Labour Market Perfection & Imperfection and the Minimum Wage Debate in Singapore Chan Chi Ling, June 2011 for the Center for Public Economics, Singapore The Classical Perspective: Flexible Labour Markets Classical economic analysis treats labour as a factor input as being driven by the same dynamics as markets for other goods. Labour demand and supply determine employment levels, with wages as the key incentive and price signal. Perfect competition ensures that workers are paid their marginal productivity. When more workers are needed to meet increases in demand for goods and services, firms are willing to offer higher wages to attract more workers to supply their labour. Conversely, falling demand for labour causes the wage rate to decline. If wages fall below the marginal productivity of the worker, rational workers will choose to withdraw from the labour market altogether, reducing labour supply and driving wages up. This implies that labour markets are self-correcting and there will never be a surplus or shortage of labour in the long term. All unemployment is purely voluntary. The smooth operation of the labour market and the effective role of wages as price signals reflecting marginal productivity depends on several key assumptions: 1. There is an absence of wage setting power, so that wages can adjust freely and are determined solely by supply and demand. 2. There is perfect information, so that firms can effectively discriminate between different worker productivity levels, and workers are aware of the value of their labour supplied. It follows that each worker is always paid a wage equivalent to his or her marginal productivity. 3. Transactions are smooth and costless, enabling workers to find jobs, and firms to hire and dismiss workers, without any search costs or other barriers.
4. All parties are perfectly rational and make labour demand and supply decisions purely on the basis of maximising their personal utility. Rethinking the Assumptions Various economists have argued that the view outlined above is an overly optimistic description of reality, and that labour markets are afflicted by pervasive market failures and imperfections. These factors in turn undermine the key assumptions underpinning the classical economic model of the labour market. Presence of Market Power, Labour Institutions In reality, workers have limited job mobility due to geographical immobility, heterogeneous job preferences and moving costs, potentially giving their employers a monopsonistic advantage. This is especially so during a recession when there is significant unemployment that raises opportunity cost of quitting one s job and lowers the probability of finding a new one. This gives firms more bargaining power and wage-setting ability over workers, implying that at least in some markets, wages are determined by forces beyond demand and supply. On the other hand, workers are represented by unions that accrue them bargaining power through collective action. Economists have argued that some unions may block pay cuts, or demand a wage increase that outstrips inflation rate and productivity increases, accounting for the general downward rigidity of wages. The presence of market power and labour institutions therefore undermines the classical assumption that wages can adjust freely and solely according to demand and supply. Broad empirical conclusions in OECD studies suggest that the presence of labour institutions and market power matter for the speed of labour market adjustments 1. 1 Scarpetta, S. 1996. Assessing the role of labor market policies and institutional settings on unemployment: a cross country study, OECD Economic Studies, vol 26, pp. 43-98.
Information is not perfect Consider an employer who wants to hire a productive employee. All prospective employees would claim to be productive, but it is often costly and troublesome to measure their true productivity levels or to determine the true value of their work. For instance, while it is relatively easy to measure a farmer s marginal productivity by quantifying his crop yield, it is much more difficult to determine the marginal productivity of a company director with subjective performance data. This problem is further compounded when workers must perform as part of a team, where productivity is determined by variables such as team dynamics. As a result, workers usually has a clearer idea of their own productivity than firms do, and firms know the value of a given job better than employees themselves do. Such information asymmetries partly explain why employers tend to pay employees an efficiency wage that is above the market clearing wage. Since they can never determine the precise productivity levels of worker, paying them a wage above market clearing level creates incentives for employee not to shirk, reduces turnover and encourages higher morale, which can contribute to higher productivity 2. Theoretically, this increased productivity then justifies the higher wages. According to Edward Lazear s Tournament Theory, some firms simply rank their workers according to their relative job performance, setting a virtuous rat-race moving by spurring competition to the top which increases productivity. This often leads to some workers being over-paid and others under-paid, which explains why the highest paid top executive can enjoy a salary 100 times that of the lowest paid staff in some firms. Another instance of imperfect information highlighted by behavioural economists is that of money illusion, which occurs when decisions are influenced by nominal dollar amounts. Consider a worker who is paid at a wage equivalent to his marginal productivity, priced at $1000 a month. His employer gives him a 5% increase in wages, but the inflation rate is 10%. The net effect is a 5.5% loss in real wages; in other words the worker s wage rate now falls below his 2 According to Akerlof s Efficient Wage Hypothesis.
