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LABOUR MARKETS, FIRMs AND

INSTITUTIONS: LABOUR ECONOMICS AND

INDUSTRIAL RELATIONS.

PETERGAHAN AND TIM HARCOURT·

T he study of the employment relation has always held a somwhat amhiguousposition within the field of economics. The nature oflahour mm"ket adjustment

processes and unique aspects of the empwyment relation have posed problems forstandard economic theo'"ies and have limited the use offormal modelling. Moreover,institutioruzlist approaches hove been a greater challenge to labour economists than inany other area of enquiry within the discipline (Jacoby, 1990). Traditionally, thisdifference has been manifest in a clear distinction between labour economics andindustrial relations as separate fields ofstudy. The artificiality ofsuch a distinction, weargue, poses prohlems for understanding the phenomena ofconcern to both disciplines.1n this paper we argue that notwithstanding the important insights gained fromstandard neoclassical models ofthe labour market, they do notprovide an adequate basisfor understanding the empwyment relationship and institutional features of labourmarkets. 1nstead, we begin with the assumption adopted by industrial relations scholarsthat the labour market is diffe1"ent from other economic exchange relationships and usethis as a basis for developing a more realistic framwork to understand both the socialand economic dimensions ofthe employment relation.

Those of us who look more closely at the labour market know that there is an importantdifference between the human factor of production, labour, and other factors which are used incooperation with labour in the productive process. Labour is not a commodity (!saac 1992a).

[A]l1 narrowly economic activity is embedded in a web of social institutions, customs andbeliefs, and attitudes ...Economic theory can only gain from being taught something about therange of possibilities in human societies. Few things should be more interesting to a civilisedeconomic theorist than the opportunity to observe the interplay between social institutions andeconomic behaviour over time (Solow 1985).

The study of the employment relation has traditionally held an ambiguousposition within the field of economics. The non-standard nature of labourmarket adjustment processes, unique aspects of the employment relation thatdistinguish it from other market transactions, and the non-market nature ofindustrial relations have all posed special problems for standard economicmodelling processes. Traditionally, this difference has been manifest in a clear

• The authors affiliations are, respectively, School of Industrial Relaoons and OrganizationalBehaviour, University of New South Wales, Sydney, NSW 2052, and Ausrralian Council ofTradeUnions, Trades Hall, 54 Victoria Srree[, Carlton 50mh, Vie. 3053. We would like to thank]effBorland, Lisa Cameran, Jane Howard, Peter Kreisler and David Peetz for useful commems on anearlier draft. The usual disclaimer applies.

THE]OlJRl\"AL OF Ii"DVSTRIAL RELATIO~S, VOL. 40, No. 4, DECEMBER 1998, 508-532

Electronic copy available at: http://ssrn.com/abstract=1769618

LABOUR ECONOMICS AND INDUSTRIAL RELATIONS 509

distinction between labour economics and industrial relations as separate fieldsofstudy broadly concerned with the same terrain: phenomena surrounding theemployment relationship.' The artificiality of such a distinction, we argue,poses problems for understanding a number of phenomena that are of concernto both disciplines, including the questions ofhow labour markers work and therole of regulation.

In this paper we attempt to reassess the nature of the relationship betweenthe two fields and to locate possible ways in which each field of study mayenhance the other. We do so by reviewing a number of theoretical approachesto the study of labour markers and the employment relation, and by re­examining a number of key debates of interest to both disciplines. We suggestthat an adequate understanding of the employment relation will necessarilyrequire theory to account for the role and inter-relationships between markets,firms and institutions.

In the process, we argue that the adherence to standard neoclassical modelsof the employment relation and labour markers does not provide an adequatebasis for analysing the employment relation. We suggest that a more helpfulstarting point is recognition of the unique features of the employment relation,and we ask why institutional mechanisms that govern various aspects of theemployment exchange are so pervasive. This view does not begin from theassumption that institutions have perverse effects on the market mechanismfunctions, but rather acknowledges that institutions reflect the non-market andunique aspects of the employment relation. From this perspective, institutionscan be viewed as arising from both efficiency concerns and distributionalconflicts. Drawing On theoretical developments within both labour economicsand industrial relations, we suggest a general framework for understanding theunique features of the employment relation and their consequences.

The paper is organised as follows. The next section begins with an examina­tion of the standard neoclassical model of how labour markets work. We outlinethe key insights and shortcomings of this approach. Then we consider in whatrespeers the employment relation diverges from the simple economic model.This section focuses on what may be termed 'non-market' aspecrs of the employ­ment relation and draws on insights from the theory of the firm and transaction­costs economics, as well as industrial relations theory and related disciplines. Inlight of these arguments, the following section addresses the question of therelationship between labour market institutions and economic performance. Wethen make a number of concluding observations in the final section.

THE STANDARD NEOCLASSICAL MODELThe perfectly competitive model

Traditionally, labour economics was viewed as a relative backwater within thefield of economics. Samuelson (1954) suggested that labour economics was

1. We would qualify this statement by noting that, to some extent, each field has been preoccupiedwith different questions, concerned itself with different phenomena surrounding the employmentrelationship and applied different criteria in judging the quality ofeconomic and indusoial relationsoutcomes.

510 THE JOURNAL OF INDUSTRIAL RELATIONS December 1998

occupied by economists who were unwilling or unable to stand the rigours offormal modelling, which dominated most other areas of economic study.2Almost two decades later Fisher (1971) again noted that labour economics didnot command substantial attention or respect within the discipline. 'Economicanalysis,' he said, 'tended to pass [the study of labour] by, either because itseemed to present no demanding intellectual problems or because it was judgedto be an area where institutional factors played too dominant a role' (p. ix).

In the decade following Fishers comment on the 'poor cousin' starns- oflabour economics, the field was transformed into one that consistently re­flected the highly formalised methodology of most other areas of economics(McNulty, 1980). In the process, however, concern with institutions and therole they played was, in many respecrs, discarded, or simply viewed as 'imper­fections' that impeded the operation of a freely functioning labour markets.This reflected what]acoby (1990,319) has termed a synchronic approach inwhich theory was

" .an abso"action from reality that isolated its rranshistorical and universal aspects ...The institu­tionalists realized that nothing was wrong with this approach to theory so long as the distancebetween absrraction and reality W1IS not great. But their empirical research led them to view thisdistance as substantial, at least for some parts of orthodox theory, and also as historicallyvariable, because the economy perpetually was 'a mOVlIlg, changing process'.J

Generally, orthodox labour economisrs viewed labour markets as analogous toother markets and expected them to behave in ways consistent with standardmarket analysis (Garvey 1994). This approach has been caricatured by Solow(1990) as treating the labour market as analogous to 'the supply and demand fordead fish'. This approach begins from a theory of the labour market based onthe assumptions of perfect competition. Then, extensions intended ro bridgethe gap between the basic model and observed empirical regularities proceededby relaxing one or more of the restrictive assumptions with which it began (seeHausman, 1989). In the remainder of this section we outline the basic competi­tive model of the labour market, and discuss the major extensions to it. Theseexrensions go a considerable way towards meeting many of the criticisms madeof standard economic models of how labour markets function. Their insightshave been invaluable. We argue, however, that the model is predicated on anunrealistic notion of the employment relation as purely a market relation.Instead we argue that, once the original match is made, the market dimensionof the relation is less important, and a non-market, or an authority relation,

2. Elsewhere, Samuelson (1951) noted the difficulties that have engulfed economic theorists whenapplying standard neoclassical economic analysis to the employment relationship:

.. .1 fear that when the economic theonst turns to the problem of wage determination and laboreconomics, his voice becomes muted and his speech halting. If he 15 honest with himself, he mustconfess to a tremendous amount of uncenainry and self doubt concerning even the mOSt basic andelemenury parts of the subject. (Samuelson 1951, quoted in Card and Krueger 1995, 312).

