5  Resource use within firms

This section discusses institutions related to the use of the factors of production – labour, capital, land and other natural resources.

5.1  Labour

Labour market institutions govern the interactions between firms needing labour and workers supplying their labour. The institutions aim to improve the operation of labour markets by addressing information problems faced by employers and workers to ensure balance in the market power of employers and workers and to provide insurance against the risk of unemployment. They aim to encourage greater commitment between workers and employers.

The existence of labour market institutions provides both employers and workers with greater certainty about their rights and obligations in the labour market relationship. They place requirements on employers that can encourage workers to take up jobs by providing protection against unfair treatment. These requirements can also help employers by providing clarity on the grounds and processes for employment separation. This can reduce the level of legal action between employers and former workers.

While labour market institutions have positive implications for employment relationships, they can also have negative consequences. They can reduce the availability and flexibility of labour and increase its cost to firms while reducing employment opportunities for workers. In the short term, this may reduce the returns to firms associated with employing workers and increase the returns to workers. In the long term, it may reduce employment levels.

The effect that institutions have on the use of labour by firms will depend on the nature of the particular institutions a country adopts. Institutions will introduce a degree of rigidity into labour market interactions, the effects of which can range from contributing to certainty to being overly prescriptive. Very prescriptive institutions may be time-consuming and costly to comply with and may limit the ability of firms to adapt to changing environments and economic shocks.

This does not imply that complete flexibility in the labour market is necessary for economic growth. While institutions can constrain employers in terms of their resource allocations, firm are likely to have some capacity to absorb excess staffing and labour costs. It is unlikely that they would need to be able to completely reduce their labour force as part of maximising their resource mix under normal operating circumstances. Firms in different industries are also likely to require different levels of flexibility, so the effect of labour market institutions will vary across industries.

Labour markets regulations are can be classified as employment protection, contracting, minimum wages, collective bargaining and non-wage terms and conditions. The regulations enhance the security of workers’ employment tenure, ensure workers receive minimum levels of payment and working conditions in exchange for their labour and by provide workers with processes for negotiating these terms and conditions with employers. Labour market regulations are described briefly in Table 1 below.

5.1.1  Resource allocation

These requirements can make labour less flexible or more costly and therefore less attractive to firms compared to other factors of production (although this will depend on what restrictions are imposed by institutions governing the use of other factors).

Employment protection rules protect workers by requiring employers to meet certain requirements before they can dismiss workers. This reduces the flexibility that firms have in terms of their labour force, leading employers to be reluctant to hire workers if they are not able to dismiss them when the labour is no longer needed or if doing so involves costly severance payments. Employment protection reduces flows into and out of employment and increases the duration of joblessness (Addison and Teixeira 2003, Lazear 1990).

Minimum wages can increase the cost of producing a given level of output and make production less profitable, reducing the incentives for firms to expand production. However, some alternative models of the labour market where firms have some wage-setting discretion and where workers have little bargaining power, predict neutral or even positive employment effects from minimum wages. (Betcherman, Lunistra and Ogawa 2001).[13]

Collective bargaining can lead labour to be more costly and less flexible. Unions can reduce labour productivity by requiring unnecessary jobs to be done or requiring necessary jobs to be done in an inefficient manner (Maloney 1998).

Where labour market institutions lead to a resource mix that is more costly from the firm’s perspective, they may choose to substitute other factor inputs for labour over time. This may mean firms do not invest in the human capital of their workers, if labour is seen as too inflexible. Alternatively, labour productivity can improve as a result of a resource shift, if the productivity of the remaining workers is increased by extra physical capital or other resources. Firms may choose to enhance labour productivity by investing in the human capital of a reduced workforce to make full use of the resources substituted for labour.

While labour market institutions can reduce the flexibility or increase the cost of labour, they may also improve the quality of the input from labour which can offset the reduction in flexibility and cost and make a positive contribution to firm productivity. Where labour market institutions create an environment that is conducive to greater collaboration between workers and employers, they can improve the quality of contribution workers make to the firm, e.g., through playing an active role in the innovation process. An enhanced contribution from workers may significantly improve labour productivity and through this the productivity of the firm.

