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CHAPTER-7: LABOR POLICY

7.1. The Role of Government in the Labor Market

Besides directly employing labor, providing public goods, transferring income, and levying taxes,
government engages in the important task of establishing the legal rules for the economy. Many
of these laws and regulations directly or indirectly affect wage and employment outcomes. Laws
affecting labor market are so numerous that we must be highly selective. Some of these include:
labor relation law, the minimum wage, the occupational Safety & health law, and the like.

Why does government regulate the labor market?

Broadly speaking, most regulations of the private labor market are sought for one or two reasons.
Regulation is sought either:

i. to overcome imperfections in competition that are perceived to exist, or

ii. to eliminate what are perceived to be, from the perspective of those seeking regulation,
undesirable consequences of competition.
In both cases, public support for regulation may be based on widely accepted concepts of fairness or
equity.

 Government intervenes in the labor market by using various labor market legislations.
Labor Market Legislations
Labor legislation that is adapted to the economic and social challenges of the modern world of work
fulfils three crucial roles:

• It establishes a legal system that facilitates productive individual and collective

employment relationships, and therefore a productive economy;
• By providing a framework within which employers, workers and their representatives can
interact with regard to work-related issues, it serves as an important vehicle for achieving
harmonious industrial relations based on workplace democracy;
• It provides a clear and constant reminder and guarantee of fundamental principles and
rights at work which have received broad social acceptance and establishes the processes
through which these principles and rights can be implemented and enforced.

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But, experience shows that labor legislation can only fulfill these functions effectively if it is
responsive to the conditions on the labor market, and the needs of the parties involved. The most
efficient way of ensuring that these conditions and needs are taken fully into account is if those
concerned are closely involved in the formulation of the legislation through processes of social
dialogue. The involvement of stakeholders in this way is of great importance in developing a
broad basis of support for labor legislation and in facilitating its application within and beyond
the formal structured sectors of the economy.

When the International Labor Office assists constituents in the process of formulating or
reforming labor law, it adopts the basic approach that where labor legislation is appropriately
developed, with the support of the parties involved, it not only promotes social justice throughout
society, but also has a positive effect on economic performance and contributes to social stability
and the reduction of social conflict.

Labour market legislation is widely used both to regulate individual employment relationships
and to establish the framework within which workers and employers can determine their own
relations on a collective basis, for example through collective bargaining between trade unions
and employers or employers' organizations or through mechanisms of worker participation in the
enterprise.

The legislative regulation of the individual employment relationship typically entails the
enactment of provisions governing the formation and termination of the relationship (that is, the
conclusion of contracts of employment, their suspension and termination) and the rights and
obligations relating to the different aspects of the relationship (such as the minimum age for
admission to employment of work, the protection of young workers, equality at work, hours of
work, paid holidays, the payment of wages, occupational safety and health and maternity
protection). Provision also has to be made for enforcement procedures and supporting institutions
(such as labor inspection services and courts or tribunals).
Regulation of the collective relations of workers and employers typically includes laying down
legal guarantees of the right of workers and employers to organize in occupational organizations,
to bargain collectively and the right to strike, as well as mechanisms for worker participation at
the enterprise level.

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Legislative provisions on these matters already exist in most countries. However, there are
considerable differences between countries with regard to the extent and detail of their legislative
regulation and the degree to which the various aspects of the matters concerned are left to
workers, employers and their organizations to determine by collective agreement or individual
employment contract.

In some countries with a common law background (that is, where the law used to be based
primarily on judicial decisions and custom, rather than statute law), the basic elements of the
employment relationship were traditionally regulated by the common law, with most other
matters being left to the parties to regulate by agreement. Examples of these countries include the
United Kingdom and many of the Commonwealth countries. However, over the past century or
more the legislature in such countries has tended to intervene increasingly broadly in the field of
labor law, so that in many cases the most substantive issues are regulated in some detail, and
often comprehensively by the legislation. But in certain of these countries, there is still a tendency
for the legislation to be piecemeal and for it to have to be read, understood and interpreted against
a background of common law legal rules which have not been entirely superseded by statutory
law. Moreover, in some cases, disputes or claims regarding legal rights and obligations may need
to be taken to different courts, depending on whether they arise out of common law or statutory
legislation.

