Our confused response to market power

The size of profits generated by banks,power companies and telecommunication firms are a frequent source of public outrage.  When those profits arise from market manipulation, this outrage is justifiable.  Yet the analogous application of market power by labour unions to raise wagesis widely accepted and often applauded.   How consistent is this?

There may be a tendency to confuse total profitswith rates of return on assets, and simply view large sums as obscene.   Butthis gut reaction has little to do with the economic theory that underpins ourregulation of dominant firms capable of influencing market prices.  

The economic concern is not strictly withthe distribution of the gains from market transactions.   Rather it is that the exerciseof market power reduces the welfare of society as a whole.  

The textbook model is that firms with alarge market share can raise their profits by reducing production and sellingfewer goods at higher prices (extracting economic rents).   It is thedead-weight loss from this behaviour that concerns us – resources areunutilised, and goods that could profitably be produced and consumed are not.

It is this surprisingly simply model thatis the basic economic justification for society’s decision to regulate voluntarilyagreed upon private transactions.  

The logic of this principle is largelyunquestioned.   But it is difficult to prove that firms with market power arenecessarily bad for society, especially when considered over a longer-time period.

Large profits may arise from being the mostefficient producer (due to economies of scale).   Large firms may still innovateto protect their market position.   Regulation can be equally problematic,discouraging efficiency gains and expansion.   Then there is the practicalproblem that it is difficult and costly to prove the existence of excessivemarket power.

In summary, a simple yet relativelyabstract principle underlies a large intervention into free market transactions,the net benefits of which are probably positive but may not be.   Given this, thevisceral public disapproval of large profit numbers seems out of proportion tothe loss suffered.

Public reaction seems even morecontradictory when viewed in context with the widespread support for labourmarket bodies and regulatory principles that seek to increase market power and rentsfor workers.  

Labour unions, for instance, openly act to increasethe market power of their members and secure higher wages.   We can easily modelunions as firms that sell labour, and intend to maximise their profit (in thiscase, member wages).  

The textbook model then proceeds on thesame basis as before.   Unions with sufficient market power can raise wages, butonly to the extent that they reduce the amount of labour supplied inequilibrium.   Again, we get the result of fewer goods and services produced andenjoyed by society.

Of course, the example of labour unions is morecomplicated.   Although they wield market power, they tend to be located inindustries with a single, dominant employer with market power of its own.     Publicsector workers are the classic example of this.   When both sides havesubstantial market power, it is unclear whether dead-weight losses will result.

Continuing with the public sector example,however, one recent estimate is indicative that labour market power canpotentially be exercised to the large advantage of workers.   Professor JohnGibson estimated that wage premium for public sector workers over their privatesector counterparts was as high as 21% in 2007, after controlling forindividual and job characteristics.

Such estimates are subject to a number ofcaveats about whether unobservable characteristics explain some of the premium.  Nor can we can conclude that the premium is solely due to the market power ofpublic sector labour unions.   However, the rapid increase in the premium to 21%from almost 0% in 2003 is strongly suggestive of public sector workerscapturing increased rents rather than a change in the composition or productivityof the workers.

Let us assume then that the 21% premium is accurate,and that it reflects the market power of the public service unions.   If appliedto the average-full time wage, and multiplied by 250,000 full-time public sectorworkers, we would come to the conclusion that the public service labour forcemakes a "profit" of $2.5bn annually from its market position.   That is roughlycomparable in size to the annual profits of the big four banks (although thecomponent of bank profits that could fairly be called rents would be muchsmaller).

The $2.5bn figure does not tell us the sizeof the dead-weight loss.   But, intuitively, if public sector wages were lower,more workers would be hired and more public goods created for society as awhole to enjoy.

Large firms and large unions can bemodelled in exactly the same terms.   Levels of outrage (or lack thereof ifmarket rents do not concern you) should be similar about both the profits madeby bank share-holders and the wages made by teachers, nurses, and publicservants.   Few readers may agree with this conclusion; but on economicprinciples there is no clear distinction between the two cases.

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