Macroeconomics For Dummies®, uk edition Published by: John Wiley & Sons, Ltd

Trade unions: Good for insiders, not so good for outsiders

One way of thinking about the role of trade unions is that they put pressure on firms to offer higher wages than the equilibrium wage. Firms are forced to do so because if they don’t, the union may call a strike or take some other industrial action. Instead of risking costly industrial action, firms may well prefer to give in to the union’s demand.

This is certainly good news for the union because its members now enjoy higher wages. However, the increase in the wage rate reduces the quantity of labour demanded by the firm. Furthermore, many people who’d be eager to

work for the higher wage but are unable to are going to be unemployed. You can see this effect clearly in the earlier Figure 6-4.


For this reason, economists think that trade unions can be good for ‘insiders’ (those already employed who receive a higher wage) but bad for ‘outsiders’ (those who’d like to work in the industry but can’t).


Efficiency wages: Paying more than you need to

A firm is said to pay efficiency wages when it voluntarily chooses to pay workers a higher wage than it needs to. This isn’t necessarily due to altruism: paying efficiency wages can increase a firm’s profits. It’s also good for those workers who happen to receive the (higher) efficiency wage. However, in a similar way to trade unions, it’s not so great for outsiders (those who would like to work at that wage but find there isn’t enough demand for their labour at that higher wage).

In 1914, Henry Ford, the founder of the Ford Motor Company, did something that turned quite a few heads – he increased the wages of his workers to $5 per day. This was about double the market wage for similarly skilled workers at the time. Why would he do such a thing? He certainly didn’t need to – the firm didn’t have problems finding workers at the old wages.

Far from spelling disaster for the firm, Ford went from strength to strength over the next few decades. Economists have posited a number of theories about why a firm may want to pay over the odds to its workers:

Better nutrition: Workers who are poorly paid tend to experience poor nutrition, which can result in low productivity. Boosting their incomes means they can afford to eat more nutritious food and do better work. Of course, in rich countries today this argument doesn’t seem that relevant, but in the past and in developing countries it could be the case.


Attract the best workers: At the time Henry Ford introduced the $5-a-day wage, lots of mechanics were working for different firms in Detroit. When Ford started paying a lot more than its competitors, all the best mechanics in town looked to move to Ford – the firm could take its pick.

Give workers incentives not to shirk: One of the problems that all firms face is how to ensure that workers exert sufficient effort. Watching

everyone all the time is very difficult. So the firm needs some other way of incentivising employees. The ultimate sanction a firm can apply is firing someone. The thing is, losing your job isn’t that big a deal if you can easily find another one paying a similar wage. By paying more than all the other firms, Henry Ford made sure that everyone was keen on keeping their jobs and thus keen on working hard.