Light on the Hill: Industrial Relations Reform in Australia
A Contracting Theory View of Industrial Relations
Economists have relatively recently begun to develop
models which allow them to explain the important features
of human institutions such as the capitalist firm in
cost economising terms. Although Ronald Coase published
the seminal article in the area in 1937, it was only
in the 1970's that his insights had begun to be developed1
and in the 1980's that this so-called transaction cost
economics started to become part of the mainstream
of economic thought, at least in the USA.
An institution which has received a lot of attention
as part of this development is the contract. Contracts
have traditionally been thought of by both economists
and lawyers as discrete transactions, and indeed the
paradigm of the contract for neoclassical economists
is the spot market contract. MacNeil (1974) questioned
the adequacy of this model, and introduced the concept
of 'relational' contracting, to describe situations
where contracts are of long and perhaps indefinite
duration, have many implicit elements, and rely in
part at least on informal enforcement mechanisms.
Labour market contracting is predominantly of this
relational nature. In such circumstances, the conduct
of the relationship, including the institutional arrangements
within which such conduct takes place, becomes of major
importance. This is what Oliver Williamson (1979) has
called 'the governance of contractual relations'. The
governance of relational contracting in the labour
market is what industrial relations is all about.
The present paper explores the relationship between
contracting theory (sometimes referred to as 'transaction
cost economics') and industrial relations. Section
II develops a theory of contract based on the work
of Oliver Williamson and Benjamin Klein in particular
and applies that theory to labour market contracting
at the level of the individual employee. Section III
extends the framework to explore the potential role
of unions, and how their potential costs and benefits
vary with the basis on which the union is organised.
Section IV examines the implications of the analysis
for industrial relations law in Australia and New Zealand.
II. A Theory of Contract and its Application
to the Labour Market
2.1 Contractual Man
Neoclassical economics has made use of a model of
human beings often referred to as 'economic man'. Under
the traditional assumptions of perfect information
and zero transaction costs, economic man is shorn of
much that makes human beings what they are. Oliver
Williamson (1985) introduced the term 'contractual
man' to specify a model of human beings which resembles
reality more closely in two respects. The first is
that there is recognition that people have limits on
their abilities to gather, process and communicate
information. This assumption is referred to as 'bounded
rationality'. The second is the recognition that human
beings have the propensity to act with guile, cunning
and deceit in the pursuit of their interests. This
human characteristic is referred to as 'opportunism'.
Much of the theory of contract referred to has to
do with the hazards or risks of contracting generated
by the interaction of these two human characteristics
of bounded rationality and opportunism with two features
of the contracting environment. The first is the difficulty
of measuring workers' output. This problem often arises
because of the team nature of production, and the consequent
difficulty of separating the output of different workers.
The problem is often referred to as 'measuring cost'.
The second is the cost of termination of a contract,
of which asset specificity2 is an important source.
In labour markets, both employers and employees commonly
face significant costs when contracts are terminated.
These costs will be referred to as 'hostages'.
The chief contracting implication of bounded rationality
is that the writing of long-term contracts covering
all possible future contingencies and adaptations to
each of them is made impractical. This means that written
long-term contracts will be incomplete. The gaps in
such contracts are commonly filled by informal understandings,
especially as regards adaptation to unforeseen changes
in circumstances. Such unwritten understandings are
commonly referred to as 'implicit' contracts. This
raises questions of how such contracts are to be enforced,
and how adaptations to unforeseen contingencies are
to be made.
Opportunism, in Williamson's terms, includes lying,
cheating, extortion, theft and strategic non-disclosure
of information. Williamson distinguishes between opportunism
ex ante, before a contract has been entered, such as
lying or non-disclosure, and ex post, such as shirking
or extortion. Alchian and Woodward (1987) distinguish
two principal forms of ex post opportunism, which they
refer to as 'moral hazard' and 'hold-up'. Moral hazard
includes shirking (Alchian and Demsetz (1972)) and
agency problems (Jensen and Meckling (1976)). Hold-up
is a form of extortion, in which one party to a contract
threatens to withdraw unless their terms are met.
It has been objected that the characterization of
people as opportunistic is too dark a picture of human
nature. The contracting implications of opportunism
arise, however, not because people are commonly opportunistic,
but because contracts need to include safeguards against
the possibility of opportunism.
As noted above, I employ the term 'hostages' to denote
all the costs of contract termination in particular
circumstances. In employment relationships, both parties
commonly have significant hostages to the continuation
of an employment relationship. Employees commonly have
hostages arising from a number of circumstances. These
include firm-specific human capital, such as skills
or information that have value within the present firm
but not as much in other firms; firm-specific social
relationships, friendships in particular; contractual
arrangements which generate costs of contract termination
such as non-vested pensions and fringe benefits which
increase with seniority; and location-specific capital
and relationships where an alternative job might entail
moving home location. They also include an employee's
Employers also have significant hostages. These include
redundancy pay, the employer's returns on an employee's
firm-specific human capital, a reputation as a good
employer, lost production while a replacement employee
is located and trained, and search and training costs
for the replacement employee. In the case of a strike,
the employer's specific assets such as specific plant
and buildings and the goodwill attached to the employer's
product brand name can act as hostages.
The size of hostages of each of the parties depend
on a number of factors, including the circumstances
of contract termination (e.g. did an employee quit
or was he fired; if the latter, was the firing justified);
whether others are simultaneously terminating parallel
contracts (e.g. as in a strike); the degree of asset
specificity (ie the difference in the value of assets,
including human capital, in the current contract from
that in the best alternative contract); the timing
of contract termination (e.g. farmers are especially
vulnerable at harvest time); search costs for alternative
contracting partners; other costs of replacing the
quitting party (e.g. training costs for employees);
the ease of communicating reputational effects to the
market (loss of reputation can be a substantial cost
of engaging in hold-up or other severely opportunistic
behaviour); and the cost and speed of availability
of legal remedies (if they are readily and quickly
available, hold-up involving the breaching of an explicit
contract can more easily be prevented).
