GLASGOWCALEDONIANUNIVERSITY
DEPARTMENT OF ECONOMICS
Labour Market Theories – Competition and Segmentation
(Concepts and Methods in Economic Analysis coursework)
Victoria Iliassova
BA Honours Business Economics
Level 4
Module Leader: Geoff Riddington
February 2000
Introduction
Labour markets are extremely important for majority of individuals and aggregate economy as a whole. Operations of labour market determine standard of living and welfare of individuals as well as efficiency of the aggregate economy. Some argue that of the many markets that exist in a modern economy the market for labour is the most important (Elliot, 1991).
Due to a special character and human dimension of labour services (e.g., “free will”, morale and motivation of workforce), the nature and operations of labour markets are very different from markets for other factors of production.
Analysis of labour markets is further complicated by the fact that there is no such thing as a pre-defined labour market and it may often have quite a vague reference. Labour market is essentially what one defines it to be for a particular case. Labour markets are usually defined on a geographical, skill/occupation or industry basis. Aggregate markets are formed from individual sub-markets and degree of movement between them is an important factor in defining what a labour market is.
Labour economics comprises numerous interrelated and overlapping theories that attempt to explain how labour markets operate. Conventionally the theories are analysed within the scope of School of thought, which developed them such as Neo-classical, Institutionalist or Radical-Marxian. However, with time, even within these theories, particularly within Neo-classical approach, there developed such an enormous range of opinions and theories that to refer to them in conventional way appears no longer to be very useful as a means of specifying a particular belief or approach (Adnett, 1996). A dichotomy between competitive and non-competitive or segmentation models of the labour markets is sometimes suggested to be more useful, particularly for consideration of labour market policies.
Competition models
Orthodox Neo-classical approach to labour markets is essentially a competitive model. It starts with several quite restrictive and unrealistic assumptions of perfect competition, homogeneity of workers, perfect information and labour mobility. Orthodox theories have internal differences of their own, but there is general agreement on the following points.
First is the central role of maximising behaviour on the part of economic agents – individuals, households and firms – subject to well-defined technological and budget constraints. In particular, individuals are assumed to be striving to maximise their utility from consumption of goods and leisure subject to time and wage rate constraints. Labour supply is determined by individual’s choice between work and leisure and is a function of real wage, non-labour income and tastes. The slope of the labour supply curve is determined by the relative degrees of income and substitution effects but is normally assumed to be positive. On the other hand, competitive model assumes that firms aim at maximising profits and therefore employ labour up to the point where marginal cost of labour is equal to its marginal revenue product. Demand for labour is a derived demand from a demand for goods that the labour produces. The price that the buyer of labour is willing to pay is related to the market value of an employee’s output (the revenue that the firm obtains from selling the output of labour). Labour demand is a function of technology, price of the good produced and the wage rate, and is downward sloping. Supply of and demand for labour interact, determining the static and dynamic wages and employment outcomes. Utility-maximisation by workers/consumers and profit-maximisation by firms are very important competitive conditions.
Second is the principle of substitution. Individuals and households are assumed to choose from a wide range of commodities and to allocate their time between many different activities. Firms select techniques of production and levels of input usage from the large number, which are available, while workers optimise in their choice of jobs, work and leisure. In competitive theory of labour, choice is the “basic behavioural mode” (Harrison et al., 1979), and the whole labour process is said to consist of the working out of essentially harmonious interests between worker/ consumer and producers.
Third is a strong tendency for markets to clear. Economic agents are assumed to be in, or rapidly approaching equilibrium. The emphasis of competitive theories is on labour markets responding to market forces. Whilst the auction market is recognised as an over-simplification, wages, according to competitive theory, do move to equilibrium levels and do produce market-clearing adjustments in labour supply. Though some rigidity in absolute and relative wage levels in the very short-run is recognised, for policy purposes labour markets are viewed as flexible-price markets.
Fourth is a deep suspicion of explanations, which run in terms of habit and custom, collective against individual decision-making, or the idiosyncrasies of human institutions.
