The Janus decision, Labor Unions and the Theory of the Second Best

Given the recent Supreme Court decision in Janus v. AFSCME, the public sector union case, I thought it worth explaining why labor unions are so important aside from the usual explanations given.​

In 1956, Richard Lipsey and Kelvin Lancaster developed the General Theory of the Second Best. They demonstrated in their paper that when one optimality condition cannot be satisfied in an economic model, altering other variables away from the optimum can result in the second-best outcome. In other words, if one market distortion cannot be removed, then a second-best solution can be achieved by imposing another market distortion. We can apply this theory to explain why labor unions are not distortionary but counter-distortionary in today’s labor market.

Anyone who has taken an introductory economics course will no doubt be — at least vaguely — familiar with the argument that unions create a distortion in the labor market. The classical example commonly used is a labor market demand and supply graph with the intersection of the two at the equilibrium wage. If labor unions demand compensation above the equilibrium market wage, the union creates a surplus of labor since labor demand at the higher wage is lower than the equilibrium wage.

The obvious problem with this argument is it assumes a perfectly competitive labor market. The reality is that most labor markets are “imperfect.” Labor market search frictions and asymmetric information are the norm. Regional monopolies are pervasive, creating monopsony power over certain labor skills (if you are unfamiliar with the concept of monopsony, I have written about it before here). Even while firms in the same industry tend to cluster in ways that make it seem competitive, differentiation between firms can disincentives to switch based on individual preferences. Other factors, such as commuting distances and tenure benefits, also create disincentives to switch jobs, even within the same industry. All of these market imperfections give firms a non-negligible influence over wages.

The natural state of the labor market is a distorted state which carries a less than socially optimal equilibrium. These market imperfections are not easily corrected or removed. Technology and job matching platforms, like Indeed or LinkedIn, may reduce search frictions and increase matching, but fixing geographical distances, compensating differentials, and reducing monopoly/monopsony power requires structural adjustments to the economy and extensive regulation that are politically difficult to implement. This is why unions are so important. Unions were created, in part, as a countervailing force to balance the power of labor with the power of firms.

But the decision in Janus has dealt a significant blow to the financing of public sector unions and, therefore, their ability to fund themselves. The Supreme Court overturned a 41-year-old precedent set in Abood v. Detroit Board of Education (1977), which permitted unions to charge an “agency fee” or “fair-share fee”. The fair-share fee was a compromise the court made in the Abood decision for non-union employees who may have disapproved or did not want to contribute to the political activities of unions but nonetheless enjoyed the compensation benefits earned from union bargaining activity. Since non-union employees were only paying for bargaining activity, agency fees were less than actual union dues. The arrangement seems to have worked pretty well for over 40 years until Janus, which ruled that agency fees were unconstitutional.

This decision is a sinister move to undermine public sector unions, whose influence and power have already been diminished considerably over the last few decades. Existing labor regulation requires that unions still represent all employees against the employer. However, it can no longer charge the fair-share fee, which will create a free rider problem, and unions will now have to divert funds into union member recruitment, retention, and collection of dues. There is no question it is a significant blow in the short term. How much of an effect this will have, only time will tell.

One would hope this blatant attack on what remains of the labor movement will engender a labor union revival because unions are crucial to the balance of power between monopolistic firms and labor, a balance that has been tilting in the direction of firms since the decline of unions in the 1970s. From the perspective of the theory of second best, we should be concerned, as only further eroding of labor union power will only result in a lesser outcome for the economy.

Originally published at aaronmedlin.weebly.com.