Where both an employer and an employee have significant
hostages, the effect is to make it likely that the
contract will be at least implicitly of long-term nature,
and also to generate an effective situation of bilateral
monopoly. This arises because the parties are separated
from the protection of competition by the amount of
their hostages. In such situations the contract becomes
a relationship rather than a transaction. The identity
of the parties matters. The bilateral monopoly nature
of the relationship creates a demand from both sides
for a fair sharing of the quasi-rents thus arising.
Hostages and bounded rationality together determine
important features of the employment relationship.
Hostages make the relationship at least implicitly
a long-term one, and bounded rationality puts constraints
on the process of long-term contracting which have
been discussed above. In particular, bounded rationality
ensures that such long-term relationships will be governed
by incomplete contracts, the gaps in which are filled
by informal understandings or 'implicit' contracts.
The adaptation of the parties to changing circumstances
is effected with reference to the whole ongoing relationship
between the parties, often by the parties themselves,
but in many cases with the help of an arbitrator.
Contracts have traditionally been thought of by both
economists and lawyers as discrete transactions, and
indeed the paradigm of the contract for neoclassical
economists is the spot market contract, of which the
market for cabbages is a standard example. MacNeil
(1974) questioned the adequacy of this model, and introduced
the concept of 'relational' contracting, to describe
situations where contracts are of long and perhaps
indefinite duration, have many implicit elements and
rely in part at least on informal environment mechanisms.
Significant hostages and bounded rationality together
are sufficient to ensure that contracts will be of
this relational nature. I turn next to the way in which
such contracts are enforced.
2.3 Hostages and the Enforcement of Implicit Contracts
Williamson (1983) developed the idea that business
arrangements similar to a mutual holding of hostages
are a common means of enforcing implicit contracts.
A similar theme is contained in the literature on self-enforcing
contracts, which includes Telser (1980), Klein and
Leffler (1981) and Klein (1985). Klein (1984) and Melnick
and Plaut (1986) have applied these ideas to employment
contracts. Contracts are self-enforcing unless the
gains from contract termination outweigh the termination
costs. The degree of self-enforcement can be increased
by increasing these costs. This can be done by investing
in assets specific to the contract or posting monetary
bonds, for example.
Court enforcement of contracts is often not practical,
either because the contract in question is implicit,
or because action through the courts would be too expensive
or take too long. The enforcement of contracts then
depends on a mutual holding of hostages, and a balancing
of the size of hostage exposure of the two parties
to the contract. If the hostage exposure of one party
gets out of line with that of the other, hold-up becomes
a more profitable strategy for the party with the lower
Contract termination costs, ie the size of hostages,
can vary considerably over time with a number of factors
(for example, farmers growing perishable crops are
particularly vulnerable to hold-up at harvest time).
This leads to a variation over time in the self-enforcing
properties of an implicit contract. A reputation for
'fair' or 'ethical' behaviour has an important role
in enforcing implicit contracts by 'smoothing' the
degree of symmetry of hostage exposure. The damage
to such a reputation is especially great if someone
takes advantage of a contracting partner when they
are temporarily especially vulnerable to hold-up. In
most industries there is a network of social relationships
and supporting institutions such as businessmen's associations
and unions which have as one of their effects the support
of values of fairness and the collection and dissemination
of information bearing on reputations. Another important
filler of gaps when hostage exposure gets temporarily
out of line is an expectation of reciprocity ('you
owe me one').
2.4 Measurement Problems and Opportunism---The Problem
of Moral Hazard
A central feature of contracting in labour markets
is the difficulty of measuring the output of workers.
This gives rise to many of the distinctive characteristics
of labour market contracts. Where this difficulty is
not present, contracts take quite a different form.
Piece work arrangements, outside contracting and commission
arrangements, for example, are feasible if it is possible
to measure output. These all incorporate high-powered
market-type incentives to work hard.
Where output is difficult or costly to measure, people's
tendency to behave opportunistically generates a problem
of shirking (Alchian and Demsetz (1972)) or, more generally,
moral hazard (Alchian and Woodward (1987)). This problem
has also been referred to as the agency problem (Jensen
and Meckling (1976)). The need to control the problem
generates many of the special contractual and institutional
arrangements in the labour market.
One means of limiting the moral hazard problem is
close supervision. This, however, may seem to imply
a lack of trust, and thus generate resentment, which
is not conducive to co-operation and efficiency. Nevertheless,
it is a method which is often employed.
Another means of limiting the problem, which may be
used with varying degrees of supervision, is a career
structure, or what Doeringer and Piore (1971) referred
to as an 'internal labour market'. A common feature
of these markets which have the effect of limiting
moral hazard is a promotion ladder, in which seniority
as well as productivity are factors in the decision
to promote. Internal labour markets also commonly accompany
a number of other 'privileges of rank' such as paid
holidays, health insurance plans, pension schemes and
an understanding that the most junior workers are laid
off first in hard times. Such arrangements generate
A different approach to controlling moral hazard,
which is especially important when output is particularly
hard to measure, is to foster a convergence of interest
between employer and employees. This method may well
include profit sharing or even power sharing arrangements.