3. Jacoby also points Out that it was in fact 'an error oflongstanding to charge that me institutionalistsdiscarded economic abstraction and me deductive method... yet it is true that instinnionalists wereunable to resolve their dispute 'with orthodoxy' (1990, 320). Also see Kaufman (1997).

completes the transaction. This concern is addressed mOte directly in thefollowing section. Here we outline the basic competitive model, and extensionsintended to address problems associated with it.

The idea of a perfectly competitive labour matket begins with a numbet ofcrucial assumptions. Notwithstanding the restrictive nature of these assump­tions, they have provided a useful statting point from which more complexphenomena can be analysed and ~xplained. The basic model of perfect compe­tition assumes that both firms and workers are rational maximisers. For thefirm this is usually interpreted as meaning that they make production decisionsto maximise profits.' That is, they are willing to hire additional labour only solong as the additional value in output generated from them exceeds the cost ofhiring them.' Workers maximise the utility from a trade-off between the use oftheir time as leisure and work. In addition to the basic behavioural axioms, thepredictions of the perfectly competitive model rely on a number of additionalassumptions: complete mobility ofworkers and productive resources, completeinformation, 'price-taking' behaviour, and the absence of any externalities.

Implicit in all of the above is the idea that adjustment to any exogenous'shock' will be costless. Worker mobility will be perfect, and firms are capableof adjusting capital-labour ratios and other inputs into production easily.Search and mobility for both firms and workers are costless, hiring and firingdecisions are assumed to be costless, and so on. This leads to the prediction offull employment at the prevailing wage rate (or wage structure); all workerswilling to supply labour will be offered employment. Where this is not the case,labour market adjustment will occur through wage adjustment. That is, whereworkers remain unemployed, the prevailing wage will be bid down until allworkers seeking work are employed. Thus, through the price mechanism, theprocess of labour market adjustment in wage and employment levels providesfor full employment.

LABOUR ECONOMICS AND INDUSTRIAL RELATIONS 511

Problems with the standllrd model

It is difficult to believe that this view of the nature of the employment relationand how labour markets function could be thought ofas an accurate descriptionof the world in which we live. Put simply, it fails to explain a number offundamental economic phenomena. The most important of these are the

4. Alternative maximands date to the work ofVeblen (1988[1904)). A number of alternatives havebeen posed, and include sales maximisation subject to the constraint of an acceptable shareholderrerum (profit), some combinations of managerial goals and profit, or that finns seek to 'satisfice',rather than maximise (see Ricken:s 1994). These are normally associated with imperfectly competi­Dve product markets or where it is costly for shareholders to gain information about managerial

performance.

5. The value of 'worker output' is, in this case, the revenue generated from the sale of the producteach additional worker produces, less other costs of production (such as additional capital used togainfully employ additional labour). In a perfectly competitive market, the cost ofhiring additionalworkers is simply the wage, as all other costs of rransactmg-such as recruitment coSts, dismissalcOSts, firm-specific rraining, and so on-are assumed to be zero. This is required for the assumption

of perfect mobility.

512 THE JOURNAL OF INDUSTRIAL RELATIONS December 1998

existence and persistence of Wlemployment and the failure of wages to adjustdownwards in periods ofWlemployment (Kaufman 1997). Other labour marketphenomena defy the predictions of the model as well, such as discrimination,the formation of unions, the persistence of a union/non-union wage differen­tial, internal labour markets and labour market segmentation. Indeed, as manyeconomists have long recognised, it rules out as irrelevant many of the institu­tions central to the operation of a market economy, such as the firm. (We shallreturn to this point later.) Despite these obvious shortcomings the standardmodel is still accepted within the academic economics profession, albeit innewer, more sophisticated forms (Greg & Manning 1997). It is associated withwhat is commonly referred to as the 'new classical' approach (Lindbeck &Snower 1988).'

All of the assumptions in the standard competitive model provide an inad­equate description of 'real world' labour markets. In the remainder of thissection we shall discuss some of the basic problems identified in labour marketsthat violate the model. Specifically, we will deal with information and mobility,wage-serting behaviour and externalities. All three sets of issues have profoWldimplications for how labour markets work and provide some rationale for theexistence of labour market institutions.

Information and mobility The basic model assumes that both workers and firmshave full information and, as factors of production, are perfectly mobile. Costsof information gathering about labour market opportunities and prevailingwage rates are also assumed to be negligible. These assumptions are problem­atic for a number of reasons, as Mortensen (1986, 849) noted: 'The timeworkers spend Wlemployed, movements from job to job during the work life,and the allocation of the working life between market work and alternativeactivities in a dynamic environment are all left inadequately characterized.'

Firms and workers have incomplete information ahout labour market condi­tions or the potential pool of possible matches; neither has adequate informa­tion about the other party when hiring and wage decisions are initially made. Insome types of employment, workers may have inadequate information aboutrisks of injury or death. The collection of such information is cosdy. Firmsmake fixed and specific investments in plant and equipment, as well as invest­ments in workers, which take the form of recruionent and selection, andinvestments in human capital. Workers themselves make investments in humancapital that are 'firm-specific' in content. In addition to these, either party islikely to face a range of barriers or costs of mobility that influence its labourmarket decisions. In short, the standard and new classical models run cOWlterto a series of basic facts known about labour markets that generate 'labourmarket imperfections.'

The standard model has been extended in a number of ways, which reflect

6. Greg and Manning (1997) note that many economist<> have begun from these assumptions wheninterpreting empirical regularities in labour markets. For one very influential example, see Lucasand Rapping (1969).

