Should trade unions be subsidised?

An externality is defined as an uncompensated impact of the actions of one person on the wellbeing of a third party. A positive externality is an externality that makes the third party better off. This creates a problem because the person creating the positive externality has no incentive to take into account the fact that they also creates benefits for other people. This leads to a situation where the market produces too little of a good, relative to the quantity that would maximise total wellbeing (or total welfare).

This is illustrated in the diagram below, which shows a positive consumption externality. The marginal social benefits (MSB - the benefits that society receives when people consume the good) are greater than the marginal private benefits (MPB - the benefits that the individual receives themselves by consuming the good). The difference is the marginal external benefits (MEB - the benefits that others receive when a person consumes the good). The market will operate at the quantity where supply meets demand, which is QM on the diagram. However, total welfare is maximised at the quantity where marginal social benefit is equal to marginal social cost, which is QS on the diagram. The market produces too little of this good, because every unit beyond QM (and up to QS) would provide more additional benefit for society (MSB) than what it costs society to produce (MSC). However, the buyers have no incentive to take into account those external benefits, so they don't consume enough.

What does that have to do with trade unions (as in the title of this post)? When a person belongs to a trade union, that provides them with some private benefit (MPB) - they can call on the union if they have a problem with their employer, they can use the union to negotiate for better pay and conditions on their behalf, and so on. However, a person's union membership also creates benefits for others (MEB), because the more people who are union members, the more negotiating power the union will have. So, it seems clear that in the case of unions, the marginal social benefits exceed the marginal private benefits, and the market for union membership will lead to too few people being members of trade unions (just as in the diagram above).

When a positive externality leads a market to produce too little of a good, we could rely on the Coase Theorem, which suggests that when private parties can bargain without cost over the allocation of resources, they can solve the problem of externalities on their own. In the case of unions, the Coase Theorem suggests that employees should be able to develop a solution to the externality that leads to the 'right' number of people becoming union members. However, the Coase Theorem relies on transaction costs being small, which is not the case when there are a large number of parties involved (which is the case when there are many employees). If the Coase Theorem fails, then that leaves a role for government.

Public solutions to a positive externality problem could be based on a command-and-control policy. That is, a policy that regulates the quantity. Compulsory union membership would be a potential command-and-control solution to the positive externality problem, but it seems unlikely that the quantity QS in the diagram above is equal to (or more than) every person belonging to a union.

In most cases of positive externalities, the government relies on a market-based solution to positive externality problems, such as providing a subsidy. The effect of a subsidy on the market is illustrated in the diagram below. The curve S-subsidy illustrates the effect of paying a subsidy to the trade union for every union member (you could achieve the same effect by partially reimbursing every union member - a subsidy on the demand side of the market). This lowers the price of union membership for members to PC (which incentivises more people to join the union), and raises the effective price for the unions to PP. The quantity of union membership increases to QS, which is the optimal quantity of union membership.

Many governments like to subsidise their favoured sectors of the economy, even though that lowers total welfare. Perhaps they should be looking to subsidise trade unions instead?

Trade unions drive up wages in L.A., but not for their own members

A couple of weeks ago, I posted about the latest research on the minimum wage, demonstrating that minimum wages do reduce employment. At about the same time, the Los Angeles city council voted to raise its minimum wage from $9 to $15 per hour. That isn't the most newsworthy bit though. As The Economist reports, the Los Angeles County Federation of Labour (a labour union) lobbied for a last minute change to the law, that would make unionised firms exempt from the higher minimum wage.

Yes, read that last sentence again. The trade union was lobbying for lower wages for its members. Why would they do that? The Economist explains:

Indeed, by exempting unionised businesses from the minimum wage, unions are creating more incentives for employers to favour unionised workers over the non-unionised sort. Such exemptions strengthen their power. This is useful because for all the effort unions throw at raising the minimum wage, laws for better pay have an awkward habit of undermining union clout. Britain’s minimum-wage law in 1998, for example, precipitated a decline in union membership. Once employers are obliged to pay the same minimum wage to both unionised and non-unionised labour, workers often see less reason to pay the dues to join a union.

So maybe it's not as crazy as it at first sounds. In ECON110 we talk about the effect of trade unions pushing wages above the equilibrium wage and increasing unemployment, and that this unemployment tends to be concentrated among non-unionised workers (who lack collective bargaining power and the job protections of union members). We refer to this as the insiders-vs.-outsiders problem. However in this case, the insiders (trade union members) are pushing up the wages for the outsiders (non-members) but not their own wages.

If unionised employers are exempt from the higher minimum wage, then their labour costs will be lower than non-unionised employers. And if unionised employees are more likely to be offered employment, then workers will be more likely to join the union. A win-win for employers and trade unions, as well as for non-union employees who receive the higher minimum wage. Trade unions are likely to be especially happy - trade union density has been declining for years (to a low of 10.8 percent in 2013 according to OECD data; or 16.3 percent in California in 2014 according to BLS data).

So, if there are so many winners, who loses from this proposal? While some non-union employees may be better off initially (from the higher minimum wage), available jobs for these employees are likely to reduce substantially. Why would employers employ a non-union employee for $15 per hour, when they can employ a union employee for much less? So, non-unionised workers are going to be made worse off. Which, according to BLS data (PDF) probably means the youngest and oldest workers, latinos, and women. Unless they are incentivised to join up to a trade union - which was likely the union's goal in the first place.