marginal productivity, but the worker instead of withdrawing from the workforce may perceive himself to be better off than before and stay on his job. In fact, according to the giftexchange hypothesis, he is likely to work even harder to reciprocate the act of goodwill if he perceives it to be so. Transaction costs exist A related point to imperfect information is the transaction cost that arises out of frictions involved in job-search, and costs of firing on the part of employers. Workers have limited information about available jobs; a worker who wishes to land himself in the best possible job that pays him his marginal productivity will need to find information, which.is a process that takes time, effort and sometimes sacrifice of current earnings. Moreover, in countries where pension schemes are not easily transferrable, quitting the job may mean a loss in pension funds for the employee. Similarly, there are hire and fire costs for the employer. In finding the suitable employee the employer faces search costs due to imperfect information, and dismissing a worker often incur costs to varying degrees. In countries with labour-market protections particularly employment protection in the form of stringent firing restrictions dismissal of workers can be costly and may dampen the response of job destruction to changing market conditions. The above market imperfections undermine the efficacy of labour markets and their ability to set wages that reflect marginal productivity. However, there is a more fundamental challenge to the classical model of the efficient labour market, and that has to do with the very assumption that economic agents are perfectly rational. People are not perfectly rational (not in the classical sense, at least) Under classical analysis, a worker who does not quit his job even when wage is below marginal productivity is irrational; the same goes for the employer who pay more than he needs to
because in both cases they are not maximising their utility. However, the fact remains that people rarely quit their jobs in recessions 3, and employers frequently pay more than they need to (as in efficiency wage theory). When unemployment is high, as Keynes and Keynesian economists such as George Akerlof and Robert Schiller explains in their recent book Animal Spirits, relatively few people will quit their jobs because they count themselves lucky to be in a job during bleak economic times even if their wages are below marginal productivity. Another explanation could be status quo bias: workers who have developed workplace attachment may resist changes in work environment in preference for maintaining the status quo even if the wage incentivew fall short. There is also evidence of anchoring, in which incumbent workers assess fairness of wages based on relative wages internally within the firm (or with their starting pay) rather than comparing them to what they could have got in the labour market at any point of time. In other words, what workers perceive as a fair wage may be affected by factors beyond marginal productivity. In the classical model, fairness concerns are irrelevant, but empirical evidence tells us that people do care about fairness, and fairness concerns impact productivity levels 4. For instance, employers resist pay cuts largely because of the strong effect of loss aversion on fairness judgement 5. A small decrease in the wage does more damage to fairness judgements than a small increase in the wage does to boost fairness perceptions. Therefore, overall and above the loss in real wage, individuals consider nominal wage cuts particularly unfair. The result of a wage cut is then falling morale, which raises staff turnover and reduces productivity, in turn outweighing firms savings from wage cuts. In response to such behavioural traits, employers typically prefer layoffs to pay cuts since the latter usually affects everybody and the former only a selected minority 6. This partly 3 According to a study by George Akerlof on the US market, when unemployment goes up by 1 percentage point, the monthly quit rate per hundred employees falls by 1.26. [Akerlof, George A., Andrew K. Rose, Janet Yallen. 1988. Job Swtiching and Job Satisfaction in the U.S. Labour Market Brookings Papers on Economic Activity. 4 Cite Gift-Exchange Hypothesis, Ultimatum Game. 5 Truman Bewley. Why Wages Don t Fall During a Recession. Harvard University Press, 2000 6 This point is supported also by a model discussed by Ernst Fehr, Lorenz Goette, Zehnder, which makes the prediction that employment should be more volatile than wages. Reason being, in the fact of a positive demand shock, rising employment lowers a firm s average profit (because of diminishing returns to effort). This leads the employees to work harder for a given wage, because their wages are not higher relative to the average profit the firm makes per worker. This increases workers effort, but does not require that the firm pay a much higher wage. Hence most of the firm s adjustment will come through changes in employment, making the wage relatively unresponsive to changes in demand on the product market. (see Danthine and Kurmann 2004)
explains the general wage rigidity observed in the labour market, and why involuntary unemployment is commonplace during downturns. Having examined instances of bounded rationality and other behavioural traits of people, the classical standards of rationality appears unrealistic. We are indeed far from being J.S Mill s Homo Economicus, a human calculating machine who spends his life computing with perfect rationality strategies that maximize his own utility. The many market imperfections and cognitive complications discussed above suggest that imperfect market is probably the norm rather than the exception. Wages are sticky, wages do not always equal marginal productivity, and people are not always rational. Nevertheless, what we have observed is that in the past three decades, the new classical paradigm with its Panglossian vocabulary of Rational Expectations Hypothesis and Efficient Market Hypothesis has gained popularity. So what? Implications for policy design If we accept that markets can never be perfect, then as an economic model the classical paradigm is inherently an inadequate reflection of reality. Not only does this open up the model to a degree of indeterminacy, it generates potential room for institutional intervention and policy activism. But perhaps perfection and imperfection is a matter of degree than of kind. Ultimately, it is more constructive to view the classical model as an ideal type that is necessarily reductionist but nevertheless useful in predicting labour market outcomes. We can relax assumptions and accept that labour markets can never be absolutely perfect, in which case a relevant policy question to ask is this: To what degree is the market perfect/imperfect? If a labour market is largely (but not absolutely) perfect, it implies that the forces of demand and supply are working largely unimpeded to achieve an efficient market outcome. In this case, it might be wise to rely on the functioning market mechanism, but apply specific, well-targeted