It may also include a process of indoctrination to
recognise the community of interest between employer
and employees, as seems to be the case in many large
Japanese companies. A requirement of arrangements which
stress a community of interest is trust on the part
of employees that they will be fairly treated. Klein
(1984) stresses the role of employer hostages in cementing
such trust. Where firms are both large and have the
potential to grow rapidly, as do many large Japanese
firms, they have a lot to lose from treating their
Hostages come into the picture in other ways in connection
with the moral hazard problem. Without employer's costs
of contract termination, moral hazard would be less
of a problem, as it could be controlled by a credible
threat to fire workers for even minor shirking. Without
employee hostages, people would not stay in a relationship
involving a range of rewards and penalties, as they
could quit the moment any penalty threatened to be
applied. Partly for this reason, employment contracts
may include arrangements that involve employee hostages,
such as non-vested pension schemes, and other arrangements
discussed above incorporating 'privileges of rank'.
It is important that the legal framework for labour
markets recognises the need to control moral hazard
and the ways this might be achieved. For example, there
should be no obstacles in the way of paying people
according to their productivity, or of incorporating
features into contracts such as profit sharing which
may enhance a community of interest between employer
and employee. These features may include the ready
ability to organise unions on an enterprise basis rather
than a craft basis where this would be appropriate.
I will say more in Section III on the subject of enterprise
unions versus craft unions.
2.5 Hostages and Opportunism---The Problem of Hold-Up
When a party to a contract has a significant hostage,
that person becomes vulnerable to extortion by the
other party. This extortion commonly takes the form
of a threat to quit the relationship unless the extorting
party's terms are met. This is known as hold-up (Klein,
Crawford and Alchian (1978)). There is an upper limit
to the amount which can be expropriated in this way,
which depends on the costs to the coerced party of
calling the bluff of the coercing party and terminating
the relationship. The credibility of the threat to
terminate depends on the costs of termination to the
coercing party. Where one party to the contract faces
considerably higher termination costs than the other,
the relationship will be subject to substantial hold-up
risk and the party facing that risk may well seek a
safeguard from the other party in the form of increased
termination costs for that party, such as the posting
of a monetary bond, or an investment in assets specific
to that relationship. This in effect completes an exchange
of hostages. Where no such safeguard is forthcoming,
the contract price will adjust to reflect the likelihood
In the labour market, whenever employees face contract
termination costs that are significant, they thereby
face a threat of hold-up by the employer. The hostages
which employers offer in return include chiefly their
own firm-specific investments in physical equipment
and special-purpose buildings and in their reputation
as an employer. The potential role of unions in rendering
both these more substantial, and thus more credible
as safeguards, is explored in Section III. That section
also looks at the potential for the hold-up of employers
by unions. Employer hostages are also involved in severance
or redundancy pay arrangements, including 'golden parachutes'
for management, and in the employer's share of the
quasi-rents accruing to specific human capital.
Employers also face hold-up problems from individual
employees. The source of hold-up is the employer's
share of the quasi-rents accruing to a particular employee's
human capital, which is the main factor which makes
quitting costly to firms. More exactly, it is all the
costs of replacing a particular employee's skills,
or of adapting to their absence. These include lost
production, search costs and retraining costs.
It was seen above that the moral hazard problem commonly
leads to the structuring of the employment relationship
to include significant employee hostages. These same
hostages serve the purpose of safeguarding employers
2.6 Bilateral Monopoly and the Sharing of Quasi-Rents
The bilateral monopoly nature of employment relationships
means that there is a problem of the sharing of what
Alfred Marshall referred to as the 'composite quasi-rent'
arising from team production. More exactly, the region
of bilateral monopoly is bounded by the hostages of
the contracting parties. Each contracting party can
extract from the other no more than the value of their
hostages. After this point, exit becomes a cheaper
option for the exploited party. This situation of bilateral
monopoly generates another of the hazards of contracting
in the labour market---the hazard of exploitation of
one of the parties by the other. Perceptions of fairness
and people's responses to them play an important part
in the control of this hazard.
Where there are perceptions on the part of employees
that they are not being treated fairly, they have a
number of common responses. These have been discussed
by Garner (1986). The first such response is exit.
There is evidence (Schmitt and Marwell (1972)) that
people exit from relationships they perceive to be
as unfair even when this involves considerable cost.
The effect on employers is to increase their costs
of turnover. These include search and retraining costs
and in some cases lost production while a replacement
is being trained.
A second such response is individual effort reduction,
and this is especially likely to be a problem for employers
where effort is difficult to monitor and control. Williamson
(1975) has spoken of the shift that can occur between
'consummate co-operation', a work mode in which initiative
is shown, and a creative and co-operative approach
is taken to the job, and 'perfunctory co-operation'
where the job is done to the minimum acceptable standard.
Garner (1986) also remarks that feelings of inequity
can reduce the flow of information within a firm and
cause generally sub optimal decisions.
A third response to perceived inequity is collective
action, such as a strike or a work-to-rule. A fourth
is deliberate sabotage. There are also consequences
of perceived unfairness for transaction costs. Ouchi
(1980) contends that it is the demand for equity that
generates transaction costs. Such costs arise in part
in taking measures to assure contracting parties that
what they give and receive is in accordance with their
expectations. Williamson (1985) has also pointed out
the importance of what he calls governance costs, which
are the costs of setting up and operating private arrangements
to safeguard against opportunism, such as monitoring
of workers' performance, or the setting up and running
of unions, grievance procedures and contractual arrangements
which involve hostages. These transaction costs are
likely to be inversely related to the amount of trust
in the relationship.
There are thus feedbacks from the perception of inequity
by employees to an employer's reputation, to turnover
costs, to production costs and to transaction costs.
The existence of these feedbacks means that it will
generally be in employers' interests to share bilateral
monopoly surpluses in labour markets fairly.