In countries with a civil law tradition (which include many French and Spanish-speaking
countries), labor law has often, although not always, been set out in systematic and
comprehensive labor codes. In most of these countries, labor matters were first regulated in the
basic civil code by the provisions governing contracts. Over the years, as other legislation has
been adopted on labor-related matters, much of it has been absorbed into and modified by labor
codes. But, the basic concepts of civil law, and sometimes certain provisions of the civil code,
have in many cases continued to be applied to issues arising in the field of labor. Interpretation of
the law may therefore require reference to the provisions of both labor and civil law.
Labour law, as comprehensively set forth in labor codes and ancillary legislation, has increasingly
come to be seen as an autonomous system of law, and as being independent of the typically more
individualist body of civil law. In those countries where labor law has been codified, it has meant

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that the respective provisions are more readily accessible in comprehensive texts based on unified
and overarching concepts that seek to provide greater coherence to the system as a whole.

Much of the developing world has been influenced by one or other of these traditions. In many
cases, labor legislation in developing countries was initially adapted from the systems of the pre-
independence colonial power. But in most of these countries the legislation has evolved very
considerably since independence. In countries influenced by the common law tradition, this
evolution has frequently entailed a partial codification, particularly on subjects such as
employment relations (including conditions of work), labor or industrial relations and safety and
health. Authority to make subordinate regulations has generally been delegated to the Minster
responsible for labor matters.

In developing countries which have followed the civil law tradition and which gained
independence after the Second World War, comprehensive labor codes were often developed and
have frequently needed to be reformed to adapt them to the economic and social realities of recent
times. In these countries too, Labour Ministries have been endowed with considerable regulatory
powers. However, due to institutional limitations and economic structure, labor markets in many
developing countries are actually regulated largely through market or informal means.

Irrespective of legal tradition, the challenge of labor law reform in recent years has been twofold:
firstly, to afford better protection for the basic rights of workers, including their trade union
rights; and secondly, to provide for a greater measure of flexibility for the social partners to
regulate the employment relationship in a manner that is more conducive to enhancing
productivity and economic growth.

In many previously planned economy, countries which have undergone the transition to market
based economies, the challenges of legal reform have centered around the need to replace the
former state-centered forms of regulation by legislation that strengthens independent and
representative institutions capable of engaging in autonomous collective bargaining. This has
normally involved adapting excessively invasive regulation and generally lightening the
regulatory burden.

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 Models of Labor Market Regulations

Countries can adopt a range of approaches to regulate the functioning of their labor market.
Mechanisms can be market based, statutory, or based on collective voice.

i) Market Based Approach

Where there is a reliance on market based mechanisms, labor markets are often characterized as
“unregulated”. However, Standing (1999) argues that this should be viewed instead as one
approach to regulating employment relations. And, indeed, it is a policy choice to use legislation
and other regulatory instruments to this end. At the heart of market based regulation is the
individual contract (either explicit or implicit) between employer and employee. There has been a
modest trend towards greater dependency on market mechanisms over the past decade or so at
least in developed countries where most of the available evidence exists (OECD 1999a).

However, there are well known arguments for public policy intervention in the labor market, as
well. These arguments pivot on the need to address market failures and injustice/exploitation. For
instance, World Bank (1995), in its World Development Report, highlighted four reasons for
public intervention in the labor market:

a) Uneven market power- workers may find themselves in a weak bargaining position. This can
raise concerns about their protection from unjust treatment. It can also have long -term
efficiency losses.

b) Discrimination- Workers belonging to groups with little voice or power (e.g., due to age,
gender, ethnicity, etc.) may experience particular disadvantages in the labor market. This also
raises both equity and efficiency concerns.

c) Insufficient information- Workers and some employers may not have adequate information
to make informed decisions about the conditions of work. Health and safety hazards are the
classic example.

d) Inadequate insurance against risk-workers are typically un able to formally insure themselves
against labor market related risks associated, for example, with unemployment, disability, or old

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age. These arguments underlie public policy interventions to support the other modes of labor
market regulation.
ii) Statutory Approach
Regulation is the classic notion of regulation rules and procedures established by laws and
decrees that govern aspects of the employment relationship. These can cover a wide range of
areas: for example, the establishment and protection of universal worker rights; the protection of
vulnerable groups of workers; principles for determining compensation; working conditions; and
the initiation and termination of the employment relationship.

