On the Economic Effects of Disobeyed Regulation in Employment Law

Alon Harel; Yuval Procaccia; Ilana Ritov

doi:10.1515/rle-2016-0008

Article

On the Economic Effects of Disobeyed Regulation in Employment Law

Alon Harel , Yuval Procaccia and Ilana Ritov

Published/Copyright: April 1, 2017

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From the journal Review of Law & Economics Volume 13 Issue 2

Abstract

Mandatory restrictions in employment law, seeking to promote the welfare of workers, are debated fiercely. Proponents argue that they protect workers. Opponents believe that they spawn inefficiency and harm workers. Yet all agree that restrictions trigger such effects only when obeyed. This Article challenges the conviction that the welfare effects of mandatory restrictions depend on obedience. We show experimentally that when restrictions are disobeyed, workers’ reservation wages rise, i. e., workers charge higher wages when offered employment that violates the restrictions. That, in turn, produces welfare effects similar in nature to those produced when restrictions are obeyed. This observation is therefore important to both proponents and opponents of employment regulation. We establish this claim experimentally by measuring the effects of disobeyed restrictions on workers’ reservation wages. We then investigate several hypotheses as to why these effects are generated. Last, we point out that our findings have important implications in other contexts of contractual regulation, such as in the domain of consumer protection.

Keywords: employment regulation; reservation wages; endowment effect; unenforced mandatory restrictions

Appendix: The Effect of Rising Reservation Wages on Welfare

The experimental part of this paper establishes that a mandatory restriction on working hours causes workers’ reservation wages to rise, even if the restriction is unenforced. In this part we establish the economic argument that this effect will leave both workers and employers worse off.

The value of an employment relationship is given by the difference between the employer’s benefit from work, and the worker’s disutility from performing it. Rising reservation wages imply a rise in workers’ disutility, and hence a reduction in the joint value of employment. As long as neither party holds absolute bargaining power, both parties will have to bear some of the loss. Hence, as the pie becomes smaller, the welfare of both parties will fall. Similarly to the imposition of a tax, the division of losses will depend on the relative elasticities of supply and demand.

The diagram above portrays this point graphically. The notion that neither party carries absolute bargaining power is reflected in the standard assumptions of a downward sloping demand and an upward sloping supply. When workers’ disutility from work rises, supply is shifted upwards. The added disutility is represented by the vertical distance between the two curves, denoted Δ. As disutility from work rises, it is easy to verify that the joint gains from employment will fall, and so will the welfare of employers.

Less obvious is the decline in workers’ welfare: although workers’ welfare is lowered by the added disutility from work, it is also enhanced by the higher wages they extract in equilibrium. However, the rise in wages does not fully compensate for the rise in disutility. Whereas disutility rises by Δ, the wage rises merely by wB−wA. Workers will therefore gain less in additional wages than lose in terms of added disutility. In addition, some workers, who previously gained positive gains from employment, will be laid off following the enactment of the restriction. This is because their reservation wages are higher than the wage that employers are willing to pay. Thus, the enactment of the restriction will cause welfare to decline for all groups involved: employers, workers who continue to be employed, and workers who are laid off.

To establish these points formally, consider supply and demand functions, Sw and Dw respectively, where w denotes the wage, S′w>0 and D′w<0. In an initial equilibrium, supply and demand intersect at wage wA: SwA=DwA. A mandatory restriction is then applied, causing workers’ reservation wages to rise. The new supply function Sˆw is then defined by Sˆw≡Sw−Δ where Δ>0. Denote by wB the new equilibrium wage, for which SˆwB=DwB.

Notice that wB>wA: if wB≤wA then DwB≥DwA and SˆwB≡SwB−Δ≥SwA. However, since S′w>0, the last inequality implies that wB−Δ≥wA, contradicting the assumption that wB≤wA.

As wB>wA and D′w<0, less work will be demanded and hence the level of employment will fall. Since wages will rise without a corresponding increase in productivity, employers’ welfare will fall as well.

To establish that welfare will also decline for workers who continue to be employed, we next show that wages will increase by less than the rise in reservation wages, i. e., that Δ>wB−wA. Observe that

DwA−DwB=SwA−SˆwB=SwA−SwB−Δ

The left-hand side is positive because wB>wA and D′w<0. Hence, the right-hand side must also be positive, and since S′w>0, it must hold that wA>wB−Δ. This establishes the result.

Acknowledgments

For helpful comments and discussions we wish to thank Assaf Ben Shoham, Edo Eshet, Guy Davidov and Yehonatan Givati. We are also very grateful to Stav Cohen, Haggai Porat and Shir Shrem for excellent assistance in research.

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Published Online: 2017-4-1

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https://doi.org/10.1515/rle-2016-0008

Keywords for this article

employment regulation; reservation wages; endowment effect; unenforced mandatory restrictions