All this is not to say that employers will never abuse
their bargaining power. They may be playing endgames,
in which case loss of reputation is no threat. They
may be fly-by-night firms with no reputation to protect.
The transmission mechanisms for information about reputations
may in some cases be weak. Some employers may unduly
discount the importance of preserving their reputations,
or in other ways misjudge the effects of the exploiting
behaviour. Some employers may be abusing their power
for their own satisfaction, as a form of managerial
moral hazard. In the last two cases, however, there
are other controls on such managerial misbehaviour
arising within the market for managers and the market
III. Implications of the Analysis for Industrial
Economists are increasingly moving away from the view
that the sole effect of unions is to lead to the monopoly
pricing of labour, with consequent losses of efficiency.
The work of Freeman and Medoff (1979, 1984) has had
a leading effect in this change of view. It is not
denied that monopoly is one aspect of unionism, but
increasingly, unions are being seen to have other functions,
many of which increase efficiency. The analysis in
Section 3.2 below extends the analysis of Freeman and
Medoff into the potential of unions to increase efficiency,
while Section 3.3 examines some of the problems and
costs of unions. Both these sections examine the question
of how the benefits and costs vary between enterprise-based
and craft-based unions.3 Section 3.4 looks at other
aspects of the choice between these two types of union.
The next two sections examine other implications of
the analysis for industrial relations. Section 3.5
examines the institution of arbitration in the context
of relational contracting, while Section 3.6 looks
at the concept of equity in wage setting.
3.2 Potential Equity and Efficiency Benefits of
3.2.1 Unions and Hostage Protection
The common existence of employee hostages, creating
market power for employers even in situations which
are otherwise competitive, together with the potential
for abuse of this market power to exploit employees,
gives rise to an equity argument for unions. Alchian
(1984) expressed the relevant union function as the
protection of employee quasi-rents. The quasi-rent
concept often focuses on employees' returns to their
specific human capital. The concept of hostages, stressing
as it does in this case all the costs of quitting or
being fired to employees, is more comprehensive. I
will therefore refer to this union function as hostage
A union's hostage protection function is enhanced
if employer hostages exist which are vulnerable to
union action. These include chiefly their own firm-specific
investments in physical equipment, special-purpose
buildings and product brand name, and also their reputation
as an employer. Representation of employees by a union
renders these hostages more substantial, and thus more
credible as safeguards. Their strike power increases
the costs to the employer of engaging in hold-up activity,
or otherwise abusing their market vis-a-vis their employees.
Unions also monitor employer behaviour and act as the
repository of the employer's reputation as an employer.
These union functions act in employers' long-term interests
as well as employees as they increase the security
of the employment relationship, and thus the readiness
of employees to enter the firm and to acquire firm-specific
Enterprise unions will generally be better placed
to identify threats to hostages and to respond than
craft unions. They will also be more readily able to
monitor the behaviour of particular employers. An exception
to this may be the employees of some small firms, who
may find it hard to organise or to bargain on an enterprise
basis. Some form of union which spans many employers
may be preferable in such cases.
The feedbacks from perceived unfairness to production
and transaction costs discussed above mean that economic
efficiency is positively related to employees' perceptions
of fairness. To the extent that unions' hostage protection
function enhances employees' perceptions that the employment
relationship is fair, therefore, this union function
increases efficiency as well as equity.4
Hostages have a two-edged nature, in that the offer
of a hostage reduces the likelihood that the offerer
will engage in hold-up behaviour but increases the
gains from hold-up by the other party. The hostage
protection function of unions protects employees against
hold-up. The increased employer hostage exposure that
this involves also obviously increases the risks of
hold-up by the union. This is the monopoly face of
unionism. Alchian (1984) refers to this function of
union bargaining power as the expropriation of employer
quasi-rents. I will examine below some contractual
arrangements which can reduce this risk.
3.2.2 Unions and the Collective Choice Problem
The formation of a union can help to overcome a problem
of collective choice. This is a problem which arises
in respect of matters which affect all or many employees.
Such matters include 'safety conditions, lighting,
heating, the speed of the production line, the firm's
formal grievance procedure, pension plan, and policies
on matters such as layoffs, work-sharing, cyclical
wage adjustment, and promotion' (Freeman and Medoff
(1984)). Each employee rightly feels powerless to have
much individual influence on such matters, and also,
even if he or she could affect such matters, only a
small part of the benefits of such actions would accrue
to him or her individually. Other employees could not
readily be excluded from such benefits. Note that these
matters are in most cases specific to particular firms,
so that the formation of a union on an enterprise basis
is often the logical solution to the problem of collective
Another way of characterising this problem is as a
public goods problem. It has been suggested (Burton
(1978)) that there is not in effect a public goods
problem of this type, at least with pay. Non-union
members, it is contended, can be excluded from the
benefits of a pay package negotiated by a union. It
is hard to see this happening, however. Employers will
generally want to have rates of pay which are the same
for comparable duties and seniority irrespective of
union membership. This is especially so in the firm's
labour market is a hierarchical internal labour market
of the type analyzed by Doeringer and Piore(1971).
Also, the costs of excluding non-members from the benefits
of improvements in the list of employment conditions
above are prohibitive, involving a physical and organizational
split in each firm. Further, employers are unlikely
to pay non-union employees less than their unionised
equivalents in the same firm, as the former would probably
then join the union. It is this factor, in particular,
which gives unions' hostage protection function a public
3.2.3 Unions and Voice
Hirschmann (1970) drew a distinction between two main
ways in which people express dissatisfaction in relationships.
These are 'exit' and 'voice' Exit is the means used
when a worker quits, an employer fires a worker, a
customer changes suppliers, or a couple divorces. Voice
is the means used when a worker and an employer discuss
their differences and seek solutions and compromises,
a customer complains to a supplier, or a couple seeks
marriage guidance counselling.