Table-7.1: Examples of Statutory Regulations

Source: World Bank (1995)

iii) Collective Voice Approach

The other mode of regulation, which refers to the voluntary negotiation and administration of the
employment relationship where workers (and sometimes employers) are represented collectively.
This mode of regulation can occur at different levels (e.g., enterprise, sector, or nationally) and
with various degrees of coordination. In developing countries, only minorities of workers are
covered by collective bargaining; often this minority is quite small and concentrated in the public
sector. Moreover, the reach of the collective voice mode likely has receded somewhat if union
membership trends are any indication.

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Obviously, the effectiveness of different modes of regulation can vary greatly depending on the
particular circumstances. A statutory approach may achieve its intended objectives in one setting
but be inappropriate or unenforceable in another. Similarly, markets operate with varying
effectiveness, as does collective bargaining. However, each of these modes of regulation does
have inherent strengths as well as potential risks as summarized in table 7.2 below.

Table 7.2: Some Potential Strengths and Risks of Market, Statutory, and Collective Voice
Regulation

7.2 Job Security or Employment protection

Employment protection, or job security rules refer to hiring and firing arrangements. These can
cover what kinds of contracts are permitted, any special rules favoring certain groups in hiring,
occupational standards, the conditions under which workers can be terminated, requirements for
severance and advance notice of termination, redundancy procedures, and special rules for mass
layoffs. Employment protection is typically considered along a “rigidity/flexibility” continuum.

At the rigid end, non-regular contracting is restricted, hiring standards may be in force, employer
dismissal rights are controlled, and severance, notice, and administrative requirements are
substantial. At the flexible end, statutory (or collectively bargained) regulations are minimal and
market mechanisms largely determine hiring and firing.

The idea behind most employment protection rules is to enhance job security by making dismissal
costly to the employer. However, by making dismissals more costly, employment protection
regulations can also have the unintended effect of creating hiring disincentives for employers.
There are various ways in which these rules can affect labor market outcomes including

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employment levels, labor dynamics (i.e., employment fluctuations), and the composition of
employment.

Theoretically, the clearest effects are on labor market dynamics – employment protection rules
can be expected to lengthen job tenure and reduce labor turnover. All other things being equal,
then, stronger job security rules will stabilize employment levels, not only reducing layoffs in
downturns but also reducing hiring in upturns. This will protect jobs for incumbent employees but
limit hiring opportunities for the unemployed. As a result, we can expect the duration of
unemployment (as well as employment) to be positively related to the degree of employment
protection.

The impact of employment protection on the average level of employment (and unemployment)
through the business cycle, however, is more ambiguous. Whether employment rates within the
firm increase or decrease with greater employment protection depends on how the decline in
hiring compares with the decline in firing. This in turn depends on assumptions about the
persistence of labor demand shocks, the elasticity of labor demand, how firms discount future
firing costs at the time of hiring, and so on. Job security rules, however, should affect the
composition of employment in various ways: depending on the details, they can shift labor
demand to uncovered (informal) sectors, firms, or employment types.

(i) Dismissals

The key policy issue concerns how difficult and/or costly it is for employers to terminate regular
(i.e., permanent) employees for economic reasons. Restrictions can take various forms: (i) what
is considered to be a justifiable reason for termination; (ii) severance obligations; (iii) advance
notice requirements; and (iv) necessary administrative procedures for laying off workers. There
may also be special requirements in the case of mass layoffs. These restrictions are often found
in national or sub-national labor codes but, depending on the country, the degree of job security
can also be defined by court decisions, collective bargaining agreements, or even unwritten
industrial norms.