LABOUR ECONOMICS AND INDUSTRIAL RELATIONS 513

these various informational and mobility problems. One key development inthe last two decades or so has been the theory ofsearch and matching behaviourof firms and workers. In these models, workers and firms have inadequateinformation about available jobs and workers, and both must therefore engagein search activity. This in turn implies that unemployment will exist as a naturaloutcome of workers' job search, and because workers (firms) may have insuffi­cient information about available job vacancies (workers with skills and produc­tivity attributes) at a wage that would make searching viable (Monensen 1986and Pissarides 1985). A key feature of these models are the processes ('tech­nologies') by which firms and worker 'match' with each other; that is, the waysin which workers and firms locate each other and signal their attributes whichinfluence skill and productivity levels. A consequence ofsearch and matching isunemployment. The level of unemployment will depend on the extent andintensity of search as well as ·the means by which search and matching areachieved. Search, matching and turnover are viewed by this theory to beoptimal behaviours; unemployment becomes a 'necessary evil' in the function­ing of labour markets. Notwithstanding the insights of the approach, it pro­vides (at best) an incomplete theory of the formation and separation ofemployment relationships. One key problemis its inability to explain persistentor involuntary unemployment. In this model the existence of unemploymentreflects rational decisions by workers to search for better job opportunities. Inthis sense unemployment is viewed as voluntary in nature.

7

Wage-setting behaviour The standard model assumes that neither firms norworkers have any capacity to influence the market wage for any particular typeof worker. The exception to this has been to consider the case where a singlefirm operates a (relatively isolated) company town, such as a mining operation.In this case the firm becomes the single buyer of labour, or a monopsonist. It isnot difficult to believe that a firm, as a monopsonist, is able to influence thewages paid to its workers. The theory of pure monopsony predicts that a firm isable to pay a wage less than the wage that would prevail in a competitivemarket.' However, economists have been reluctant to accept the hypothesisthat beyond this extreme case, employers exercise labour market power asbuyers of labour (Manning 1996)9

7. Ths approach has been used to hypothesise a direct relationship between unemployment andthe level and duration ofunemployment benefits. As the level ofunemployment benefits increases,so the theory goes, the incentive to eng:ilge in search is reduced. Although there has been someattempt to demonstrate that such a relationship exists (Layard, Jadanan & NIl:kell 1991, Layard1997), the assumptions and methodology of this research have been found wanting (Atkinson &

Micklewright 1991, and Gahan 1998).8. The monopsonist would pay a wage less than the marginal (average) productivity of the lastworker (all workers) employed, and would make the level of employment lower than would be thecase under perfect competition. For a more detailed exposition of the monopsony case, see Boal and

Ransom (1997).9. See, for example, the debate between Kaufman (1989 and 1991) and Reynolds (1991). Morerecently, see the 'Policy Forum: Economic Aspects of Minimum "rages' (1996) in the Eamumic]ou17lIJ1, and a similar 'Review Symposium' (1995) in the Industrial and Labar Relations Rev;ro'.

514 THE JOURNAL OF INDUSTRIAL RELATIONS December 1998

This view of monopsony, however, ignores a range ofpossible 'frictions' or'imperfections' that enable firms to exert some influence over wage settingwithin the labour market. For example, consider the informational and mo­bility costs described above. Both job search and mobility were found to becostly to workers. Workers' decisions to search and change jobs were viewedas rational decisions. It assumed that workers were only willing ro change jobswhere the benefits of doing so were larger than the costs." ~ereas theperfectly competitive model implies that a decision by a firm to decrease thewages of its workers (by any amount) should lead ro the turnover of its entireworkforce, the existence of costs of mobility imply that this will not occur.Mobility costs and costs of search can thus be seen as one source of a firm'sability to influence wage setting, or ro act in a monopsonistic way (Boal &Ransom 1997). The extent of its wage-setting influence will be positivelyrelated ro the level of such costs (Ehrenberg & Smith 1997).

The modern theory of monopsonistic competition draws heavily from theinstitutionalist or 'realist' labour economists, such as Clack Kerr, RichardLester, Lloyd Reynolds, John Dunlop and Sumner Slichter (Kaufrnan 1988,Segal 1986). Armed with a wealth of empirical studies, these economistsargued that standard models did not seem to apply in the case of labourmarkets." Labour mobility appeared relatively low and unresponsive ro wages,and workers were reluctant to change jobs. These results were inconsistentwith the standard neoclassical view. Subsequent research by Doeringer andPiare (1971) and Gordon (1972) highlight the role of internal labour marketstructures and labour market segmentation as important sources of monop­sony power.

Tests far the existence of monopsonistic behaviour by firms are difficult toconstruct, not least because of the fluid nature of labour markets. Nonetheless,recent research on the effects of minimum wage laws and equal pay providessome evidence that the theory the monopsony model has validity well beyondthe single-firm town. In a comprehensive study, Card and Krueger (1995) re­examined a number of studies of the effects of minimum wage increases onemployment levels, as well as completing new studies using data from fast-foodoutlets in a number of American states. These labour markets have generallybeen assumed by most economists to be the closest approximation to a com­petitive labour market. They found that increases in the minimum wages,rather than reducing employment, had no or insignificant effects on employ­ment. In a number ofcases, minimum wage hikes were associated with increasesin employment levels (also see Katz & Krueger 1992)." Dickens, Machin and

10. That is, workers would, in the words of Ehrenberg and Smith (1997), 'invest in mobility wherethe present value ofa future stream of benefits associated with mobility outweigh the costs of doingso. In this sense the decision to turnover is seen as analogous to the decision to InVest In humancapital.'

11. See for example, the famous debate Letween Lester (1946) and Machlup (1946).

12. This research has not been without its critics; see 'Policy Forum' (1996), 'Review Symposium'(1996) and Burkhauser, Couch and \Vittenburg (1996).

Manning (1993) and Machin and Manning (1992) report similar results forBritain (also see Machin & Manning 1997). More recently, Manning (1996)used the passage of the 1970 Equal Pay Act in Britain as a natural experiment totest for the existence of monopsony power. Consistent with the theory ofmonopsony, he found the Act was associated with an increase in the employ­ment ofwomen. These empirical results are more consistent with the industrialrelations literature, which emph~1iises the importance ofasymmetric power andthe exercise of authority in employment.

t,.f

ii.I'e

LABOUR ECONOMICS AND INDUSTRIAL RELATIONS 515

\,,[,l

;,jf!ir,.-tf

Externalities and public goods The standard model also assumes that any benefitsand costs associated with the behaviour ofeither firms or workers will accrue tothose parties directly involved. This assumption is required for any wage andemployment outcome to be consistent with the criteria of efficiency.13 Thisignores the possibility that any decision or action of either party will involvesocial costs or benefits, and will therefore create 'free-rider' problems(Eggensson 1990). There are a number of cases, however, in which rivalry inconsumption and problems of excludability create both negative externalitiesand public goods (see Ostrom 1990).