The discussion of contracting theory above drew attention
to the common existence of hostages, or costs of terminating
a contract, in labour markets. In such situations exit
is a costly means of expressing dissatisfaction, and
voice assumes increased importance. Put differently,
labour market contracting is often about relationships
rather than transactions. Where contracting is of a
'relational' nature (MacNeil (1974)), employee voice
is an essential part of the governance of the employment
relation. An enterprise union is often the logical
vehicle for the expression employee voice.
Also of great importance is the response of employers
to the communications of employees resulting from unions'
'voice' function. Freeman and Medoff (1984) have linked
union voice with employer response in their analysis
of the effects of union action in promoting efficiency.
Employer response is explored further in Section 3.4.1
3.2.4 Economies of Scale and Gains from Specialisation
The existence of a union can reap two other sorts
of benefits which individual contracting does not capture.
These are the economies of scale in contracting that
are involved when contracts are collectively negotiated,
and the gains from specialization from employing a
specialist negotiator in such circumstances. By themselves,
these factors favour larger rather than smaller unions,
perhaps organised on a basis which includes the employees
and employers of many firms. Such larger unions also
involve costs, however. Many of the benefits of having
unions organised on an enterprise basis may be lost,
and there are other problems discussed below arising
from the excessive aggregation of contracts.
3.2.5 Other Union Efficiency Functions
Managers are agents of the workforce in that the actions
they take can affect the value of employment contracts.
This is especially so if workers have significant firm-specific
human capital, or ii the value of their pension rights
depends on the firm's fortunes, or if they are paid
in part by means of a profit-sharing agency cost terms,
and have shown that, just as managers benefit from,
and so hire, reputable public accountants to audit
the financial accounts the firm produces (bonding costs),
so they would benefit from having an enterprise union
monitor their behaviour on behalf of their employees.
In discussing opportunism, Alchian and Woodward (1987)
point out that the parties to a contract may have differing
perceptions about whether a particular course of action
is opportunistic (unfair), because of bounded rationality
(or information asymmetry). In a world where perceptions
of fairness have productivity consequences, it may
well be in management's interest to include enterprise
union representatives in a listening capacity on the
board of directors, in order to reduce the information
asymmetry, which can breed suspicion.
It has been seen above that employee hostages anchor
employees in an employment relationship, allowing the
use of rewards and penalties by the employer without
stimulating exit by employees. It is important to employers
that the imposition of such penalties is seen as fair
by employees, because of the sorts of response to perceived
unfairness discussed in the previous section. An important
adjunct to any penalties procedure is therefore a credible
and accepted grievance procedure. Enterprise unions
have a part in the due process which accompanies such
a procedure. Also, allowing grievances to be brought
only by the union discourages the opportunistic or
frivolous use of the procedure by employees.
3.3 Potential Problems with Unions
The formation of a union is a solution to employees'
collective choice problem, and uuions have the potential
to increase efficiency in a number of other ways, as
discussed above. However, these benefits are bought
at a cost to both employees and employers, which arises
from a number of sources. From the point of view of
employees, they include in particular agency problems
of union leadership, problems brought about by the
aggregation of contracts, and free rider problems of
union funding. Employers' costs arise from the 'monopoly
face' of unions, which poses a threat of employer hostage
expropriation. These various costs are now discussed.
3.3.2 Agency Problems with Union Officials
A potential agency problem arises whenever one person
(the agent) acts on behalf of another (the principal).
The problem arises because the interests of the two
parties are not identical, and so the actions of the
agent may diverge from those that would be in the best
interests of the principal. Costs are involved both
in this divergence and in measures taken to reduce
it. These measures include unilateral actions by both
parties (monitoring and bonding) and bilateral contractual
and other arrangements to align incentives.
Examples of monitoring include the observation of
how the union leadership handles major pay and conditions
negotiations and how it manages day-to-day matters
such as individual grievances. An example of bonding
is the production of audited union accounts (where
legislation does not require this). Examples of contractual
and other arrangements include the rules of the union
such as its election rules and rules for voting in
general meetings. It is important for the control of
such agency problems that monitoring of unions by their
members is relatively easy. This bears on the question
of whether unions organised at the level of the enterprise
may be preferable to craft-based unions.
The mechanisms of exit and voice have been discussed
above in relation to the expression of dissatisfaction
by employees with actions of employers. Union agency
problems can also draw either exit or voice responses.
Voice responses include the use of voting in union
elections and more direct verbal or written expressions
of dissatisfaction, either informally or at union meetings.
It is important for the control of agency problems
that both mechanisms can work well. There are likely
to be more opportunities for contact between employees
and union officials if unions are organised on an enterprise
basis rather than a craft basis. This increased contact
would enhance the use and effectiveness of the voice
Exit consists of leaving the union, either by setting
up an alternative union or joining an existing alternative,
or quitting the unionised section of the workforce.
An effective exit option is important, not only for
its own sake, but because it would enhance the incentives
for union officials to take notice of voice responses
to dissatisfaction. The monopoly powers conferred by
the state on unions in Australia and New Zealand effectively
preclude the exit option, and thus also weaken the
effectiveness of the voice option. This will be discussed
further below when considering what the legal regime
for industrial relations should be.
Another aspect of the agency problem in unions is
the use of 'show-of-hands' voting which may have the
effect, sometimes intended, of inhibiting union members
from expressing their true preferences when voting.
There may be a role for a law which makes the use of
secret ballots compulsory in some circumstances to
combat this problem. A further way in which the law
combats agency problems in unions is by requiring the
production of audited financial reports.