Collective bargaining can increase firm productivity where it is associated with better worker-employer relationships. Where collective bargaining provides greater “voice” for workers it can facilitate discussion and resolution of workplace disputes, leading to reduced job turnover and greater communication over productivity improvements. Job protection can also improve the contribution that labour makes to production. Nickell and Layard (1999) find that substantive employee participation, where employees have some degree of autonomy in decision taking, is associated with productivity growth. They suggest productivity improvements often depend on the cooperation of workers or on their ideas and suggestions. These will be withheld if individuals feel their jobs are at risk as a consequence. Substantive participation can require more training and this is only worth providing if the employment relationship is long-term.

Overall, the effect of labour market institutions on firm productivity via changes in labour productivity will depend on how the institutions affect the relationship between workers and employers and whether improvements in the quality of labour’s input increase productivity more or less than they increase the cost and inflexibility of labour.

5.1.2  Innovation and human capital

Labour market institutions will influence the share of the returns from an innovation that accrue to the firm as profits and to labour as higher wages. The share accruing to workers from greater productivity will depend on the strength of their bargaining power, which is determined by institutional arrangements and demand for their skills in the labour market. Firm investment levels can be reduced where unions are able to capture some the rents associated with these investment (Nickell and Layard 1999).

Implementing an innovation often requires moving to a new optimal mix of human and physical capital. Acquiring a different range of skills is not simply a matter of reducing the number of workers but changing in the composition of the firms’ workforce in terms of its human capital characteristics. Labour market institutions such as job protection and unionisation can make the adjustment of employment arrangements associated with shifting to a new technology difficult or costly, particularly in industries where there is limited scope to expand production (Bassanini and Ernst 2002, Scarpetta, Hemmings, Tressel and Woo 2002). Unions may slow down the introduction of new technology and work place practices where these undermine the bargaining strength of union members, although when a union embraces new technology or work practices it can enhance their contribution to productivity growth (Nickell and Layard 1999).

With job protection and unionisation, the relationship between workers and employers is more permanent. To get the most out of the workforce that they have, firms are more likely to invest in their human capital. However, where the current labour force is not well suited to acquiring the human capital required, labour market institutions may hinder innovation. The effect of labour market institutions may depend on the technological characteristics of the sector in which firms operate. In low-tech industries, high firing costs may lead to higher adjustment costs with negative effects on innovation and technology adoption while the effect on high-tech industries depends on the nature of the technology employed (Scarpetta and Tressel 2004). Countries with high firing costs tend to specialise in innovations that improve the efficiency of the production of existing goods rather than innovations that lead to new goods. Where technological progress arises from further innovations following a trajectory, rather than innovations that require shifts in the type of physical and human capital used, investing in the internal labour force can be an effective way to overcome high firing costs (Scarpetta and Tressel 2004).

5.1.3  Productivity

Of the labour market institutions, the most significant in terms of their effect on productivity are likely to be job protection regulations and unionisation. They will limit firm resource flexibility and may limit the returns that firms can capture through innovations. However, they can also increase the quality of labour’s input into the production process. The overall effect of a country’s labour market institutions will depend on the extent to which they encourage productivity enhancing or diminishing behaviour. This may be influenced by institutions in other areas, such as product markets, that maintain pressure on firms to look for efficiency and innovation opportunities and that influence the technological characteristics of the industries operating in a country.

At the national level, Nickell and Layard (1999) suggest that labour market institutions appear to have a strong association with unemployment, some association with labour input and a weak association with productivity growth. Freeman (2000) notes that differences in the labour market institutions that exist among advanced countries have significant distributional effects, but weaker and uncertain effects on efficiency outcomes. He suggests that while wage setting institutions reduce inequality in economic rewards they have modest effects on efficiency outcomes as interventions in advanced capitalist economies rarely give unions significant power over a critical part of the economy.

Flexible labour market institutions may be most useful in allowing a country to adjust to economic shocks while minimising the effects on output. The IMF (2003) notes the that when labour markets are more competitive, the economy reacts more quickly and smoothly to changes in interest rates, which means smaller changes in interest rates, and therefore output, are necessary to stabilise inflation in the face of shocks.

5.1.4  Government activities affecting the supply of labour

As well as institutions in the labour market, there are other governmental factors that affect the labour market through their impact on labour supply. Government activities such as taxation, benefit provision, public education provision and public health provision determine the quantity and quality of labour that is available. These influence the decisions of workers to supply their labour and to invest in their own human capital.