Consider, for example, the case of occupational health and safety. Thestandard model assumes that both workers and firms will make rational choicesabout the efficient levels of safety within the workplace through bargainsbetween employers and individuals. Thus, the more dangerous the workplace,the larger will be the wage premium demanded by workers exposed to risk.This analysis rests on the assumption that the level of risk inherent in exposureto work hazards is well known to both firms and workers, and that the provisionof safety in a workplace is not a public good (Gahan & Mitchell 1995).However, the public good nature of workplace safety, and the lack of informa­tion workers have about the true nature of risks to which they will be exposed,are likely to mean they will underestimate the premium required to offset thehigher risk of injury. There may also be difficulties for workers in verifying thequality of the precautions taken by management to prevent risk (Risa 1995).These difficulties for workers in assessing risk are often paralleled by similarinformational asymmetries for management. \Vbere employers are unable tomonitor the true extent to which workers take due care to avoid possible risks,the assumption of efficient contracting is unlikely to hold (Lanoie 1991). A

13. Economics uses the tenn 'efficiency' in a very specific way. Here we distinguish betweena//.ocativt (or social) efficiency and Panto efficiency. Allocative efficiency refers to the allocation ofresources that maxlmises their use in production, or that maximises social welfare or utility. Thereis a range of difficulties associated with this concept (see Knight 1992). In assessing economicoutcomes economists generally rely on the Parem criteria. An outcome is considered Paremefficient when no one agent can be made better off without making someone else worse off. Thisimplies that while a change in work organisation may make the transformation of inputs intooutputs more profiwble, this does not mean It is 1ficimt if, say, workers are made worse off in theprocess. Such changes may simply involve the transfer of a surplus from workers m firms (seeMarglin 1974 for the classic statement of this argument).

516 THE JOURNAL OF INDUSTRIAL RELATIONS December 1998

similar argument also applies to the cases of training and innovation (Freeman1994 and Acemoglou 1997), profit-sharing schemes (Kmse 1994) workerparticipation (Levine 1992), wage bargaining and strikes (Schott 1984).

In summary, the main conclusion of this section is that the standard com­petitive model fails to account for a range of feamres that pervade labourmarkets and contravene its core assumptions. Both neoclassical and instirn­tional economists have PQinted to a range of ways in which empirical regulari­ties contradict the predictions drawn from the theory. Many of these feamreshave been accounted for, however, in a range of extensions to the basic model,without challenging the market paradigm from which it derives. These devel­opments have generally viewed any inconsistencies with the basic model asimpediments to efficient labour market adjustment. Moreover, the standardapproach ignores the central role of labour market instimtions to the operationof a market economy, or views such institutions as impediments to the opera­tion of efficient markets. 14

NON-MARKET ASPECI"S OF TIffi EMPLOYMENT RElATIONThe theory ofthe firm and the emplayment relation

Notwithstanding the theoretical developments so far discussed, the neoclassi­cal model has, in the last decade or so, faced a renewed challenge frominstimtional approaches. Industrial relations scholars and many instimtionaleconomists have taken exception to the view that the employment relation isbest modelled as a market-mediated exchange. IS The alternative approach hasbeen to view the employment relation as a 'mixed exchange', in which bothmarket and non-market aspects are viewed as important, or to focus entirely onthe internal characteristics of the finn's employment structure and policies.

The first of these alternative approaches, which derives from a radicalpolitical economy of labour markets (Rebitzer 1993), has been examined his­torically by Marglin (1974) and fonnalised by Bowles (1985). In this model theemployment relation is described as a two-stage exchange. The first stage,which is characteristically a market exchange, is the hiring of labour. This doesnot complete the process, however, as the procurement of labour involves thehiring of what Pencavel (1991) has tenned 'raw labour'. The second stageinvolves the conversion of raw labour, or the capacity to work, into effectivelabour, or acmal work effort. This phase does not involve a market exchange,but occurs within the confines of the finn and the authority relation thatdefines it (Bray 1986). From this perspective the exchange occurs, not within amarket relation in which the price mechanism fonns the basis for allocation and

14. Thus far, the term 'labour market institutions' has not been defined in any meaningful way.This issue of definition has more direct relevance to the themes developed in the fourth section andbeyond. Coru;equendy it will be discussed in that section.

15. 'The definmg characteristic of a market is,' Lazonic (1991, 59) notes, 'the impersonal relationbetween the buyer and seller ...The impersonality of the market is manifest by the willingness ofsellers of goods and serVlces to enter into exchange with the highest bidders. As long 3S a buyer hasthe purchasing power to pay the hJghest price, his or her identity is of no concern to the seller.'

LABOUR ECONOMICS AND INDUSTRIAL RELATIONS 517

co-ordination decisions between separate economic agents, but within anauthority relation in which the allocative and co-ordination functions are theprovince of managerial decision making.

\Vithin the industrial relations literature, this line of research has beendominated by labour process theory and analysis of management strategy (seeThompson & McHugh 1995), while within institutional economics it has beenassociated with segmented labOULmarket theory and internal labour markettheory (Doeringer & Piore 1971). Unlike much of rhe standard economicsliterature, there is no presumption that the employment relation is likely to bestructured in a way that reflects both firm and worker preferences or efficiencyconcerns. Rather, the internalisation of the employment relation reflects man­agement preferences for profit maximisation through minimisation of labourcosts and increasing intensity ofworker effort (Gospel 1992). In this sense, theemployment relation cannot 'be described as efficient (see Rebitzer 1993,Bowles 1985 and Gordon, Edwards & Reich 1982).

This approacb parallels recent developments in microeconomics and thetheory of the firm, which has primarily been concerned with understanding theinternal stru~Jloliciesof the firm as a substitute for the role of marketsin co-ordinating economic decisions. I' It begins by asking some fundamental.questio'£ \Vhy do finhs exist? \Vhat economic functions do they serve? \Vhatexplai~s differences in'the internal structure of firms? This approach views thefinn and markets as alteqlative modes of organising economic activity, or in\Villiamson's (1979) terms, 'governance structures'. The firm, by its nature,replaces the market mechanism with non-market mechanisms to determineallocation and production decisions. The perfectly competitive model, withwhich we began, rules out the possibility that firms could make more efficientdecisions than market-based co-ordination. Coase (1937), who made one of theearly attempts to address these questions, argued thar the existence of firms(and economic and social institutions) was a response to inefficiencies in markettransactions.17 He suggested that the displacement of markets by firms was aresponse to higher 'transaction-costs' associated with certain" market exchanges;exchanges where transaction-costs were high were more efficiently organisedby authority (also see Arrow 1974). \Vithin the field of labour economics, thisinsight allowed for an efficiency explanation of internal labour markets struc­

tures eracoby, 1990).

16. Hart (1995: 5) recognises more explicitly the connection between the modem neoclassical

theory of the finn and Marxist approaches:

Given its concerns with power, the [modern theory of the finn] has something in common withMarxian theories of the capitalist-worker relationship, in particular with the idea that an employerhas power over a worker because the employer owns the physical capital the worker uses (and cantherefore appropriate the worker's surplus) ...The connection between the two approaches has not

so far been developed in the literature.