The competitive model described above is a wage competition model. Wages are assumed to be determined competitively by the forces of supply and demand and to respond readily to shortages or surpluses of labour in the various markets. Wages tend to adjust to equilibrium level. The pay structure within a firm is expected to contract or widen accordingly as the relative balance of supply and demand for the jobs in the market as a whole changes. According to the competitive theory, it is the price that adjusts to bring supply and demand into balance. Yet, in the real labour market it is very difficult to see this presumed adjustment process at work. There are many criticisms of the orthodox competitive labour market theory, which stem to a large extent from its unrealistic assumptions. It fails to explain many important phenomena of real world labour markets. There have been several attempts in the form of other additional theories to adjust and improve competitive model and to reconcile it with real world observations. At the heart of the standard competitive view of labour markets there are many theories that are consistent with each other.
Theory of Equalising Differences is fundamental to the competitive theory and was first formulated by A. Smith. It states that intense competition for better-paid jobs (i.e. increased demand for more advantageous jobs) should in the long run result in the lowering of their advantages as wages fall and, conversely, continuous quitting of lower-paid or less desirable jobs in search of better ones (i.e. decreased demand for less advantageous jobs) should in the longer term result in employers having to raise wages to retain or attract labour. This process is expected to continue until the advantages and disadvantages of different jobs are equal. It follows then that if all other conditions of employment are the same across the jobs, wages should tend to equality. As many of the conditions of different employments are not the same, wage differentials are observed. The long-run movement towards equalising wage-differentials means that any persisting differentials, after adjustment for the non-pecuniary aspects of the employment, reflect differences in employee productivity, due to uneven investments in education, training and experience.
Efficiency Wage theory states that employers may pay wages in excess of market clearing rates because it results in good incentives and beneficial productivity effects. Shirking model, Turnover model, Superior Job Applicant model and “Fair” Wages model can all be grouped under the heading of Efficiency wage Theory.
Human Capital theory is another development of the competitive theory. Human Capital is skills and knowledge, embodied in the workforce. This concept is extensively used in both competitive and segmentation theories. Human Capital theory allows for the assumption that the workers are homogeneous to be relaxed. The theory focuses on compensation for the cost of investments in education and training. Under this theory, the structure of earnings is highly dependent on the costs of these investments, including the foregone earnings associated with time spent in education and training. Wages and productivities adhere to the jobs themselves, not to the capacities of individual workers per se. On-the-job training is argued to be the cheapest method of training in most cases, and access to primary sector jobs becomes a prerequisite for enhancing human capital. Therefore, most job skills, general or specific, are acquired either formally or informally through on-the-job training after a worker finds an entry job and associated “promotion ladder”.
Education and training are seen as investments into Human Capital. The theory states that firm’s decision to train its workers is an investment decision and is based on a “rate of return” concept. Firms provide on-the-job training if the discounted benefits from that investment cover the costs of training and compare favourably with returns from alternatives. The training is provided by the firm only if it is specific to the firm and trained workers cannot subsequently be poached away.
The assumption of perfect information is relaxed within the Search theory, which states that because of a variety of sub-labour markets, information is costly and firms and workers search prior to job-matching causing unemployment and unfilled vacancies.
Various attempts to reconcile competitive view with persistent unemployment and sticky wages have been made in efficiency wage theory, job search theory, job-matching theory and theories of implicit contract.
Segmented Labour Market (SLM) theory
SLM theory is a more complicated explanation of operation of labour markets since its main hypothesis is that labour market is a combination of a series of distinct interconnected markets rather than one competitive market. This distinction arises as a result of existence of barriers determined by geographical, occupational andinstitutional factors as well as social attitudes to gender, race and age.
Segmented Labour Market (SLM) theories were developed as an attempt to explain inequality of opportunity and persistence of poverty that remain as prominent features of modern economies and which orthodox forces of competition failed to eliminate. Segmented labour market theory states that competitive forces in many real world firms are to a great extent “muted” or “shut out” at least in the short run, and have little impact on firms’ wage and employment structure. Such “imperfect” operations remain typical characteristics of many real world labour markets. SLM theory attempts to provide better explanations for them.