There are significant variations across countries in terms of the protection offered to regular
workers. Table 7.3 provides examples of statutory arrangements regarding what are legally
acceptable reasons for economic dismissals; what severance requirements exist; and what

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advance notice is required. The United States has the least restrictive employment protection
laws: there are no restrictions on dismissals in the private sector, no statutory severance
obligations, and advance notice requirements only in the case of mass layoffs. In reality,
employers in the U.S. do face some constraints on their dismissal rights because of court
decisions and collective agreement provisions. As the table shows, however, other countries have
various statutory employment protections – ruling out certain reasons for lying off workers and
imposing severance and advance notice obligations. During the past decade or so, there has been
no clear trend in regulating dismissals in OECD countries; some have strengthened protections,
others have eased them, but in most cases, arrangements have remained relatively stable. In many
Latin American countries, however, job security rules have been scaled back.

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Table 7.3: Legal Arrangements for Termination, Selected Countries

Source: World Bank 2001, Social Protection Discussion Paper Series, No. 0128

(ii) Hiring and contracting

The most important policy issue here concerns the rules for employing “non-standard” workers
specifically, employees on fixed-term contracts and temporary agency workers. Restrictions in
these areas are akin to job security protections by limiting the number of workers who do not
have access to such protection. These forms of contracting typically do not involve significant

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dismissal costs. So, in theory, their effects should be similar to those stemming from job security
rules.

Table 7.4: Legal Arrangements for Fixed-Term Contracts and Temporary Agency Work,
Selected Countries

Source: World Bank 2001, Social Protection Discussion Paper Series, No. 0128

The most extensive study of the labor market impacts of different contracting arrangements was
carried out by the OECD (1999), based on the experience of its member countries. Unfortunately,
there is little empirical evidence for developing or transition countries. According to the OECD
analysis, strict limitations on the use of fixed-term and temporary agency contracting are
associated with:

• Lower aggregate employment rates;

• Lower employment for women and young people;
• Higher levels of self-employment (as a share of total employment);

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• No impact on aggregate unemployment levels; and

• Lower flows into unemployment but longer average unemployment durations.
As we have already noted, at least in the OECD countries, restrictions on the use of non-standard
employment reinforce job security rules that constrain employer dismissal rights. Where
regulations are strong, regular employees have job security and the economy has more stable
employment. However, there generally is less dynamism in the labor market. There is also less
opportunity for regular employment in the formal sector. This increases the vulnerability of
certain groups of workers including women and youth, and the unskilled or poorly educated who
are less likely to get these jobs. Many of these workers, then, will be relegated to either being out
of the labor force or to the informal sector. This has to be assessed against weaker job protection
rules which do not discourage formal sector jobs but accommodate a lower level of protection in
these jobs.

7.3: Income Security Measures/Income Policy/

The government may enact a number of programs to make the lifetime income of workers more
secure. Some of these programs may include: cash grants to certain group of workers, minimum
wage legislation, unemployment insurance, social security, workers compensation and the like.
Let’s see some of them in detail.

i) Social Security- while the social security system involves a number of income security
programs, its main objective is the securing of a retirement income for workers. Individuals
currently employed are taxed, as are their employers, and these receipts are used to finance
current benefits of eligible retired individuals. As our analysis of Unemployment Insurance
indicated, it does not matter whether the tax is imposed on the employer, the employee, or both.
In all cases, the positive slope of the supply curve of labor will result in the tax burden being
shared by employees and employers. Because, currently employed workers and their employers
must pay for the benefits paid out to current retires, any change in the ratio of the number of
retired to the number of currently employed will affect the burden of payment on the currently
employed. In the number employed rises at least at fast as the number retired, then benefit levels
can be increased over time without increasing the tax burden placed upon current employees.

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Studies show that in countries where social security system is enacted, the motivation of working
people to save for their retirement years has been declined.

ii) Workers Compensation- are programs used by some country governments (eg.USA),
which attempts to provide, among other things, income security to workers who are injured on the
job or who suffer from certain occupational diseases. Such program compensate workers for
injury without requiring the employee to establish that the employer is totally (even partially) at
fault. Firms are required to buy what are essentially “no-fault” insurance policies.