17. Coase was by no means the first to ask these questions. See Berle and Means (1932) and Knight

(1965[1921]),

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THE EMPLOYMENT RELATION AS A GOVERNANCE STRUCTIJRE:TRANSACTION-COSTS AND THE FIRM

The modem articulation ofthis approach, associated with the work ofWilliamson(1964, 1975, 1979, 1985)," rakes the transaction (or exchange) as thobasic unit ofanalysis. 19 Transactions between economic agents are viewed as being regulatedby various types of contractual relationships, or governance strucmres.10 Macneil(1974, 1978) and Williamson (1979) distinguish between three contractual forms:classical, neoclassical and relationa1. Classical contracting involves the formationof contracts that specify in a complete and discrete way the nature of theexchange between parties, whereby all future contingencies that may influencethe contractual relation are specified and accounted for. Moreover, the identity ofthe parties to the exchange is of little interest to buyers or sellers; each is perfectlysubstitutable. Such contracts are analogous to the relations between finn andworker specified by the perfectly competitive market (Macneil 1978).11 Whilemany examples of classical contracts can be identified, most contracts do notmeet the strict conditions that define them; few economic transactions aregoverned by complete or discrete contractual re1ations.22 Mere informationabout the future is incomplete or costly, and the anticipation of all futurecontingencies or the pre-contractual specification of the best response to them isnot possible, neodassical or relational contracts are to be preferred as moreefficient governance mechanisms.

Neoclassical contracts result from the existence of 'neoclassical uncertainty'over future conringencies. ZJ They involve economic agents establishing incom­plete contracts, but with specified mechanisms to resolve disputes over per­fonnance of contractual obligations, such as third-party involvement (forexample, arbitration). The defining features of neoclassical contracts are thediscretionary power for the parties to continue or terminate such contracts

18. The formal articulation of the approach can be found in the work ofHart(1991 and 1995), Hartand Moore (1988 and 1990) and Holmstrom and Milgrom (1994).

19. This idea will be well knovm to industrial relations scholars through the work of Commons.

20. Here the term 'contract' is not used in a striCt legal sense. An economic Contract is defined asany agreement that governs the relation between economic agents, irrespective of whether it hasleg,Jl status. See Milgrom and Roberts (1992, chapter 5) for a more complete discussion.

21. Macneil (1978, 856) defines a classical contract thus:

A rruly discrete exchange transaction would be entirely separate not only from all other presentrelations but from all past and future relations as well. In short it could occur, if at all, only betweencomplete strangers, brought together by chance (not by anycomrnon social strucrore, since that linkconstitutes at least the rudiments ofa relation outside the transaction) ...Moreover, everything musthappen quiclcly lest the parties should develop some kind ofrelation impacting on the transaction soas to deprive it of discreteness.

22. For a larger historical analysis of the development of contract as an economic device forgoverning exchange, see Atiyah (1979).

23. 'Neoclassical uncertainty' refers to a sirnaoon where furore states of the world are unknown, butthe probability of each outcome is known. Consequently, expectations reguding outcomes andvalues of specific contracrnal forms can be formed and (expected) wealth-maximising decisions alnbe made (see Eggensson 1990).

LABOUR ECONOMICS AND INDUSTRIAL RELATIONS 519

where rhey no longer procure ner benefits, and rhe fact rhat such contractsusually govern relations between firms." Complexity and durability of contrac­tual relations have resulted, Maeneil suggests, in rhe displacement of borhclassical and neoclassical contracts by an even less specific contractual device,rhe relational contract. These contractual forms reflect rhe existence of 'realuncertainties' in which future states of rhe world are not known or whereexpectations about known possible outcomes cannot be formed (Eggertsson1990). Under rhese conditions, less specific contractual obligations are sup­ported by trust relations in which reciprocity is assumed for rhe long run.'Relational contracts' can be rhought of as rhe formal and informal rules rhatdefine intra-organisational relationships rhemselves.

The assumptions of rhe perfectly competitive model imply rhar rhe condi­tions that give rise to either neoclassical or relational contracts are not present.Borh rhese types of contracts emerge as alrernatives to market-based relationsgoverned by classical contracts. This occurs where certain attributes of a giventransaction conducted through market-based contractual relations generateltransaction-costs'. The transaction-costs literature identifies five key attributesof transactions rhat detennine rhe nature and magnitude of transaction-costs:rhe fi'equency and duration of transactions, rhe complexity of transactions, rhecapacity to measure performance of contractual obligations, rhe extent to whichany transaction-specific investments are involved, and the uncertainty about furorecontingencies rhat may affect rhe terms of any exchange (see Dow 1996, Miller1992 and Williamson 1981). The type of transaction-costs will in turn deter­mine rhe nature of rhe governance structure adopted (Williamson 1979). Theseideas have now been extensively used to explain why rhe employment relation istypically removed from a market-based relation and governed by alternativegovernance structures, such as internal labour markets (Williamson, Wachter& Harris 1975), as well as rhe structural features of different types of internallabour markets to resolve co-ordination, motivation and bargaining problems(Dow 1997, Miller 1992, Milgrom & Roberts 1992 and Williamson 1980).

UNIQUE ASPEUS OF THE EMPLOYMENT RELATION

The transaction-costs rheory of rhe firm suggests a number of ways in whichlabour economic concerns converge with those of industrial relations, particu­larly in terms of understanding rhe structure of rhe employment relation and itsefficiency and equity consequences. There are fundamental points of depar­ture, however, berween rhe rwo disciplinary perspectives on rhe nature of rheemployment relation itself. A central point of contention is wherher rhe em­ployment relation is in any sense unique or different from other economicexchanges. Despite rhe incomplete contractual nature of rhe employmentrelation, many economists have assened that it is no different from other

24. Macneil (1978, 887) identifies consornums, franchise agreements, and relations with creditorsor law finns as archetypal examples of neoclassical contracts that firms typically enter into. In thefield of industrial relations, collective agreements between finns and unions, and subcontracting

arrangements, are the primary examples.

520 THE JOURNAL OF INDUSTRIAL RELATIONS December 1998

economic relations where transaction-costs imply a non-market· governancestructure. In an influential account of this view, Alchian and Demstez (1972,337) make this argument in the following manner.

It is common to see the firm characteriz.ed by the power to settle issues by fiat, by authority, orby disciplinary action superior to that available in the conventional market. This is a delusion.The £inn does not own all its inputs. It has no power of fiat, no authority, no disciplinary actionany different in the slightest d~gree from ordinary market contracting between any two people.I can 'punish' you only by withholding future business or by seeking redress in the coUrtS forany failure to honor our exchange agreement. That is exactly all that any employer can do. Hecan fire or sue, just as I can fire my grocer by stopping purchases from him or sue him fordelivery faulty products. VVhat then is the content of the presumed power to manage and assignworkers to various tasks? Exactly the same as one little consumer's power to manage and assignhis grocer to various tasks. The single consumer can assign his grocer to the task of obtainingwhatever the CUStomer can induce the grocer to provide at a price acceptable to both parnes. Tospeak of managing"directing, or assigning workers to various tasks is a deceptive way of notingthat the employer continually is involved in renegotiation of contracts on terms that must beacceptable to both parties. Telling an employee to type this letter rather than file that documentis like telling a grocer to sell me this brand of tuna rather than that brand of bread. I have nocontract to continue to purchase from the grocer and neither the employer or the employee isbound by any cono-actual obligations to continue their relationship. Long term contractsbetween employer and employee are not the essence of the organization we call a firm. Mygrocer can count on my returning day after day and purchasing his s.ervices and goods even withthe price not always marked on his goods-because I know what they are-and he adapts hisactivity to conform to my directions to him as to what I want each day; he is not my employee.

