David R. Henderson  

Response to Tom West

Michael Kinsley on Disagreemen... Climbing the Meritocratic Pyra...

On Wednesday, Tom West asked:

Let me ask you again, David. Are they any non-fraudulent contracts between capable parties that you believe *should* be disallowed by law?

If your bargaining power is strong enough, is there anything you shouldn't legally be allowed to ask for? Conversely, if your bargaining power is poor enough, is there anything you shouldn't legally be allowed to offer?

I'm not playing gotcha. I really am curious.

I promised to answer him. Here's my answer.

I think many such contracts that should be disallowed. Here's the general category for disallowance. Take any action that I think should be disallowed--rape, murder, theft, etc. Contracts between two or more people to do these things should be disallowed.

However, if I think action X should be allowed, then person A should be allowed to combine contractually with others to carry out action X. So, for example, if it's legitimate for me to produce a shirt, then it's also legitimate for me to hire someone else to produce a shirt.

Tom raises the issue of bargaining power. But bargaining power is positively correlated with the number of options. The way to give someone more bargaining power is to give him more options, not to take away his ability to bargain. In a Fortune debate about so-called "sweatshops" that I had with then-U.S. Labor Secretary Robert Reich in 1996, I castigated him for trying to take away the best opportunities that poor workers in poor countries had. He responded that he wanted them to get out of sweatshops and into schools. I pointed out that he wasn't doing or advocating anything to give them schools and that even if he did give them schools, then they still should be able to decide.

A couple of months later, Paul Krugman came in on my side of the argument in an article in Slate. He wrote:

Workers in those shirt and sneaker factories are, inevitably, paid very little and expected to endure terrible working conditions. I say "inevitably" because their employers are not in business for their (or their workers') health; they pay as little as possible, and that minimum is determined by the other opportunities available to workers. And these are still extremely poor countries, where living on a garbage heap is attractive compared with the alternatives. And yet, wherever the new export industries have grown, there has been measurable improvement in the lives of ordinary people. Partly this is because a growing industry must offer a somewhat higher wage than workers could get elsewhere in order to get them to move. More importantly, however, the growth of manufacturing--and of the penumbra of other jobs that the new export sector creates--has a ripple effect throughout the economy. The pressure on the land becomes less intense, so rural wages rise; the pool of unemployed urban dwellers always anxious for work shrinks, so factories start to compete with each other for workers, and urban wages also begin to rise. Where the process has gone on long enough--say, in South Korea or Taiwan--average wages start to approach what an American teen-ager can earn at McDonald's. And eventually people are no longer eager to live on garbage dumps. (Smokey Mountain persisted because the Philippines, until recently, did not share in the export-led growth of its neighbors. Jobs that pay better than scavenging are still few and far between.)
BTW, Krugman's whole article is worth reading.

Comments and Sharing


COMMENTS (10 to date)
Prakhar Goel writes:

"But bargaining power is positively correlated with the number of options."

Au contraire dear Dr. Henderson!

Suppose we have company A selling product P to company B.

Let us say that A can afford to sell for anywhere above $100.

Let us further suppose that company B can buy for anywhere less than $1000.

Then, can company A improve its position by restricting its options? Absolutely. If it restricts its options somehow so that it can only afford to sell for $900 or above, it is in a significantly better position.

This is why companies go to the trouble of hiring negotiators. Why they sometimes try to portray themselves as irrational, etc...

I am not arguing for a minimum wage laws, etc... I only wish to point out that to assert a uniformly positive link between options and negotiating power is shockingly naive.

Chris Koresko writes:

@Prakhar Goel,

I'm completely confused. Are you equating Company A's self-interested decision not to sell P to Company B for less than $900 with a loss of options available to Company A?

If I understand correctly (and it's been a long time since I took an economics course), the equilibrium selling price for P would depend on whether or not A has a monopoly on it: if it does, the price is just under the maximum that B is willing to pay, and if not then it's just above the minimum at which A's cheapest competitor can afford to sell.

For the sweatshop workers, the assumption would be that each has individually chosen the sweatshop as the job he finds most attractive, and if sweatshops are banned then those workers will necessarily be forced into less attractive options.

What am I missing?

Chris Koresko writes:

@David Henderson,

What if the contract itself is deceptive in nature, either intentionally (e.g., obfuscated language) or unintentionally (e.g., one of the parties is not competent)?

david writes:

@Chris Koresko

Not an answer, but I'd like to toss in Megan McArdle on the elderly: "[either] you let some people get ripped off, or you infringe the liberty, and the dignity, of people who are still capable of making their own decisions".