In assessing the labor market impact of worker’s compensation, the costs of the program can be
thought of as fixed costs of employment, since the premiums are charged on a per-employee basis
rather than on a per-hour worked basis. This type of fixed costs of employment provides
employers with an incentive to work employees at the standard work and, in the long run, to
adjust to changes in demand by altering the number of employees rather than the average number
of hours that each employee works. Because, the security provided through workers’
compensation is valued by employees, wage levels in all covered industries are probably
somewhat lower than they would otherwise be.

However, wages in some industries and occupations will be more affected than others. Jobs with
high accident risks must pay a compensating wage premium in order to attract workers. It stands
to reason that, since workers’ compensation partially mitigates the consequences of accidents, the
compensating differentials necessary to attract workers to physically risky jobs will not be as
large as they would be in the absence of workers’ compensation. While worker’s compensation
may give employers an incentive to increase job safety precautions, it may have the opposite
effect on workers. Because, they are partially insured against financial loss resulting from injury,
workers may be less cautions at the workplace.

iii) Unemployment Insurance- program is intended to protect workers from the financial
difficulties of unemployment, but has several other effects as well. Unemployment benefits may
be financed through payroll taxes, but the amount of the tax, and the ways in which it is imposed
vary somewhat from country to country. Economists have devoted considerable study to the
effect of unemployment insurance on the unemployment rate. Unemployment Insurance affects
the unemployment rate in a least two ways:

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a) First, unemployment insurance benefit, because they cease when a worker finds a job, may
actually subsidize leisure in much the same way as social security does.

b) Second, Unemployment insurance affects an unemployed worker’s search strategy. The

benefits provide the workers with the financial means for continuing to search for a desirable
job appropriate to the worker’s skill level and long-term expectations rather than accepting
the first opportunity to work that becomes available.

In this section, we are interested in the allocative efficiency of unemployment insurance. The
question of whether employers or employees bear the burden of the tax (used to finance
unemployment insurance) is analytical one, and does not depend on whom the tax is legally
imposed. To show this diagrammatically, imagine initially, that no unemployment insurance tax
exists. The labor market would be in equilibrium at a wage rate W* and an employment level of
Ebt. Now assume that a payroll tax (to finance unemployment insurance) is imposed on the
employer. The demand for labor shifts downward from Dbt (before the tax) to Dat (after the tax).
The amount of the downward shift is simply the amount by which the firm’s costs per unit of
employment are increased by the tax.

Fig.7.1: The Effect of the Unemployment Insurance Tax

In equilibrium, the firm’s costs per unit of labor rise from W* to Wf, while the wage received by
workers fall from W* to Ww. Thus, we can see that the tax (Wf – Ww) is born partly by employers
(Wf - W*), and partly by employees (W* - Ww). An additional effect is a reduction of employment
from Ebt to Eat as fewer individuals choose to work at the now lower wage.

Workers’ choice of industry and occupation may also be affected by the existence of the
unemployment insurance system. Workers value income stability or security. In industries and/or

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occupations that are highly susceptible to unemployment must pay a premium or compensating
differential in order to attract workers. The presence of unemployme nt insurance, however,
reduces the size of the premium that must be paid to attract workers into jobs that are seasonal in
nature or particularly sensitive to the business cycle. Thus, the unemployment tax is seen to affect
not only the overall level of wage and employment, but also the structure of relative wage across
occupations and industries.

 Who gains and who loses from income Security Measures?

Identifying the gainers and losers from minimum wage legislation may be relatively
straightforward, but can be quite complicated for income security programs. In the case of social
security programs, income is obviously redistributed from the working population to the retired
population. But, present workers hope to be among the retired someday, so the program can be
loosely thought of as an attempt to require individuals through legislation to reallocate lifetime
income. This fact is not withstanding, the currently retired have already supported a previous
generations of retired persons. Their present interest is to obtain as high a level of benefits as
possible since they will never again bear the burden of the payroll tax. The social security system
involves another type of income transfer. Persons whose lifetime earnings are low receive
disproportionately high retirement benefits; income is effectively redistributed from high-wage
earners to low-wage earners.

