Why A Free Market Wage System Doesn’t Work

Michael Sharp

The general decline in collective bargaining coverage across western economies in the 1980s and 1990s was driven by the belief of governments and employers that freer labour markets would work more efficiently. New Zealand lead the way with collective bargaining coverage rates declining from some 60% to 17% (Creighton and Forsyth, at 7765) However, there are real questions about whether the resulting ‘freer’ labour markets have resulted in improved results.

Neoclassical economic theories suggest that a labour market is working efficiently when pay is determined by the marginal productivity of the last employee hired. As such, pay should be relative to productivity levels of employees (Stiglitz,2013).

When assessing whether an economy wide labour market is working efficiently a good rule of thumb is to look at the relationship between improvements in national productivity and wage levels. On this basis it appears that in the post war period up until the 1980s labour markets in many western economies operated efficiently with pay increases across all income levels roughly keeping pace with improvements in national productivity. However, from the 1980s, when labour markets were ‘freed up’ from the influence of collective bargaining, a different picture emerges. Over the last three decades there has been a trend of the pay of lower and middle income earners significantly falling behind improvements in national productivity, and hardly improving in real terms, while higher pay earners have received above productivity increases (Stigliz, at 1837).

For example, in New Zealand, if the pay of lower and middle wage earners had moved in line with national productivity it is estimated that their current pay would be about 25% higher than it is at present. By contrast, the pay of top pay earners has tended to increase well above the national productivity rates. In New Zealand, the pay of the top 10% of wage earners during this period has risen in real terms by some 80% (Rashbrooke,2013).

Data suggests that these above productivity pay increases at the top of the scale have been particularly focused on managerial staff. In New Zealand CEOs pay has improved by 80% since the 2000s alone (Rashbrooke, at 838) In the US over the last three decades the pay ratios between CEOs and typical workers increased from around 30/1 to 200/1 (Stiglitz, at 1074).

While this trend seems to have slowed down during the Global Financial Crisis in the subsequent recovery it seems to have picked up again. In many economies, there has been an historically unusual trend of pay for most wage earners continuing to lag behind productivity increases during the period of economic recovery (UK Office for National Statistics, 7/11/2012), but with management making up for restraint over the early recession years with renewed pay increases (Stiglitz, at 752).

There is data that suggests that these pay trends are driven by a pattern of management pay increasing with the profitability of the firm, while non-management pay is not determined by profit levels but by general rates that apply across the whole labour market (Lin Ma,2014). Thus, despite the significant decline of industry and nationwide collective bargaining, the pay of non- management employees appears to have remained detached from firm performance and anchored to going rates of pay applying across the economy.

Given these trends that have developed in modern ‘free’ labour markets what can be said about how efficiently they are operating?

There are those who argue that the pay gaps between upper level and other wage earners reflects a structural change, where skilled work has been lost to overseas competitors and technology leaving a greater proportion of unskilled employees. However, this thesis is not supported by the fact that the pay of many of the remaining skilled employees still does not appear to be keeping pace with productivity. More importantly, there does not appear to be any evidence that the productive skills of management staff have improved anywhere near the significant pay increases they have received (Stigliz, at 1406 and 1640).

As such, it appears to be the case that modern “free” labour markets are not operating efficiently in keeping wages and productivity aligned. Why is this the case and what can be done about it?

A fundamental reason why labour markets do not operate in the manner modelled by neoclassical economic models is that the models are based on perfect market conditions that in reality rarely exist. In the bulk of firms wages are not determined in accordance with marginal productivity – this would be far too difficult for management to implement and attempts to do so tend to usually lead to distorted incentives. In imperfect labour markets, where a firm can pay wages at less than marginal productivity rates and still retain employees, firms will employ at a wage and number which will maximise their surplus over labour costs. Labour will attempt to bargain to a point where there is no surplus. In these circumstances the exact wage and employment rate depends upon the bargaining power of firms and workers respectively. To reduce the bargaining power of employees firms are also said to engage in “pay matching,” where they pay the same rates as other firms as a strategy to reduce the risk that employees will leave to go to a firm paying better rates (Sloane, Latreille and O’Leary, 2013).

