Light on the Hill: Industrial Relations Reform in Australia

A Contracting Theory View of Industrial Relations

Peter Gorringe

I. Introduction

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.

2.2 Hostages

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 reputation.

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 hostage exposure.

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 employee hostages.

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 employees unfairly.

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 of hold-up.

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 against hold-up.

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 for takeovers

III. Implications of the Analysis for Industrial Relations

3.1 Introduction

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 Unions

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 protection.

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 human capital.

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 choice.

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 goods character.

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 below.

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

3.3.1 Introduction

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 option.

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 union.

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 represents.

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 a trade-off.

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, however.

3.3.6 Expropriation of Employer Hostages---The Monopoly Face

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 influence.

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 as follows:

    '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 arising.

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 relations.

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 present.

IV. Implications of the Analysis for Industrial Relations Law

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 3.3.5 above.

4.5 Arbitration

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 3.5 above.

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.

4.9 Conclusions

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 disputes.


    1. The key articles and books include the following:
    Coase (1937)
    Alchian and Demsetz (1972)
    Williamson (1975)
    Jensen and Meckling (1976)
    Klein, Crawford and Alchian (1978)
    Williamson (1979)
    Cheung (1983)
    Williamson (1983)
    Alchian (1984)
    Williamson (1985)
    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 non-union counterparts, expressed greater feelings of being unfairly treated.


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