Assume you want to buy tomatoes at a vegetable market in Tbilisi. At a booth, you see beautiful tomatoes of flawless quality, red, fleshy, and shiny. Right next to them are offered semi-rotten tomatoes with corky blotches, but to your surprise, both kinds of tomatoes are tagged with the very same price. “Something wrong with this seller”, you may think and buy the shiny tomatoes.

When we speak about market failure in economics, we usually mean that the economy is in a situation in which we can make everybody better off without making anybody worse. A state in which such a painless improvement is impossible is called Pareto optimal, after the great Italian economist Vilfredo Pareto (1848-1923). With complex mathematical models, it can be proved that for a market economy to be in a Pareto optimal situation, in every market prices must be such that supply equals demand. In our above example, given the prices, every customer will buy the perfect tomatoes, nobody will buy the rotten ones, and there will be an excess supply of rotten tomatoes. So, the situation would indicate market failure.

Let us now move from tomatoes to human labor, as a market failure similar to the one described above can be observed in the Georgian labor market. We will argue that this points at a more fundamental problem, namely that there is something missing in Georgia that is important for making a market economy socially acceptable: a balance of power between workers and employers.

LABOR MARKET FAILURE

Most people consider it more stressful and unpleasant to work on weekends than on workdays. Therefore, from an economic point of view, work on workdays is not the same as work on weekends, and both kinds of work should be considered to be different goods with different prices. Indeed, it is common all over the world to pay extra compensation for work on holidays, similar to the different prices paid for good and bad tomatoes.  Yet in Georgia, work on workdays and on Sunday is often paid equally. Those people who do not work on Sunday populate the restaurants and cafes, enjoy shopping (as many stores are open on Sunday), served by those who do have to work, and sacrifice their Sunday relaxation.

This observation suggests that there is a fundamental flaw in the Georgian labor market – there is no effective representation of laborers’ interests. Apparently, Georgian employers are in such a strong position vis-à-vis their employees that they do not have to take into account their preferences. Remaining with our starting example, we are in a situation where the seller can offer rotten tomatoes for the same price as good ones, and the customers are in such an extreme need of tomatoes that they are willing to pay that high price also for the rotten tomatoes.

There are two possibilities for how to tackle this market failure. One might either specify in the labor code that extra compensation has to be paid for Sunday work, and one could be quite specific about this (e.g. require wages on the weekends to be 20% higher than on workdays). However, the new Georgian labor code does not contain any such regulation, and this makes sense, as setting wages by law will lead to new distortions. Minimum wages are a good example of this – often they are irrelevant, if nobody is paid at the minimum wage anyway, but sometimes they are harmful when they further decrease the competitiveness of the weakest participants in the labor market. Wages should never be set irrespective of the overall situation of the economy. If the economic situation for large parts of the population is dire and there is high unemployment, like in Georgia, wages should not increase too much (though there should still be a differentiation between workday and weekend salaries). If, on the other hand, the economy is running hot, also the laborers should get their share.

In European countries, wages are determined in negotiations between labor unions and employers. The labor unions have a legal right to organize strikes, improving their bargaining position. Without the threat of strikes, there would be no reason for the employers to give in to any demand of the labor unions. In many countries, organized workers are even allowed to lock out those workers who are not members of labor unions from their workplaces.

THE CARTELIZATION OF LABOR SUPPLY

Allowing for labor unions and legally endowing them with the right to strike is nothing else but allowing for the establishment of a cartel among the suppliers of labor. If in a European country the suppliers of, say, raw steel would coordinate their price-setting behaviors and their supplies to the market, this would be a case for the competition authority. Yet when workers do essentially the same, this is explicitly backed by the law. So, at first sight, the establishment of labor unions may look like jumping from the frying pan into the fire.

However, as the first-best solution of the economic textbooks is often not feasible in the real world, in economics it is very common to fight one evil with another evil (the so-called Theory of the Second Best). For a couple of reasons, employers are usually much more powerful than workers. In a village, there may be just one employer but many potential workers, so the employer does not depend on any individual worker. He can replace workers at his disposal, while all the people in the village depend on this one employer. This gives the employer a much stronger bargaining position, something not included in the standard model of perfect competition, where employers compete for workers in the same way as workers compete for employment. Now, the Theory of the Second Best says that if one of the conditions of market optimality is violated “beyond repair” (and the first best solution is therefore out of reach), the outcome may be better if even more violations are introduced into the system. If there is no perfect competition between employers, it may be an improvement to also restrict competition between workers.

Economics is full of examples where the Theory of the Second Best applies. When in the 1990s, price transparency was enforced in the concrete market in Denmark, to the surprise of many politicians (less so economists) the price of concrete soared. While prices were not transparent (a deviation from the textbook optimum), prices between suppliers and buyers of concrete were usually determined in backroom negotiations, effectively leading to relatively low concrete prices. Once prices had to be made public, it was much easier for the few concrete suppliers operating in the Danish market to coordinate their price-setting behavior. In a world, without perfect competition between suppliers, it was, therefore, better to have yet another violation, namely a lack of information about prices.

THE BIGGER THE BETTER

If the establishment of labor unions would be fostered in Georgia and they would get the right to strike legally, it would be important to not repeat mistakes made in other countries.

Paradoxically, labor unions feel the more responsible for the good of the whole society the bigger they are. In Sweden, almost every citizen is a member of a labor union, also people who are not working, like students and unemployed. As a consequence, Swedish labor unions take into account the interests of almost every stratum of society. For example, there will be no excessive demands for wage increases, because even if that would be useful for those who do have jobs, it makes it more difficult for the unemployed to get back to employment.

In France, on the other hand, there are many small labor unions that ruthlessly pursue their limited selfish interests, and they are legally entitled to extensive rights to strike. Therefore, French labor unions are regularly bringing down the whole country with their collective actions. Even now, when France is arguably in its worst economic crisis since the end of the Second World War, the labor unions still run amok, preventing the implementation of highly necessary reforms. Germany, on the other hand, tends traditionally towards the Scandinavian model, with the Deutsche Gewerkschaftsbund, the confederation of classical industrial labor unions, representing more than 6 million workers. Yet also in Germany, the problem of small labor unions is being felt when the Lufthansa pilots and train drivers strike, as it happened frequently in the preceding weeks. Both groups have their own labor unions and cause enormous damage to their companies and the whole economy.

Georgian policy should consider pushing for the establishment of powerful, large labor unions. It is important to understand that the introduction of labor unions is not something directed against the market, but something that is necessary in a well-functioning market economy to correct market failures.