SLM theory is now used as an umbrella term for alternative theory developments in labour economics and segmentationist school of thought. It is based on the Institutionalist approach and comprises many diverse and overlapping models of labour markets including dual (primary, secondary), tripartite (core, peripheral, irregular), stratified, hierarchical and job competition model. A fundamental dichotomy between “internal” and “external” labour markets is related to dual and tripartite theories
Clark Kerr divided the labour markets into two groups: “Structureless markets”, which function like Neo-classical competitive markets and where the only attachment between employer and worker is the wage rate, and “Structured markets”, where those on the inside enjoy more favourable treatment than those on the outside. Internal and external labour markets are an example of a structured market. Internal Labour Market (ILM) is “an administrative unit” (workplace or a firm), where pricing and allocation of labour are determined by administrative rules and procedures. Internal Labour Markets can be either horizontal or vertical. The concept of ILM can be traced back to the work of Kerr (1954) and Dunlop (1957), and was fully articulated by Doeringer and Piore (1971) (Adnett, 1996). Internal Labour market is opposed to External Labour market, where pricing and allocation of labour are determined by supply and demand. The two markets are linked by “ports of entry and exit” (i.e. lower paid jobs that are needed to be entered in order to enter ILM and start climbing the promotion ladder). However, the promotion or transfer of workers, who have already gained entry, fills the majority of jobs within ILM. ILM jobs are shielded from the direct influences of competitive forces in the external unstructured market. The mobility between internal and external labour markets is very limited.
According to SLM theory, internal labour markets are generated by several factors not envisioned in conventional economic theory. They include skill specificity, which often arises from the requirements of the technology employed in many firms and the uniqueness of the job that individuals perform; information imperfections and resulting substantial costs associated with obtaining and processing information about potential employees’ productivity; and on-the-job training.
Dual Labour Market theory developed by Doeringer and Piore (1980) is the simplest form of segmentation theory. The theory assumes that the labour market could be viewed as being composed of two sectors: Primary sector and Secondary sector. Primary sector is characterised by consisting of good jobs with good wages, promotional opportunities, good working conditions, job security, powerful trade unions and consultancy style management. The secondary sector, on the contrary, is characterised by having bad insecure jobs, low wages, non-involvement of workers in the decision-making process, poor working conditions and ununionised firms. Mobility between the two sectors is very limited, resulting in a queue for primary sector jobs. Whilst competitive forces may dominate the secondary labour market they are not completely absent from the primary sector. Primary labour markets need to attract entrants and firms in this segment face competition in the product market. These forces may be weak in the short run but cannot be ignored in the long run.
The sharp dichotomy between “good” and “bad” jobs in the dual labour market model appears too simple, and the distribution of the quality of jobs is more likely to be multi-modal rather than bi-modal. The emphasis upon the social foundation of internal labour markets, as opposed to human capital, price incentives and technical efficiency foundations, has produced additional insights into labour market behaviour.
Some argue that the main contributions of SLM approach to our understanding of the operation of labour markets are theoretical modifications and additions to orthodox theory rather than an introduction of an alternative to it (Cain, 1976). As Cain put it, segmented labour market theories are “continuations of older debates” (Cain, 1976).
Contributions of SLM theories stem from their alternative Institutionalist approach to viewing the labour markets. SLM theories do not treat firms and other organisations, representing demand side of labour markets, in conventional orthodox way of dealing with “black boxes”, completely ignoring what is happening inside them. On the contrary, SLM theories provide their explanations by looking at organisational structure, social relationships, custom and power, and by emphasising the importance of firm-specific, internal factors of wage determination and employment. The segmentation theories attempt to explain the development of the institutions themselves as a result of interactions of groups or classes of individuals with objectively different interests. SLM theories concentrate upon the demand for labour as a restrictive force upon earnings of lower class workers and minorities. SLM theories are interested in the market for labour within a particular firm and the structure of pay that emerges as a result. If in competitive theories it is the characteristics of an individual that are important, in SLM theories it is the characteristics of jobs that matter.
Job Competition Model
Job Competition model developed by Lester Thurow (1976) continues the above argument. In this theory Thurow emphasises the attributes of individuals and role of training. He argues that the marginal product resides in the job and not in the man, as it was conventional to believe. Individuals are trained into the productivity of the job they hold. Therefore, the job allocation procedure assumes a much greater importance than it does in wage competition, where an individual’s skills automatically place him or her in some particular job market. The function of the labour market in such a theory is the allocation of “training slots”. On-the-job training is assumed to be the cheapest, most efficient method of training. Employers’ objective is minimisation of training costs, which is consistent with competitive theory assumption of profit maximising behaviour of firms. Distribution of earnings is dependent on the distribution of training slots. Distribution of training slots in its turn, is a function of labour queue and actual distribution of job/training opportunities in the economy. Labour queue is determined by employers. Workers’ background characteristics affect the cost of their training. Potential workers are ranked in queue according to the costs required to train them into the job. The higher the training slots, the lower the position in the queue.