Price Externalities

The discussion of price externalities, re-initiated³¹by the important contribu-tion of Calmfors & Driffill (1988), plays an important role in the centralisacontribu-tion debate since then. Since the argument is very simple, we will give here only a short verbal summary of the argument. By the way, Calmfors & Driffill did not provide an explicit formal presentation of the argument. Instead they showed the results on the basis of numerical simulations. An elegant formal

31It is interesting to note that the US government attempted to foster centralisation of bargaining institutions after the Korean war, and that this attempt was justified by sim-ilar arguments. The Construction Industry Collective Bargaining Commission (CICBC), was established 1969 with the intension, “to curb the excess of decentralised, locally au-tonomous bargaining by adopting procedures to strengthen the role of the nationale labor organisation and the national associations of contractors...”, see Hartman & Franke (1980).

The CICBC was, however, unsuccessful and short-lived. About ten years later, the gov-ernment tried to impose direct controls in order to tackle significant increases of wages in the construction industry.

formulation contains Hoel (1991) which is summarised in Hoel et al., 1993.

The Argument

Consider an economy with identical firms. If wages of a firm are raised by its union, this (in general) induces an increase of its output price. In general (we will discuss special cases below), this generates an externality since the output price increase raises the aggregate price level and decreases real wages also in the rest of the economy. By this, it creates an incentive for an individual local union to realise areal wage increase by shifting part of the price effects to the rest of the economy. The evolving externality depends on the elasticity of output prices with respect to wages and on the elasticity of the aggregate price level with respect to an individual firm’s output price.³² It is clear that the externality disappears in local wage setting under per-fect competition since then an individual firm cannot raise its output price.

Consequently, the union considers the aggregate price level as independent of its behaviour and has no price-shift incentive. This is not valid any more, however, under monopolistic competition. In this case, a firm can shift part of the wage increase to its consumers and thus induces its union to exploit the ‘beggar my neighbours’ mechanism (Hoel, 1991). The externality van-ishes in completely central wage setting since then wages of all workers are arguments of the union utility function. Basically, Calmfors & Driffill’s argu-ment can be interpreted as an application of an important aspect if Olson’s (1965) theory of groups: Small groups are forceful because they are not urged to care about the externalities they exert on the rest of the economy when pursuing their interests.

A closer inspection of the issue reveals that the relation between the lev-els of bargaining (centralisation) and wages may be nonlinear if intermediate levels are considered too. Specifically, Calmfors & Driffill claim that inter-mediate levels of bargaining are associated with higher wages (and lower employment) than completely centralised and decentralised ones. This is the celebrated hump-shape hypothesis. Again the argument is very simple.

Products of firms within an industry (e.g. butter from firm A and but-ter from firm B) are closer substitutes than between industries (e.g. butbut-ter and furniture). Therefore competition between firms of the same industry is more intense than between industries.³³ Consequently, industry unions are able to exploit the output price externality if they rise all wages in a sector

32The external effect can be decomposed further. For example, it works also through input-output relations, since the output of some firms are inputs for others.

33This idea is not new. Marshall has pointed to this fact already a century ago.

simultaneously. On the contrary, local unions are defeated by the high price elasticity within industries.

The results from the analysis can be summarised in three points: (1) De-centralised and De-centralised wage setting generate equivalent outcomes under perfect competition. (2) Under monopolistic competition, complete central-isation is superior since price externalities prevail with local wage setting.

And (3), intermediate levels of bargaining are generally inferior.

Empirical Relevance

Since the empirical relevance of the argument depends on the magnitudes of the involved elasticities, an empirical evaluation of the argument could, in principle, be performed by estimating these elasticities. Unfortunately esti-mates of these elasticities (especially at the firm level) are hard to obtain, at best with huge errors. Therefore almost all empirical studies concentrate on themacroeconomicrelation between the level of wage setting and the macroe-conomic indicators wages, inflation and unemployment. We have shifted the discussion of these applications to a special section (2.5), since the empir-ical evaluation of the argument is associated with several econometric and measurement problems (demanding an extensive discussion), and the empir-ical literature has grown considerably in the last decade (demanding much space).

Two intuitive theoretical criticisms of the hump-shape argument can be summarised here, however: Danthine & Hunt (1994) point to the fact that firms of an industry compete with firms of the same industry in foreign countries. Therefore the impact of the price externality should be correlated negatively with the degree of openness for international trade and the hump-shape should disappear in small open economies.

Rowthorn (1992) shows in an extension of Calmfors & Driffill’s (1988) simulation model that the hump-shape levels off under moderate cooperation of industry unions. He formalises cooperation by assuming that individual unions maximise a weighted sum of their own member’s utilities and the utilities of workers in other industries.³⁴ In his simulations the hump-shape flattens significantly even with moderate weights for workers from other in-dustries.

34Rowthorn argues that cooperation be not necessarily driven by altruism, but may also result from intertemporal optimisation.