Labor Unions and the Theory of 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 Theory of Second Best for the Walrasian model. They demonstrated in their paper that when one optimality condition cannot be satisfied, manipulating other variables away from optimum can create a second best outcome in an economic model. In other words, if one market distortion cannot be removed, then a second best equilibrium can be achieved by imposing a second market distortion. The Theory of Second Best can explain why labor unions are not distortionary, but counter distortionary to the general state of the labor market.

If you have taken an introductory economics course, you might be vaguely familiar with the argument that unions create a distortion to the economy. By unions demanding higher compensation above the equilibrium wage, the union creates a surplus of labor since labor demand at the higher wage is lower than the equilibrium wage. The problem with this argument is it assumes a perfectly competitive labor market. The reality is that in most labor markets have significant imperfections. Labor market frictions are pervasive. Regional monopolies are pervasive creating monopsony markets for certain labor skills (if you are unfamiliar with the concept of monopsony, I have written about it before here). Even while certain regions encompass enclaves of industry, differentiation between firms can produce inadequate alternatives based on individual preferences. Commuting distances and tenure benefits create disincentives to move between jobs. Imperfect information between firms and workers is also a crucial assumption of the perfectly competitive market, yet we know perfect information is not possible, nor even desirable to both parties. All of these market imperfections give firms a non-negligible influence over wages; evidenced by the fact that real wage earnings have been stagnant since the 1970s.The natural state of the labor market is a distorted state which carries with a less than social optimal equilibrium. The market imperfections are not easily corrected or removed. Technology may reduce search frictions by increasing the probability of matches through online job search sites, but fixing geographical distances, compensating differentials, and reducing the monopolies requires structural adjustment to the economy that come at no small cost. This is why unions are so important. They were created in response to these imperfections which gave firms undue influence over wages. Unions become a countervailing force to the monopsony power of firms.

The decision in Janus of course has dealt a significant blow to financing of public sector unions. For those that don’t know — which is understandable given our crazy news cycle these days — this Supreme Court overturned 41 year old precedent set in Abood v. Detroit Board of Education (1977) which permitted unions to charge an “agency fee”. Agency fee was a compromise the court made 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 gains 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 puts unions, whose influence and power have already been diminished considerable over the last couple decades, between a rock and a hard place. The law of the land is that unions still have to represent all employees of a company, state, or municipal government. However, it can no longer charge the agency fee, which will create free riders, and unions will now have to divert funds into union member recruitment and retention. There is no question it’s a significant blow in the short-term, but there is an argument to be made that it could make unions stronger in time. Only time will tell. And it’s imperative that they do because unions are crucial the balance of power between monopolies and labor, and the theory of second best explains why.

Originally published at

Doctoral student of Economics at the University of Massachusetts Amherst. Commentary, research and more at

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