Transaction-costs economics takes a similar approach (see \Villiamson, Wachter& Harris 1975, and \Villiamson 1980). We agree that neither the existence ofnon-market governance structures, nor the incentive and co-ordination prob­lems they generate, themselves make the employment relation unique; theseare also found in a number of contractual and organisational relations whereimperfect information and costs of transacting generate incomplete contracts.Although the transaction-costs approach provides a number ofkey insights intothe nature of the employment relation, we argue that this view is based on apartial analysis of the employment relation as the nature of real uncertaintiesthat pervade the employment relation are by their nature asymmetric (seeBlyton & Tumbull 1998, Brown & Nolan 1988 and Miickenberger & Deakin1989). While the employers obligations are specific in the form of a givenwage, the employee's obligations are uncertain and unspecified."

The employment relation is defined by a number ofadditional attributes thatdistinguish it from other exchange relations. As the quotation from Isaac (1992a)heading this paper indicates, the employment relation distinguishes itself fromother exchange relationships by the nature of the object of exchange and thecharacteristics of the exchange itself. Unlike other exchange relations, labourmarkets involve the exchange of human services, rather than inanimate objects or

25. Miickenberger and Deakin (1989, 188) note three sources of uncenainty: the length ofservice,the exact content or tasks required, and the intensity of work. Some obligations Imposed onemployers by common law are by their naroce imprecise, most notably the implied duty of careemployers have to their employees.

LABOUR ECONOMICS AND INDUSTRIAL RELATIONS 521

inputs into the production process. It is these human aspects that reflect the'psychological contract' between finns and workers in which nonnS of behaviorare implicitly established (Klass & Ullman 1995, McFarlane, Shore & Tetrick1994, Rousseau 1989, Robinson & Rousseau 1994).26 Moreover, the employmentrelation is unique in that the object of exchange, the mental and physicalcapacities to work, is inseparable from the subject of exchange, workers them­selves (Blyton & TurnbullI998)."The Isaac quote goes on to point out:

Labour is subject to complex social and psychological forces. People are less receptive todirection than a piece of equipment. They react to their environment...In their workingenvironment, they are not individuals but form pan of a group, open to group pressures andvalues. The place ofwork is not merely part: ofan economic process but also a social institution.And so is the labour marl.:et. In such a context, people develop norms about what is right andwrong and fair. Work is not merely to earn an income. It has meaning in itself. The size ofpayment for work reflects on the worth. statuS and self-esteem of the person concerned. Peoplemeasure their wonh not in absolute terms but relative to one another. But while the financialincentive is imponant, people are also motivated by non-financial consideration<;.

The incomplete nature of employment contracts and the human dimensions ofthe exchange combine to make the employment relation unique, in tenns of thegovernance structures that define it, the tenns of the exchange and the actualexchange itself (Brown & Nolan 1988). This perspective raises twO important,questions." First, how do labour markets adjust? And second, are labourmarket outcomes likely to be efficient?

\Vbat is clear from the preceding discussion is that any focus on the 'pricemechanism' as the primary source of labour market adjustment is inappropri­ate. Both finns and workers are able to alter the tenns of the exchange in arange ofother dimensions: 'there are too many margins, but not enough prices'(see Bazwli, Kirat & Villeval 1994). Moreover, the unique aspects of theemployment relation imply that a range of psychological and social determi­nants of worker behaviour and management practice will influence labourmarket dynamics. Isaac's (1992a and b) own perspective on this issue reflects awider a body of theory thar examines the important role of fairness in wagedetermination; economists such as Akerlof (1982), Solow (1990), Rees (1993)and Yellen (1984) have argued that the most important of these is the nonn offairness. These aspects of the employment relation have important

26. These human or psychological aspeCts of the employment relation can be viewed as theprecondition for relational contracting (Rousseau 1989), and have been used to explain whysrandud free-rider problems do not appear in workplace environments where economic theory

suggests they should (see Miller 1992).27. This attribute-and its implications for understanding the employment relation-is evoca­tively described by Weiler (1990, chapter 4), where he compares an employer who hires a robot with

the one who hires a human being to perform work.

28. There are of course other important questions that stem from this observation. One concernsthe issue of whether the basic supply and demand model is appropriate at all. We argue that theseobservations rule out the idea that a unique relation between wage levels and labour supply or labourdemand is identifiable. That is, we question whether a labour demand or supply curve can be

idenofied in any meaningful way.

522 THE JOURNAL OF INDUSTRIAL RELATIONS December 1998

consequences for both the efficiency of such relations and, more imporrantly,the relationship between its efficiency and equity characteristics.

Efficiency and equity

A final point of concern is the nature oftabour market outcomes. The transac­tion-costs approach argues that governance structures used to displace marketswill generally have an efficiency rationale: the minimisation of transaction costs(Williamson, Wachter & Harris 1975, Williamson 1985 and Milgroni &Roberts 1992). The internal governance structure of the firm (which includesinternal labour market arrangements) is likewise viewed as efficient in that bothworkers and firms are able to negotiate an outcome that is optimal for them­selves. The efficiency claims of transaction-costs theory rely on the assumptionthat the Coase Theorem holds. The Coase Theorem states that, absenting anywealth effects,19 where the parties are able to reach a solution that is efficient forthe parties themselves, the toral value (or surplus) of the outcome will notdepend on the bargaining power of the parties or the initial distribution ofresources. In other words, the parties will be capable of exploiting all gainsfrom trade. This assumption perfonns two important functions: it provides apredictive hypothesis for the theory (that is, efficient outcomes will generallyprevail), and it neatly separates efficiency and distributional concerns (Milgrom& Roberts 1992).

Given the imperfect nature of markets, which in a transaction-costs frame­work explains the existence of finns, the efficient contracts hypothesis appearssomewhat contradictory (Elau 1993 and Lazonick 1992). Jacoby (1990), Dow(1993,1996 and 1997) and Marginson (1993) have pursued this argument inderail. They suggest that many of the problems and transaction-costs thatdisplace market-based transactions can be found in some fonn within theemployment relation." Among the many reasons for this, six are worthy ofbrief mention here. First, Dow argues that the distributional goals are in manysenses inseparable from efficiency arguments, due to capiral constraints thatworkers face. We have already alluded to this in relation to the role of fairnessin wage determination. Here, wealth effects are also found to be important.Second, assets in the fonn of human capiral, particularly those ofa finn-specificnarure, cannot be traded because of the inseparability of the object and subjectin an exchange relation. Under these conditions, the authority relation takes ona different meaning than is implied by Alchian and Demsetz (1972). Third, thenarure of authority relations within the finn is likely to produce what Demsetz(1988) refers to as 'management-costs'. Milgrom and Roberts (1988 and 1990)argue that the reliance on an authority structure within the finn is also likely to

29. The 'no wealth effects' assumption requires that an individual's preferences be separate fromtheir wealth endo\Vlllems (see Milgrom & Robern 1992, chapter 2).

