Labour Markets
Productive unions

In search and matching models of the labour market, the optimal level of employment depends on the specification of workers' and firms' search strategies. In Discussion Paper No. 882, Eric Smith develops such a model in which productivity falls with firm size, and bargaining over productivity causes wages to fall as the labour force increases. Firms' resulting savings induce them to hire excess labour and become inefficiently large, but this expansion of labour demand also reduces the probability of matching for particular vacancies, raises the expected costs of opening vacancies, and induces some exit. Having fewer but larger firms thus reduces overall employment, vacancies and aggregate output.

Smith proposes breaking the link between wages and marginal productivity, for example by introducing a fixed wage, in order to reduce firm size. Setting this wage close to the bargained wage could raise equilibrium employment and vacancies and hence workers' matching rates and expected utility. With more workers employed and also more productive, output rises, so the important issue for policy is how to discourage individualistic worker-firm bargaining. Minimum wage legislation can achieve this only for jobs at or below the minimum wage, but collective bargaining by unions that negotiate wages for all workers simultaneously can raise productivity and reduce firm size more generally. Unions reduce employment only at the firm level, so aggregate employment increases, which may account for the relatively low unemployment found in economies with strong unions and rigid pay, such as Sweden.

Smith concludes by likening this pro-union argument to the case for monopsonistic unions in neoclassical markets, which improve economic performance by setting wages bilaterally rather than unilaterally. His model demonstrates that the establishment of collective bargaining can also influence the wage setting environment to raise wages, output and employment in a free-entry economy with many workers and firms.

Search, Concave Production, and Optimal Firm Size
Eric Smith

Discussion Paper No. 882, January 1994 (HR)