3.3.3 The Median Voter Problem
A problem arises in any democracy from the need for
those seeking election or re-election to appeal to
the average, or median, voter. The interests of minorities
can thereby be neglected. An effect in the union context
may be to work against the adoption of systems of which
properly reward the wide range of abilities within
a workforce. The pay packages which appeal to the average
union voter are apt to stress a degree of egalitarianism.
Freeman and Medoff (1984) cite evidence that pay is
more uniform in unionised than in non-unionised firms
in the USA. While this tendency could work against
efficiency, there is no solution to it in a democratic
union. They also argue that greater pay equality may
actually have efficiency benefits, in that feelings
of rivalry among workers may thereby be reduced, leading
to a greater readiness to impart on-the-job training
to other workers.
3.3.4 Problems Arising from the Aggregation of Contracts
The discussion above of contractual arrangements showed
that the ideal individual contract was likely to vary
between individuals, being a function of the difficulty
of measuring output and of the specific human capital
of the employee and the other hostages of the two parties.
Thus when a large number of employees contract with
an employer through a union, there is a loss of contractual
flexibility arising from the aggregation of many employment
contracts with individual employee into a single contract
with the union.
When a craft-based union contracts with the representatives
of many employers, the loss of flexibility is generally
greater than when an employer contracts with an enterprise-based
union. In particular, this restricts the ability of
individual employers to experiment with the form of
the employment contract, for example by instituting
a system of contracts based on some form of profit
sharing and/or sharing of control. It also restricts
the opportunities to enter into employment contracts
which take into account the circumstances of individual
employers. Against this, it is possible that ideal
individual contracts for members of a particular trade
might have common features.
An enterprise union can feasibly negotiate separate
contracts for different occupational groupings. However,
it is possible that even an enterprise union may be
too aggregated a basis for contracting in some circumstances.
The legal system should not only allow enterprise unions
to form readily, but should also allow for a more disaggregated
basis for unions where the employees concerned wish
to form a union on such a basis. Other factors such
as the gains from union scale and from specialisation
in monitoring and negotiation would act to limit the
proliferation of unions. Giving the potential for such
smaller groupings to form would also act to control
problems of the tyranny of the majority in democratic
unions, and of agency problems whereby union officials
neglected the interests of particular groups within
The loss of contractual flexibility from contract
aggregation is especially great when, as in Australia
and New Zealand, bargaining takes place between centralised
representatives of employers and employees spanning
the entire country. Agency problems of unions, including
unions of employers, are also likely to increase as
union leadership gets more remote from the people it
3.3.6 Free Rider Problems with Union Funding
Because of the high cost of excluding those who don't
contribute to union funding from the benefits obtained
by the union's efforts, non-contributors can free ride
on those who do contribute. This difficulty is often
put forward as an argument for compulsory unionism.
If compulsory unionism had no costs, this argument
would have some force. The difficulty is that there
are costs involved in compulsory unionism, which arise
partly from the restriction this places on individuals'
choice and partly from the greatly increased agency
problems which compulsion generates---when agents have
captive principals, agency problems are apt to run
rife. The question of compulsory unionism thus involves
The view I take is that the increased agency costs
generated by compulsory unionism are more important
than the benefits of solving the free rider problem
in this way. Union membership can be encouraged by
union welfare schemes, discounts at certain stores
for union members and similar schemes. Also, there
are effective informal ways of expressing group disapproval
to free-riders which help to solve the free-rider problem
without unduly exacerbating the agency problem. The
increased agency costs of compulsory unionism are unavoidable,
3.3.6 Expropriation of Employer Hostages---The Monopoly
Hostages have a two-edged nature, in that the offer
of a hostage reduces the likelihood that the offerer
will engage in hold-up behaviour but increases the
gains from hold-up by the other party. The discussion
of the role of unions above mentioned their role in
protecting employees against hold-up, or protecting
employee hostages. The increased employer hostage exposure
that this involves also obviously increases the risks
of holdup by the union. The threat of hold-up by unions
can be reduced by hostage-type arrangements which link
the value of employment contracts more securely to
a firm's fortunes, such as the investment of a substantial
part of pension funds in the firm's stock, or the underfunding
of pension liabilities (Ippolito (1985)). These, however,
will have little effect on the union's behaviour if
contracting does not take place at the level of the
individual firm. Craft-based union officials cannot
be expected to respond to such incentives.
3.4 Other Advantages of Enterprise Unions
3.4.1 Enhancement of Incentives for Co-operation
The nature of capitalist production is that employers
and employees are co-operating in production even while
they compete over factor shares. A craft union official
has a much less obvious community of interest with
employers as a whole than the community of interest
between an enterprise union official and his or her
employer. Craft union officials are thus more likely
to see the world chiefly in terms of conflict over
the shares of a 'cake' over whose size they have little
The recognition of a community of interest within
a firm, which can be enhanced by such means as profit
sharing, or the devices discussed above which tie the
value of a pension to the wealth of a firm, provides
the basis for other changes associated with the existence
of an enterprise union. The first is the opportunities
created for workers to learn new skills, including
those not associated with their particular trade. This
'multiskilling' not only provides much greater flexibility
in the workforce, but also enhances opportunities and
motives for shop floor innovation, which has been identified
as an important factor in Japanese economic success.
Another aspect of multiskilling is the potential thereby
provided for a dramatic reduction in demarcation disputes.
A second set of changes arising from the recognition
of a community of interest within a firm is the opportunities
this gives to employers to use industrial relations
creatively, for example as a learning channel about
production problems on the shop floor and the performance
of lower level supervisors. Again, the opportunities
for exchange of information and mutual learning are
likely to be important factors in innovation and the
improved use of existing techniques.
