trade unions depending on whether the domestic economy is barely open, moderately open or highly open, respectively.
5. Concluding remarks Although it seems nowadays accepted that both centralized wage bargaining and negotiation at the firm level perform better than sectoral wage bargaining, the ranking may be quite different in an open economy. This is because higher wages push up the price of the domestic good, thus improving the terms of trade, much the same as a tax on exports in the
M. Rama. Bargaining structure and
Welfare
economic
performance
413
level
1 Intermediate
Negotiation
settings
by firms
Centralized negotiation
Fig. 1. Barely open economy.
Welfare
level
_;:
Negotiation by firms
Intermediate settings
Centralized negotiation
Fig. 2. Moderately open economy.
optimal tariff literature.’ The difference lies on the nature of deadweight costs: going through the labor market gives rise to unemployment, whereas some consumer surplus is lost when levying taxes on foreign trade. In the ‘The idea is not new: Latin-American economic thought traditionally pointed out the role of labour market institutions in the ‘centre’ as a source of unfavourable terms of trade for the ‘periphery’ [Rodriguez (1980)].
hf. Rams, Bargaining structure and economic performance
414
Welfare
Negottalion by firms
level
lntermedtate settings
Fig. 3. Highly
Centralized negottatlon
open economy,
general case, the first of these two costs is likely to be higher, since Harberger triangles are seldom significant. Yet union activities are not subject to retaliation by foreign governments, as may be the case with trade policies. ’ O Needless to say, the discussion in this paper is based on a simple case, so that the results may not generalize. In order to get an analytically tractable setting, very simple specifications were chosen for the individuals’ utility function and the lirms’ production function. Besides, there are obvious criticisms to the equilibrium concepts used for both the goods market and the labor market. However, the model provides interesting insights into the relationship between the bargaining structure and economic performance in the open economy. It suggests, particularly, that the relationship does not depend on the centralization degree of negotiation only, but also on the ‘quality’ of the external insertion of the economy. Indeed, in order to improve welfare by raising wages, foreign demand must be less than infinitely elastic. In addition, there must be a productivity gap with the rest of the world, because otherwise the latter would start producing the domestic good. Finally, imports must represent a significant share of domestic consumption. The
“‘Similarly, the effects of a higher centralization of wage bargaining could be compared to those of firms’ collusion. In this case, an important issue is whether agreements involving a large number of firms can be actually enforced. By contrast, cooperation among workers in the context of trade unions has proved sustainable.
M. Rmm. Bargaining structure and economic performance
question remains to what extent different bargaining structures downgrade such a ‘quality’ in the long run.
415
improve or
References Blanchard, 0. and N. Kiyotaki, 1987, Monopolistic competition and the effects of aggregate demand, American Economic Review 77, no. 4, 647-666. Cahuc, P. and A. Zylberberg. 1991, Niveaux de ntgociation salariale et performances macroeconomiques. Annales d’Economie et de Statistique 23, I-12. Calmfors, L. and J. Dritlill, 1988, Bargaining structure, corporatism and macroeconomic performance, Economic Policy 6, 16-61. Dixon, H., 1990, Macroeconomic policy with a floating exchange rate and a unionised nontraded sector. Economic Journal 100, Supplement, 78-90. Horn, H. and T. Persson, 1988, Exchange rate policy, wage formation and credibility. European Economic Review 32, 1621-1636. McDonald, 1. and R. Solow, 1981, Wage bargaining and employment, American Economic Review 71, 896-908. Oswald, A., 1985, The economic theory of trade unions: An introductory survey. Scandinavian Journal of Economics 87. no. 2, 160-193. Rama, M., 1990, Wage bargaining and economic performance in the open economy, Mimeo. (CINVE, Montevideo). Rodriguez, O., 1980, La teoria de1 subdesarrollo de la CEPAL. Siglo XXI, Mexico. Van Wijnbergen, S., 1987, Tariffs, employment and the current account: real wage resistance and the macroeconomics of protectionism. International Economic Review 28, no. 3, 691-706. Winckler, G. and E. Amann. 1986, Exchange rate policy in the presence of a strong trade union. Journal of Economics, Supplementum 5, 259-280. Yip, C., 1988, The employment effects of tariffs in an efficient bargain model. Journal of Macroeconomics 10, no. 3 477-485.