30. Demserz (1988) distinguishes the transaction-costs associated with markets from 'manage­ment-costs' associated with internal exchange relations within the finn. The fanner provide therationale for the displacement ofmarket<> by hierarchy, while the latter detennine the solution to theinternal contracting problem within the finn.

LABOUR ECONOMICS AND INDUSTRIAL RELATIONS 523

generate 'influence' and bargaining costs as individuals attempt to influencedecision makers within organisations. Fourth, the more complex are exchanges(that is, where the number of tasks or valuable attributes is greater), the largerwill be management costs associated with negotiating an appropriate govern­ance structure and monitoring and enforcing performance. Finally, we havealready discussed in some detail the problem of externalities in relation to anumber of aspects of the employment relation. These apply directly to theproblem of establishing internal governance structures.

The sixth concern arises from Jacoby's (I990) concern about the sychronicbasis of economic theory. His own historical research on the origins of internallabour markets Oacoby, 1985) suggests that many of the characteristics associ­ated with internal labour markets, which were said to have efficiency effects(deferred payments schemes, employment security and severance payments,and so on), did not become prevalent attributes of American internal labourmarkets until after the process of internalisation had occurred. Moreover,emergence of internal labour markets, he argues, typically developed during'crisis' in older systems of labour administration. Wright, in his 1995 work onAustralian labour management practices, finds a different historical pattern ofinternalisation which reflects historically specific problems of management andinstitutional constraints. He likewise questions whether this process can onlybe viewed as having an efficiency rationale (see Wright 1995).

The transaction-costs approach then provides a useful starting point forexamining the role of markets and firms, and for examining the internalstIucture of the finn as a governance structure. There are, however, a numberof concerns regarding the way in which it has been employed by 'new institu­tionalist' analysis of labour markets and the employment relation. The majorone noted here is the efficient-contracts assumption, which has formed thebasis of much of this theory. Moreover, the assumption that efficiency anddistributional issues can be separated was found to be problematic (see thediscussion in Buchanan 1996). This conclusion suggests that firm-level ineffi­ciencies, including worker dissatisfaction with governance structures, mayprovide an explanation for the existence of other institutions within the labourmarket. It is therefore to the issue of labour market institutions and economicperfonnance that we now turn.

LABOUR MARKET INSTITUTIONS

The preceding sections have sketched an outline for an alternative frameworkfor analysing the employment relation. We have argued that an understandingof the firm as a non-market institution is crucial to this task. Even where theclassical attributes of internal labour markets are not strong, the employmentrelation is defined by a number of unique aspects, mOSt notably an incompletecontract governed by an authority relation in which 'psychological contracts'supplant economic contracts as governance structures. These characteristics ofthe employment relation did not support the hypothesis that governancestIucrnres would necessarily be efficient.

These conclusions draw our attention to the role of economic and social

524 THE JOURNAL OF INDUSTRIAL RELATIONS December 1998

institutions in the labour market. An initial issue that must be addressed is what wemean by institutions. Here we adopt the definition proposed by North (1991,3-4):

Institutions are the rules of the game in society or, more fundamentally, are, the humanlydevised constraints that shape human interaction. In consequence they stnlctUre the incentivesin human exchange, whether political, social, or economic ...A crucial distinction... is madebetween institutions and organizations. Like institutions, organizanons provide a structure tohuman interaction ...Conceptually what must be differentiated is the rules from the players.

The distinction drawn here between firms as governance structures and institu­tions as 'rules of the game' is also found in the industrial relations literature.Buchanan and Callus (1993) develop a similar schema of la bour market regula­tion. They distinguish between 'internal' and 'externa]' sources of labourmarket regulation. Internal regulation can be viewed as the governance struc­ture of the firm concerned with the employment relationship, as well asinformal rules that evolve from norms of fairness and custom and practicewithin the workplace. In contrast, external regulation is found in the form ofinstitutions that govern the behaviour of firms, unions and other organisations.Again, these may be informal or formal in nature. 31

'The major role of institutions in a society,' North suggests, 'is to reduceuncertainty by establishing a stable (but not necessarily efficient) structure tohuman interaction' (1991, 6). Institutions also 'provide a structure for exchangethat, together with the technology employed, determines the cost of transact­ing and cost of transformation' (North 1990, 192). The rationale for theexistence of labour market institutions (or external labour market regulation) isthat used to explain why internal governance structures within the firm areunlikely to be efficient or equitable. These were examined in the previoussection. Given the debates over the magnitude and significance of these prob­lems it is not surprising that economists and industrial relations scholars havedebated the role oftabour market institutions and whether they can be justifiedaccording to standard efficiency and equity criteria.

The standard approach within institutional economics is to focus on theefficiency aspects of institutional arrangements. Most attention has been placedon the importance of institutions of property rights and regulation of commongoods, marriage, and the institutions of the state (see Goodin 1996). Theseinstitutions have been viewed by economists as performing the important tasksof reducing costs of transacting ind providing some stability and certainty forefficient exchange relations to develop."

Following earlier work by Stigler, Tsebelis (1990) argues that such a view

31. In many respects the distinction between instirotions (as non-contractual constraints onbehaviour) and the firm (as a nexus ofcontracts) parallels the conceptual framework ofcontract andsums used by legal scholars (see K..ahn-Freund 1967, and Muckenberger & Deakin 1989) andapplied to the study of the employment relation by Fox (1974) and Streeck (1987 and 1992).

32. Curiously, labour market instironons have not generally been viewed from this perspective asproducing similar results. There are some notable exceptions. Calmfors and Driffill use efficiencyrationale to explain the emergence ofcorporarist institutions, while Freeman and Medoff(1984) usethe same argument to explain the role of unions In the workplace. For a more recent analysis of therole of institutions, see Dow (1997).