A third set of changes arising from the recognition
of a community of interest is the likely diminution
in problems of restrictive work practices. These are
more likely to be recognized as factors affecting the
size of the 'cake' more than its distribution. Put
differently, restrictive work practices and 'feather
bedding' are more likely to be seen as involving costs
to the enterprise as a whole which are often much greater
than the increased distributional benefits workers
thereby receive. In such circumstances there is the
opportunity for mutually beneficial exchange which
entails contracting at the enterprise level. The likelihood
of strike action may also be reduced as a consequence
of the recognition of a community of interest. The
parties would have more incentive to try to settle
disputes peacefully, for example by voluntary recourse
to mutually agreed arbitration processes, with arbitrators
hired by the parties and thereby having significant
incentives to work towards the maximisation of the
joint wealth of the parties.
3.4.2 The Distinctiveness of Particular Workplaces
Workplaces tend to be distinctive in two respects
which are important for the conduct of industrial relations.
The first is the business situation of the employer.
There may be a particular export order that needs completion
by a certain date, or profitability may be particularly
low or high. Because craft unions bargain with the
representatives of large numbers of employers, it is
not practical for them to take into account employers'
individual business situations when they bargain.
The second way in which workplaces are distinctive
is in the rules and customs governing industrial relations
in particular workplaces. Howard (1983) has written
'The distinct needs, traditions and characteristics
of each workplace require that working rules, those
which apply in fact, be developed by those who understand
the unique environments.'
Craft union officials do not fit this bill. They must
work in terms of rules of general application. As Howard
points out, it is not possible to provide effective
workplace government by exclusive resort to such rules.
A connecting link between the various ways in which
enterprise unions are likely to be superior in many
situations to craft-based unions is that industrial
relations is about the conduct of relational contracting
between an employer and his or her employees. An enterprise
union is a much more appropriate institution for the
conduct of this relationship than is a craft union.
Put differently, an enterprise union represents a more
appropriate governance structure for the relationship.
3.5 Relational Contracting and Arbitration
The institution of arbitration has a natural place
within the relational contracting analysis of industrial
relations that has been developed in this paper. Hostages
of employers and employees generate an employment relationship
that is implicitly of a long-term nature. They also
generate an effective situation of bilateral monopoly
between the parties, where perceptions of fairness
have productivity consequences. Bounded rationality
ensures that the long-term contractual relationship
thus generated will be governed by a contract which
is incomplete in many respects with regard to adaptations
to unforeseen contingencies. What can be foreseen is
that there will be such unforeseen contingencies, and
thus it is in the joint interests of the contracting
parties to adopt ways of solving the problems thus
One institutional response is to the incompleteness
of long-term contracts and the need to fill the resulting
gaps is to increase the hostage exposure of the parties
through various means. I have discussed above the role
of 'privileges of rank' together with a promotion system
where seniority is one criterion for promotion in generating
such hostages. I have also discussed hostages connected
with pension schemes, such as non-vesting of employer
contributions, underfunding of employer pension liabilities
and investment of pension funds in the firm's stock
in filling such a role. This increased hostage exposure
increases the incentives of the parties to adapt the
contract rather than terminate it or hold out unreasonably.
A second, and probably more important institutional
response to the incompleteness of long-term contracts
and the resulting need for flexibility is an arbitration
mechanism designed with the interests of the contracting
parties in mind. Bearing in mind the idiosyncrasies
of particular workplaces, it is logical that the contracting
parties in those workplaces, which might be employers
and enterprise unions, should have the prime say in
who arbitrates and how. It is important also that arbitrators
should work towards increasing the joint wealth of
the parties. Private, voluntary arbitration is likely
to be a suitable response to these demands. Private
arbitrators are likely to develop considerable expertise
with regard to the problems of a particular workplace.
They are able to use informal proceedings, in which
elucidation of the particular problem to be solved
is a guiding principle. They are also able to utilise
a greater flexibility of remedy than public arbitrators
constrained to follow rules. Litigation is inferior
to arbitration in relational contracting circumstances.
Courts are not there to further the joint interests
of the parties. They do not have an interest in promoting
continuity of relationships, and indeed, litigation
is often destructive of long-term relationships. Judges
are generalists rather than specialists in the problems
of a particular situation, and so come to any dispute
with less knowledge of the idiosyncrasies of a situation
than specialist arbitrators. The procedure of courts
is formal and based on an adversary situation. In contract
law, the emphasis is likely to be on interpretation
of some original written agreement, rather than on
working out suitable adaptations to unforeseen circumstances.
The remedies available to courts are severely constrained
by statute and case law.
It can be argued that the public conciliation and
arbitration systems in Australia and New Zealand resemble
this portrait of the court system more closely than
that of private arbitration in a relational contracting
context set out above. Public arbitration is often
directed towards quite different goals---those of centralised
wage determination, or close interpretation of some
written agreement---than those normally associated
with the institution of voluntary, private arbitration.
It is important that voluntary arbitration, using private
arbitrators if this is preferred by the parties, should
become part of Australian and New Zealand industrial
3.6 Equity in Wage Setting
A criticism which is sometimes levelled at the idea
of more decentralised wage bargaining in Australia
and New Zealand is that this would violate principles
of equity, such as comparative wage justice. I will
not deal with the question of whether comparative wage
justice and other conceptions of equity in wage setting
have any valid ethical content. What is real is that
many workers feel that their pay should be based to
some degree on some sort of traditional relativity
with the pay of other trades.
In a world in which perceptions of unfairness have
productivity consequences, as discussed in the last
part of Section II, bargains struck between employers
and employees or their unions where bargaining was
decentralised would be likely to take into account
feelings of this sort where they were strongly held.