policies to correct specific market failures and imperfections. The first-best policy approach targeting the problem directly at the source of the market imperfection would be desirable. For instance, if the market does not function efficiently due to information imperfection, the preferable thing to do is not to introduce a fundamental market distortion that is potentially destabilizing, but to correct it at its source by providing more information - just as a wheel bearing can be made to function more smoothly by applying grease instead of going to great lengths and changing it altogether. However, if we know that a market is subject to fundamental, wide-ranging flaws that make it highly imperfect, then there is a case for more substantial governmental intervention involving wide-ranging, structural reforms. This is in line with the Lipsey and Lancaster s theory of the second best 7, which suggests that if one industry can never satisfy all the conditions for perfect competition, it is no longer clear that the optimal is to move towards perfect competition; in this case it might be justifiable to introduce a distortion that moves the market further away from perfect competition. This, alongside grounds of equity, has lent weight to interventionist measures such as anti-trust competition policies. Knowing whether a labour market tends towards perfection or imperfection has important implications. Consider, for instance, the recent debate on minimum wage in Singapore ignited by concerns over high inflows of low-skilled foreign labour dampening wages at the low end. If the labour market is largely perfect, the problem lies not with the inefficiency of the market mechanism, but in its failure to produce socially-desirable outcomes. Instead of distorting the already efficient market through a minimum wage, it is probably more desirable to mitigate rising income inequality through income redistribution. The Workfare Income Supplement is a prime example of how a government can legitimize market outcomes without distorting price signals and undermining efficiency of the market. If the labour market is largely imperfect, say, due to the widespread monopsonistic power 8 of employers over employees, then there is a stronger case for imposing a minimum wage to resist suboptimal wages. In this case, a possible 7 R.G. Lipsey & Kelvin Lancaster. 1956-1957. "The General Theory of Second Best," The Review of Economic Studies. 8 The greater bargaining power of employers can give firms a considerable degree of wage-setting power, forcing some workers to accept low wages and conditions they would not have accepted in a more perfectly competitive labour market.
countervailing measure could be imposing a minimum wage that resists unfair wages, in essence correcting an existing distortion with another distortion as the second-best theory would have it. But how do we know? The question that necessarily follows is this: How do we know whether a labour market tends towards the classical model of flexible labour market or one that is highly imperfect? Unfortunately, there is no clear answer. We know that if a labour market is absolutely perfect and efficient 9 (as in the classical model) the wages of workers necessarily equal their marginal productivity, the market clears and so there is no unemployment. In reality, however, it is extremely difficult if not impossible to measure precisely the marginal productivity of individual workers in the market and determine if their wages correspond. So there is no sure-fire way of knowing whether a market is perfect. It is unsurprising, therefore, to find economists being divided when it comes to assessing whether the current labour market is competitive or monopsonistic. On one hand are economists who claim that the current labour market is monopsonistic due to an imbalance in bargaining power between worker and employee. This may be due to the deeper financial clout of firms compared to the thinner resources of low-skilled workers and the lack of social safety nets such as unemployment benefits, thereby undercutting workers bargaining power. Moreover, the fact that the National Wage Council explicitly encourages wages to lag behind productivity gains in the long term and to base wages on profitability levels of firms further increases the wage-setting power of firms, and the incidence of wages falling below marginal productivity. On the other hand are others who suggest substantial evidence pointing to a relatively flexible labour market: For one, our small size has made geographical immobility within the country almost irrelevant. Secondly, the absence of unemployment benefits minimizes disincentives that discourage workers from working. Thirdly, transaction costs have been kept low since there are 9 Which also implies an absence of market imperfections in which case there is no market power or labour institutions impeding the invisible forces of supply and demand at work, no imperfect information, no transaction costs, and people are perfectly rational.
few hiring and firing restrictions. Also significantly, the National Wage Council has tried to minimize wage rigidity through the introduction of the Flexible Wage system in 1987 which promotes a wage system that is performance-based and responsive to business cycles. Paradoxically, the rising income inequality with the influx of immigrant workers is a possible outcome of a well-functioning labour market given that low skill wages are adjusting downwards to account for the influx of cheaper low skilled labour. There is a case to be made for both viewpoints, and it is not entirely clear where Singapore might stand between the two extremes of market perfection and imperfection. One thing, though, is more than clear: The current market outcome is unsatisfactory given the widening income gap that it brings and this begs questions of social legitimacy. In a think piece 10 about minimum wage in Singapore, Tommy Koh argued: Is it not true that the market is not infallible? Is it not true that, when there is a market failure, the state should intervene in order to make the world a fairer one? The writer of this article entirely agrees, and would go further to say that the type and nature of the market failure matters too since it has important policy implications. In the final analysis, it is not a question of whether the government should intervene to correct market fallibilities, but how to do so to the best of effect. And this, as this article has shown, is not as clear-cut as it seems. 10 Tommy Koh. 11 November2010. Don t Knock Minimum Wage Yet. The Straits Times, Review. A32