Thursday, January 17, 2008


Slovenia's labor market is known for an extensive regulation and barriers that hinder productivity growth. According to the latest Index of Economic Freedom, Slovenia's labor market is known as the most regulated and inflexible in the European region. High labor cost, regulated working schedule, and extensive taxation are hampering the capacity of productivity performance.

Recently, trade unions in numerous fields demanded a collective wage increase that would, in their opinion, boost the growth of welfare. If those demands are not fulfilled by the government in the process of collective bargaining, trade unions promised to launch demonstrations on the streets of Ljubljana. Not surprisingly, the majority of demands come from the public sector.

In Slovenia, inflation rate is currently above the EU average and is also the No.1 political issue in the public debate.

The question is whether suggested wage increases would really boost the growth of purchasing power or broader negative consequences are inevitable, following wage increases.

Collective bargaining is a zero-sum game

In the long run, wage rate is moving together with the productivity growth. Wage increases are justified only if the value of marginal product of labor is above the actual wage rate. The value of marginal product of labor is, of course, determined by the market value of labor unit. A sudden shock such as an inconsistent wage-increasing claim would leave disastrous consequence to the output activity. If wage claims are above the productivity growth rate, then a private sector would face a significant loss and cost pressures that would be further transformed in higher prices and a decreasing probability of creating jobs in the future. In the absence of perfect competition, price increases would go above the marginal cost. Such a complex situation, does not yield an optimal outcome as firms in imperfect competition create a deadweight loss. Given the conditions of global economy such as an increasing demand for commodities in China and India, the pressure on prices would inevitably be intensified. Consequently, mark-ups on current prices would eliminate the positive effect of wage increases on the purchasing power considerably.

Sudden wage increases tend to make the price elasticity of demand more inelastic. Usually, the elasticity coefficient is between 0 and 1. For example, if price elasticity coefficient is 0,31, it means that given a 1 percent increase in the price of product A, the demand for product A decreases by 0,31 percent. In this, the company has an incentive to raise the price of A, given the gain of price increase. If wage increases and productivity evidence are mismatched, the effect of wage growth on purchasing power is a zero outcome, whereas higher price level reduces (!) the overall capacity of purchasing power and therefore consumer choice and welfare.

Game theory and collective asymmetry

Distinguished economists such as John Nash successfully attempted to derive an equilibrium in non-cooperative games. In the so-called Nash Equilibrium, changing strategy is the best response in non-cooperative games with n-players. Nash equilibrium also became universally applied in national labor relations. The question is what are likely to be the preferences and strategic behavior of trade unions in the collective game. Trade unions can choose the negotiating strategy that aims to stimulate job growth. In this case, wage rate temporarily falls below the equilibrium floor, but only in the short run. Also, union's prime joker can be the maximization of wage fund for all employees. In this case, wage increase is much more sensitive to the level of productivity than in the previous case. The third option is the worst one. Under its circumstances, trade unions can move up the curve of marginal revenue, reducing labor supply and increasing labor demand. This step is called rent-seeking as union's negotiating strategy attempts to bargain the maximization of an economic rent for union members. Aftermath, the analysis of labor market shows that the overall level of welfare has not been increased after union's claims were realized. The wage rate of labor supply in non-unionized sector, is below the equilibrium line while unionized sector's claims reduce the level of employment and the pace of job creation.

How wages affect output and inflation?

In Slovenia, a sizeable proportion of the labor force is employed in the public sector. If trade unions in the public sector claim unjustified and illogical wage increases, the latter could seriously boost inflation pressures. In the negotiating circle, trade unions obviously neglect the principle of budget constraint. In Slovenia, robust economic growth originially based on diseconomies of scale, produced a positive output gap where aggregate demand raised the level of prices. By the fundamental laws of macroeconomics, the difference between potential and real GDP converged into an additional source of inflation. Employment in the public administration is funded through annual budget. Additional wage increases, of course, would have to be conducted by an increasing public spending or by an undisciplined fiscal stimulus that would infuse wage fund. In turn, an increase in aggregate demand would further raise the price level and, again, the effect of wage increases on purchasing power would disappear as the inflation rate would rise.

Proposed wage increases as a threat to macroeconomic stability

The empirial investigation has shown that an additional collective wage increase by 1 percent, would accelerate the inflation rate by 0,6-0,7 percent. Inevitably, higher inflation rate would cause an immense damage to long-term sustainable growth performance and overall macroeconomic stability.

Rok SPRUK is an economist.

Copyright 2008 by Rok SPRUK

No comments: