Fairness Considerations in Labor Union Wage Setting – A Theoretical Analysis

Date01 July 2016
Published date01 July 2016
Matthias Strifler* and Thomas Beissinger**
We consider a theoretical model in which unions not only take the outside option
into account, but also care about the performance of the firm and base their
wage-setting decisions on a firm internal reference, called the fairness reference.
Two references, which measure the earnings situation of the firm, are considered
productivity and profits per worker. Wage and employment outcomes as well
as the degree of wage rigidity depend on the size of the fairness reference rela-
tive to the outside option. A high fairness reference leads to wage pressure and
real wage rigidity, whereas a low fairness reference leads to wage moderation
and real wage flexibility. An increase in the weight on the fairness reference
amplifies these deviations from the standard model.
Our theoretical analysis is based on the assumption that workers care about
fairness, and labor unions have the necessary market power to transform these
fairness considerations into actual market outcomes. We develop a model in
which unions not only take the outside option into account but also base their
wage-setting decisions on a firm internal reference. This deviation from stan-
dard union models profoundly changes the workings of the wage-setting pro-
cess and the reaction of the aggregate economy to macroeconomic shocks. It
is shown that the inclusion of fairness considerations nests both increased
wage pressure as well as wage moderation depending on the firm’s earning sit-
uation. It is also demonstrated that the extent of real wage rigidity in the
economy is affected differently, again depending on the firm’s earnings situa-
In the light of the available empirical evidence, it is highly likely that fair-
ness in the form of relative comparisons indeed plays an important role for
the wage-setting process when unions bargain with firms over wages.
For example, Strøm (1995) found empirical evidence that Norwegian unions
*University of Jyv
**University of Hohenheim and IZA, Bonn
Scottish Journal of Political Economy, DOI: 10.1111/sjpe.12094, Vol. 63, No. 3, July 2016
©2015 Scottish Economic Society.
compare wages to an internal reference. Agell and Bennmarker (2003, 2007)
did a representative survey on wage setters in Sweden. According to their
results, wages are compared to a within-firm reference level as well as to the
outside option. Results from experimental economics and psychology also
make it evident that it is a too narrow conception of utility if workers, or
agents in general, are restricted to care only about material gains. Especially
in settings with incomplete contracts, such as labor contracts, the phenome-
non of reciprocal behavior based on the notion of fairness plays an important
role, for example, Fehr et al. (1998, 2002), Charness (2004), and Falk and Fis-
chbacher (2006).
Bolton and Ockenfels (2000) find that fairness is important
in many different economic situations.
Fairness entered the labor union literature with Ross (1948) who consid-
ered fairness and equity comparisons to be the major issues in union wage
determination. Apart from some works discussing the union rivalry, see
Oswald (1979) and Gylfason and Lindbeck (1984) or ‘status’ associated
with an occupation, see Sessions (1993), fairness has been mainly incorpo-
rated in form of relative wages. Beginning with Wood (1978) who consid-
ered pay norms to be the beliefs about fair relativities, workers have been
mainly modeled to compare their wages to some sort of wage reference.
Fuhrer and Moore (1995) modeled workers to compare their wages with
the past wages of other workers. Following Bhaskar (1990), Holden and
Driscoll (2003) and Driscoll and Holden (2004) and others considered the
workers to compare wages with the current wage of other workers. The
main focus of the more recent work was on integrating fairness to explain
inflation persistence.
Our analysis differs from previous work in two respects. First, we
include fairness into a labor union model in the form of a pay norm which
aims directly at the firm’s ability to pay. Some recent works in the effi-
ciency wage literature, see Danthine and Kurmann (2007, 2010) and Kosk-
ela and Sch
ob (2009) and in the international trade literature, see Egger
and Kreickemeier (2012) and Egger et al. (2013) use these firm-specific
wage references. Second, our focus is on the consequences of the fair
wage-setting mechanism for the level of pay and its connection to wage
rigidity rather than inflation.
The paper is organized as follows: Section II explains how we include fair-
ness into the union’s utility function and how this affects the labor union’s
marginal rate of substitution between wages and employment. Section III pre-
sents the theoretical model. We first analyze the wage-setting behavior of the
union on the micro level and then discuss the implications for the wage-setting
curve and for labor-market outcomes on the aggregate level. In Section IV, it
is analyzed how fairness modifies the reaction of the economy if hit by an
adverse technology shock. Section V concludes.
Moreover, there exists some empirical literature which pursued the wage reference per-
spective to explain wage rigidity, see Pehkonen (1990).
Scottish Journal of Political Economy
©2015 Scottish Economic Society

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