LABOUR EC()~O.\HCS AND INDUSTRIAL RELATI07"'S 525

provides a somewhat naive perspective on institutions. He ffi3kes a distinctionbetween instimtions that have efficiency-enhancing characteristics and instim­tions that arise as the outcome of social conflicts over the distribution ofresources. Efficient instirntions will arise, he argues, where uncertainty aboutthe future position of any social actor prevents them from determining theeffects of any social instirutions on their welfare in furore periods. Uncertaintywill therefore favour the promotion of efficient institutions..o

Knight (1992) points out, however, that the design of instimtions and theway they function are likely to retlect both efficiency and redistributive con­cerns. In his view, the redistributive basis of social institutions is likely topredominate, as social actors favour their own welfare at the expense of othersin advocating specific institutional strucrnres. From this perspective, the rela­tive bargaining power of social actors is likely to intluence both the design ofinstitutions and the extern to which redistributive motivations prevail. More­over, the capacity of social actors and policy makers to hide the real effects ofinstitutional change and their own true motivations will be an importantdeterminant of the outcome of social instimtions (Coate & Morris 1995).V\'hile this perspective has not been pervasive, Robinson (1996) has argued thatsuch a perspective can be used to explain the nature of labour market reform ina number of industrialised economies during the 1980s (also see Pontusson &Swenson, 1996 and Ponmsson 1995). These struggles over the redistributiveconsequences of institutions also imply that it is unlikely that unique institu­tion,1 forms exist to resolve any given problem (Ostrom 1990), and thatinstirntions are likely to take on time- and context-specific characteristics

oacoby 1990).In summary, three points can be drawn from this analysis. First, contrary to

pronouncements that instirntions are no longer important (Purcell 1993), thissection has highlighted the continuing importance of instirntional analysis tothe smdy of industrial relations and economics. By their namre, employmentrelations will always take some institu.tional fonn, although this will vary giventime and context. Second, these instirntions cannot be assumed a priori toreflect either efficient or redistributive motivations-this will be an empiricalquestion and will retlect the narnre of exchange being governed by instirutions,the motivations of the parties involved and their relative bargaining power.Third, this has significant implications for understanding debates about labourmarket regulation. \Vhile the argument cannot be developed here, we wouldassert that it simply inappropriate to consider labour market policy in terms ofa regulation-deregulation framework. H Rather, the interaction between insti­tutions and firm-level rules implies that these policy changes can be morefruitfully an,lysed as institutional change, not deregulation ordeinstimtionalisation (also see Muckenberger & Deakin 1989).

33. This view parallels R;]"-ls' (197 I) concept of a 'just' institution.

34. See Dabscheck (1995) for a useful critique of Aus[ralian dt:n:guhHion ddlJtcs.

526 THE JOUR:-':AL OF INDUSTRIAL RELATION'S December 1998

CONCLUSION

If the labour market was a competitive one where contracts were complete,information and commionent perfect, where problems of 'hold-up' or ex postenforcement, moral hazard and adverse selection were nonexistent, as wasdiscrimination along lines of gender or race, economic theory would imply thatthe wage rate would adjust to clear markets and generate a Parero-optimallevelof employment. The distrIbution of wages and income that emerged from suchequilibrium would reflect differing levels of (acquired or innate) skills and theproductivity endowments of individual workers. Moreover, if capital markerswere competitive, perfect and complete, and there were no market failures orexternalities connected with the accumulation of human or physical capital ortechnology, such an allocation of labour could be part of an inter-temporallyefficient .allocation of resources with a Pareto-optimal rate of productivity andper capita income growth.

I f the economy could be understood in such a way, it is hard to imagine thatthere would be a place for government interventions in the labour market (onceproperty rights were well defined). There might be some necessity for them inachieving equity, but in general this would be more efficiently organisedthrough taxes and transfers (such as a negative income tax policy). There wouldbe no need to restrict dismissals (caused perhaps by bad shocks or innovations),since these would be mutually agreed upon and could be insured against.Unemployment would be efficient matching. Minimum wages either would beirrelevant, or would cause unemployment by forcing employers to pay morethan the market clearing wage. Similarly, trade unions would be monopolysuppliers of labour who inefficiently restricted the supply (and lower equilib­rium employment) to raise the wage.

The desire to promote labour market 'flexibility' can be thought of in termsof the above theory of the labour marker. Regulations and interventions causedistortions and deviations from the conditions characterising an efficient allo­cation of resources, and should be removed. Yet ·this view of how labourmarkets function hardly describes accurately the world in which we live.Indeed, as many economists have long recognised, it rules out as irrelevantmany of the institutions central to the operation of a market economy, such asfinns. Moreover, this view assumes that the employment relation can beunderstood as a market-based exchange, no different from any other.

In contrast, the industrial relations literature begins with an examination ofthe employment relation as an authority relation in which market forces play asecondary or exogenous role. From this perspective, the employment relationis viewed as having unique attributes, implying that the relation is unlikely to beequal or efficient. Labour market regulation is typically viewed as a means ofpromoting both efficiency and equity within the workl'lace (Gahan & Mitchell1995).

These differing approaches have been manifest in a clear demarcationbetween labour economics and industrial relations as two fields of study. In ourview, this distinction is somewhat artificial and poses fundamental problems for

LABOUR ECONOMICS AND INDUSTRIAL RELATIONS 527

understanding a number of phenomena of interest to both disciplines, mostnotably questions regarding the nature of the employment relation, how labourmarkets work and the role of labour market institutions.

In an effort to reassess these different approaches we began with the ques­tion of why instirutional mechanisms that govern various aspects of the em­ployment relation are so pervasive. In order to understand the economic role ofinstitutions we examined problems concerning the competitive model of thelabour market. We then examine non-market aspects of the employmentrelation and the theory of the firm. This approach views institutional featuresof the economy as responses to problems of incompleteness and the existenceof transaction-costs in market-based exchanges. In our view, exchange in thelabour market is plagued by many of, if not all, the causes of market failureraised earlier, and many types of labour market institutions can, in this context,be understood as the outcome of both efficiency problems and social conflictover the distribution of resources.

In addition to these arguments derived from the economics literature, theindustrial relations approach to understanding the employment relation alsoprovides insights that explain the existence of institutions. The industrialrelations perspective views the employment relation as fundamentally differentfrom other exchange relations due to the non-market and human dimensions to

the exchange relation. In this context, concepts of fairness and equity play acentral role in shaping governance structures and the nature of-the exchange.Institutions fonn as a 'natural outgrowth of such concerns, but may not neces­sarily be motivated by efficiency.

This reappraisal provides an important starting point for a re-examinationof both economic and industrial relations theories of the employment relation.Both disciplines, we argue, can learn a great deal from each other. Consistentwith ]acoby's (1990) analysis of institutional labour economics, we argue thatlabour economics can learn from both the theoretical presumptions and em­pirical basis of industrial relations scholarship to provide a .realist context formore abstract conceptualisation. Most importantly, as the quotation from ]oeIsaac that heads this paper implies, this requires economists to be more sensi­tive to unique aspects of the employment relation. Industrial relations scholar­ship, in contrast, suffers from a failure to develop strong theoretical modelsbeyond a general framework based in systems theory. Theoretical develop­ments in understanding institutions have in fact come from economics andpolitical science rather than industrial relations. Yet an understanding of insti­tutions and their role as governance structures remains central to industrialrelations scholarship. This makes labour markets fertile ground for research inthe tradition of]. E. Isaac.

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