Adopting more of an institutional view of the operation of labour markets and firms (Sharp), firms can also be seen as adopting standard pay rates as legitimate reactions to uncertainty. Firms adopt and employees accept standard pay rates as norms for job types which firms in general have been able to pay while trading profitably. Within this norm based approach employees will need to bargain across firm adjustments to pay norms that reflect general increases in productivity

From any of these perspectives, the key to employees driving pay increases to reflect improvements in productivity is by having sufficient bargaining power. This will generally require employees to bargain collectively. To be effective the collective bargaining should be on a wider basis than with the individual firm. If firms are surplus maximising, pay-matching , or following pay-norms, then they will unlikely be forced by firm specific collective bargaining to break ranks from other firms to pay higher rates of pay. To do this, collective bargaining on a wider industry or economy-wide basis is necessary.

This type of broad base collective bargaining was common in Western economies during the long post war boom up until the 1980s. This ranged from the “collective laissez faire” consensual bargaining between unions and employer groups in the UK and the US , to the “compulsory arbitration” award basis systems in New Zealand and Australia. In these environments industry and nationwide wage increases linked to general productivity improvements were consistently given (Bamber, Lansbury and Wailes,2011). However, when governments and employer groups were persuaded by free market philosophies to abandon support for broad based collective bargaining the compact broke down and general productivity increases came to an end.

With management lead corporate governance models operating within firms, under which management effectively control the distribution of surpluses (Alchain and Demetz, at 781-3) management have been able to take the increased surpluses made available by not giving general productivity pay increases, and use this to award pay rises to themselves.

Stiglitz refers to this type of conduct of management as an example of game theory involving collusive behaviour by a group of dominant individuals to keep the dominated group repressed. As such, he considers that management pay increases are the result of management exploiting market imperfections to their own benefit by controlling norms within firms to their advantage (Stiglitz, at 1610).

Of recent times firm shareholders have been raising concerns about rises in management pay outstripping increases in dividends. As a result there have been ‘say on pay’ law reforms in a number of countries giving shareholders a greater say on management pay. However, these reforms are somewhat misdirected in that the opportunistic behaviour of management is largely at the cost of non-management employees rather than shareholders.

What is required for pay markets to be made to work more efficiently in maintaining an alignment between pay and productivity is for government and employers to return to the pre-1980s acceptance of broad based collective bargaining. In the current environment in New Zealand this will require the government to make legislative reforms to support industry and nationwide collective bargaining. A return to a compulsory arbitration award based system should not be discounted. After all, Australia persisted with such a system (although with a greater enterprise bargaining focus), during the intervening period where the “pay gap” between the two countries has significantly widened in Australia’s favour.




B Creighton and A Forsyth Rediscovering Collective Bargaining – Australia’s Fair Work Act in International Perspective (Routledge, New York, 2012, eBook ed).

Joseph E Stiglitz The Price of Inequality (Penguin, UK, 2013, eBook ed).

Greg J Bamber, Russell D Lansbury and Nick Wailes International and Comparative Employment Relations – Globalisation and Change (5th ed, Allen and Unwin, Crows Nest (NSW), 2011)

Max Rashbrooke Inequality: A New Zealand Crisis (1st ed, eBook ed, Bridget Williams Books, 2013)

UK Office for National Statistics, Real Wages up 62% on Average over last 25 Years, 7 November 2012

Lin Ma “Globalization and Top Income Shares” (2014) US Census Bureau Center for Economic Studies Paper No. CES-WP-14-07

Peter Sloane, Paul Latreille and Nigel O’Leary Modern Labour Economics (Routledge, Abington, Oxon (UK), 2013)

Michael Sharp, A Norm Based Analysis of Obligations of Confidence and Trust (2012) 18 NZBQ 341

A Alchain and H Demsetz Production, Information Costs, and Economic Organization (1972) 62 American Economic Review 777 at 781–783

Michael Sharp
About the author

Michael Sharp

Michael Sharp is a barrister based at Mount Maunganui. He has completed post-graduate studies in employment law at the University of Waikato and the London School of Economics and Political Science. Michael has contributed a number of articles adopting a law and economics approach to legal issues.