(i.e., it's tempting to say "then let's rule decisions made by incompetent people as non-binding" but this line isn't clear either)

Bill Woolsey writes:

The "bargaining power" theory of prices and justice always assumes perfectly elastic supply and demand curves. A transaction is going to occur, and the only question is at what price. You are at the used car lot, and the buyer will buy and the seller will sell. You bargain for the price of the one car.

The boat comes by a about to drown in the middle of the ocean. The boat is going to take the person on board, the person swimming will enter the boat. But the unfair bargaining power! Free contract means the swimmer will promise to be a slave to the boat owner!

In reality, supply and demand are not perfectly inelastic. Regulations aimed at controlling bargaining power that fail to mandate transactions will often hurt those that are supposed to benefit. You can hire who you want, if you pay a decent wage. You can rent or not as you choose, if you provide a decent apartment and/or a reasonable rent (or both.)

If demand and supply were perfectly inelastic, then the number of transactions are unaffected. By improving the bargaining power of the renter or employer, the result is that they benefit at the expense of the landlord or employer. But the reality is that the result is either other, unregulated parts of the transactions get worse (say, rent controls result in poorly maintained apartments or decent apartments are unaffordable) or else there are shortages or surpluses on the market and some must do without.

The bargaining theory of prices and justice completely ignores the role of prices in coordinating a market order. If supply and demand are perfectly inelastic, then there is no coordinating to be done. Everyone will do the same thing regardless of price. And, people who don't understand the economics of markets generally just ignore the need for coordination. Generally, they fall for vacuous statements about coordination--we must focus on green jobs--or something. The details of how the whole system fits together (or not) is something they never bother to think about.

Instead, prices just transfer wealth between the buyer and seller. The used car lot is the scenario. (And the issue of how the all the cars get to the lot and whether or not the buyer shows up to the lot are ignored.)

P.S. slavery contracts for people rescued at sea should not be enforced. Efforts to enforce such a contract should result in judicial "price control," where only a reasonable paying--based on cost--should be allowed. However, for that to work anywhere close to right, the rest of the economy, where these "costs" are determined, needs to be based upon prices freely adjusting in ways that coordinate the market order rather than being based upon some theory of justice--which in practice nearly always means--what we are used to.

Tracy W writes:

Then, can company A improve its position by restricting its options? Absolutely. If it restricts its options somehow so that it can only afford to sell for $900 or above, it is in a significantly better position

This doesn't make sense. How can a company set it up so it can only afford to sell for $900? By raising its costs to $900. So where does the extra profit come from? Before the company made profit from anything they managed to sell it for above the first $100, now the profit comes from anything they sell it for above the first $900.

I'm guessing you're getting at the thing of burning your boats behind you, like that American explorer. But that's a risky decision - yes, you might inspire your men to fight harder, but on the other hand if they lose anyway you are in a worse-off position than before.

A safer way, it strikes me, is to increase your options. For example, if company A could sell its product to not merely company B, but company C as well, isn't it better off in terms of bargaining power?

Prakhar Goel writes:


It is an irreversible decision, so yes, it is a loss of options.

My comment was not about equilibrium price. The negotiation for P is a one-on-one transaction to be evaluated in a game theoretic sense. This happens to be a very common occurrence in actual business where it is quite common to want rare goods with very few seller/buyers and where negotiation comes very much into play.

@Tracy W.

If this doesn't make sense then you haven't though about it for very long. it is very easy to restrict options. I gave an example: hire a professional negotiator with a reputation to protect. Another particularly easy way is to project irrationality.

Yes, burning boats is a risky decision but guess what, life is risky and if a business avoids all risky decisions, it is dead.

It is quite possible that the safer options are not available.

Both you and Chris seems to be making my comment out to be more than what it is. I was arguing against a uniform assumption of greater options = more bargaining power. This (the assumption) is simply not true and completely ignores the reality of situation.

Tom writes:

The article is twelve years old, very close to the last time Krugman made an ounce of sense.

Tracy W writes:

If this doesn't make sense then you haven't though about it for very long.

Thinking about it longer has not helped me. Feel free to assume that I am an idiot and explain all the steps in your logic. Yes, life is risky and you will never make money if you make no risks, but increasing options does strike me as generally better.

it is very easy to restrict options. I gave an example: hire a professional negotiator with a reputation to protect.

How is that restricting your options? You can always fire the negotiator if you think they are throwing away money in their need to sound tough. Hiring a negogiator sounds to me like division of labour.

Tom West writes:

Thank you David for a cogent and justified reply. It's much appreciated. It will no doubt have bearing on my responses in future articles.

(Personally, I think there are significant negative social externalities to many contracts that make them worth prohibiting despite not involving illegal acts, but I'll wait until a topic where this might be relevant.)

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