Failure to do so would risk the sorts of responses
to perceived unfairness discussed in that section.
Perceptions of equity might thus well act to constrain
wage setting to some degree even where this was decentralised.
While this would be unfortunate from the point of view
of promoting the efficient allocation of resources,
it would be preferable to a situation in which judicial
perceptions of equitable wage outcomes were forced
to be a major consideration in wage setting, as at
IV. Implications of the Analysis for Industrial
This section applies the analysis in the rest of the
paper to the question of reform of industrial relations
law in Australia and New Zealand.
4.1 Enterprise Unions
In both countries, existing rules for the registration
of unions have the effect of protecting the existing
craft basis of unions and strongly discouraging the
formation of new unions on an enterprise basis. The
analysis in Section III of this paper implies that
this should be changed.
4.2 Agency Problems Within Unions
The protection which existing unions have under union
registration rules in both countries from the formation
of any new union in an area in which an existing union
already has coverage serves to block an important control
on agency problems within unions. This is the ability
of workers to exit from an unsatisfactory union by
setting up a new union. The effects of this prohibition
on exit is discussed in Section 3.3.2 above. The union
registration rules, together with the blanket coverage
of industrial awards, effectively give existing unions
the status of statutory monopolies, which permits agency
problems in unions to flourish.
Other changes to the law which might reduce agency
problems within unions are a requirement for secret
ballots in unions in certain circumstances, and a requirement
that unions produce audited financial accounts periodically.
4.3 Aggregation Problems
I have discussed in Section 3.3.4 above how the aggregation
of large numbers of individual employer-employee contracts
within aggregate contracts between groups of workers
and groups of employers leads to a loss of flexibility.
The centralised nature of wage determination in Australia
and New Zealand makes these problems particularly severe.
The problem is exacerbated by the blanket coverage
given to industrial awards under the law of both countries.
4.4 Free Rider Problems
In New Zealand, there is compulsory unionism at the
moment. This is seen partly as a response to the free
rider problem of union funding which was discussed
above. My view is that the increased agency problems
that are engendered because unions have a captive clientele
outweigh any good which arises from the resulting solution
of the free rider problem. Further, there are other
ways of addressing the free rider problem without unduly
exacerbating agency problems, as discussed in Section
Arbitration needs to be seen within the context of
relational contracting between an employer and his
or her employees. An important feature of many relational
contracts is the convention that, when bargaining breaks
down, there should be recourse to independent arbitration.
Arbitration, as an element in industrial relations
within firms, can be an important contributor to harmony,
avoiding many of the responses to perceived unfairness
that might otherwise be forthcoming. Conciliation and
arbitration are important features of the process of
adjustment to changing circumstances in a set of incomplete
long term contracts.
It is likely that conciliators and arbitrators chosen
and hired jointly by employers and enterprise unions
and following procedures agreed by the parties as part
of the total mechanism of collective bargaining and
other elements of industrial relations within the firm
will lead to better outcomes than public sector officials,
as are required by law in Australia and New Zealand,
using quasi-judicial procedures. The latter have much
weaker incentives to seek the joint interests of the
parties, and are more likely to use procedures and
methods which accentuate an adversary mentality between
the parties. The issues are discussed further in Section
4.6 The Enforcement of Contracts
A prime requirement of relational contracting of any
kind is that there should be confidence that agreements
negotiated between the parties will be adhered to.
The present industrial relations law in both Australia
and New Zealand is inadequate in that unions are effectively
more free to breach their contracts without legal redress
than are employers. This disparity is destructive of
the trust and confidence which is necessarily part
of effective relational contracting in labour markets---ie effective industrial relations.
4.7 Union Size Requirements
Unions operating on an enterprise basis in a small
enterprise may well be very small. A minimum size requirement
for unions would prevent the formation of enterprise
unions in such circumstances. There should therefore
not be any minimum size requirement for unions.
4.8 Demarcation Disputes
A change to a system of industrial relations law which
allowed enterprise unions would mean a considerable
period of adjustment. Also, greater freedom to form
new unions or to change union membership would increase
the amount of adjustment of union structure. A feature
of such adjustment processes could be demarcation disputes.
There may be a role for the law in providing for solutions
to such problems, for example by a requirement for
a ballot of affected workers to decide union coverage.
The main conclusion to be drawn from the analysis
in this paper is that industrial relations law in Australia
and New Zealand should be changed to allow much more
ready formation of alternative unions, especially unions
organised on the basis of the individual enterprise
rather than on a craft basis. Other policy conclusions
include the need to do away with blanket coverage;
the undesirability of compulsory unionism; the need
to privatize conciliation and arbitration; the need
to make labour contracts enforceable; the undesirability
of a minimum size requirement for unions; and the need
for a system for the ready resolution of demarcation
1. The key articles and books include the following:
Alchian and Demsetz (1972)
Jensen and Meckling (1976)
Klein, Crawford and Alchian (1978)
Alchian and Woodward (1987)
2. Assets, including human assets of skill and information,
are said to be specific to a firm if they are more
valuable in the firm than outside it. For example,
a general knowledge of accounting or a general-purpose
truck are non-specific, while a particular knowledge
of a firm's computer system or an item of special-purpose,
custom-built machinery are specific.
3. Enterprise unions and craft unions are compared
chiefly because the union registration rules in Australia
and New Zealand severely constrain unions to a historically
determined craft basis, putting considerable obstacles
in the way of the formation of new unions on an enterprise
basis, or indeed on any other basis.
4. Unions' effect on perceptions of fairness is strongly
influenced by their need to whip up feelings of unfairness
as a part of the bargaining process. Freeman and Medoff
(1984) report that workers in unionised firms in the
USA, although paid on average about 15% more than their
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