On a superficial level, it would seem as though the only redistribution involved in the
unemployment insurance system would be from the employed to the unemployed as intended. The
system also may work so as to redistribute income in other ways. The incidence of unemployment is
very uneven across industries, but payroll tax is imposed almost uniformly across industries.
Generous level of unemployment compensation provide firms that experience unstable or seasonal
product demand with an incentive to use temporary layoffs to a much greater extent than they would
in the absence of the program. It would appear that workers and firms in high-unemployment
industries are subsidized by workers and firms in low unemployment industries, since workers with
this firm would now be receiving unemployment benefits in excess of the unemployment insurance
taxes that they have paid. But, if the compensating differential paid in high-unemployment
industries is reduced by the existence of unemployment insurance, workers in those industries may
not actually find their total income (inclusive of unemployment compensation benefit) increased.

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Even so, the reduction in the compensating differential will lower the cost of production to firms in
high unemployment industries and raise it in other industries. Consequently, the relative prices of
goods produced in industries with unstable and seasonal demand will be lower (and those in stable
industries higher) than would be the case in the absence of unemployment insurance/compensation.

7.4: Occupational Health and Safety Regulation

Another important and controversial area of direct government intervention into the labor market
is the regulation of occupational health and safety. This intervention may take different form
depending on the countries specific context.

Government regulation of workplace health safety is worth of discussion for several reasons.
First, studies show that work is more dangerous than generally perceived i.e. quite a lot of people
my receive injuries or die in connection with work related accidents. Second, job safety-or the
lack thereof-is an important nonwage aspect of work, which is an important determinant of labor
supply. Therefore, degrees of work place safety help explain wage differentials among
occupations. Finally, just as with such labor market interventions as the minimum wage and
affirmative action legislation, controversy exists over the appropriateness and effectiveness of
regulations of work place health and safety.

 Profit-Maximizing Level of Job Safety

Competition in the product market will force a profit-maximizing firm to minimize its internal
costs of producing any specific amount output. One cost of production is the expenditure
necessary to make the workplace safe. The production of job safety normally involves
diminishing returns, which, translated into cost terms, means that each dollar of additional
expenditure yields successively smaller increase in job safety. More concretely, firms will first
use such relatively inexpensive techniques as disseminating safety information and issuing
protective gear (say, hard hats) to make the job safer; but to make further gains, they may have to
resort to such increasingly costly actions as purchasing safer equipment’s and slowing the work
place. Therefore, most firms experiences a rising marginal cost of job safety: successively higher
amount of direct expenses, reduce output, or both will be required to gain additional unit of jobs

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safety. We depict a marginal cost of safety curve MC, in fig 7.2. Each additional unit of job
safety, measured on the horizontal axis, costs more than previous units.

Knowing that it is costly to provide job safety, why would a firm choose to offer workers any
protections from workplace hazards? The answer is provided by the marginal benefit of safety curve
MBs (disregard the curve labeled MB’s for now). An employer benefits from creating a relatively
safe workplace; job safety reduces certain costs that the firm might otherwise incur. Notice,
however, that as more units of job safety are produced by this firm, the marginal benefit from job
safety (MBs) to the firm falls. Just as individuals experiences diminishing marginal utility as
successive units of goods are consumed, firms find that the extra benefit (cost savings) of job safety
diminished with every increase in the amount of job safety.
Just what are these benefits to the firm? First, lower risks of injury or death enable employers to
attract workers at lower wage rates. Because workers value job safety, they are willing to accept a
lower wage for work performed in a healthful, relatively safe environment. Second, a safer
workplace reduces the amount of disruption of the production process that job accidents create.
Workplace mishaps and the absence of key employees during rehabilitation often halt or slow the
production process. Third, a safer workplace reduces the cost of recruiting, screening, and training
workers. The fewer workers injured on the job, the fewer resources will be required to hire and train
new employees. Fourth, workplace safety helps maintain the firm’s return on its specific
investment in human capital. Job fatalities and injuries termination or reduce the firm’s returns on
its previously financed specific, formal and on-the-job training. Finally, fewer job related accidents
translate into lower workers’ compensation insurance rates. Such rates are determined by the
probability and types of accidents experienced in a given firm.

To determine the profit-maximizing level of workplace safety, the cost-minimizing firm will
compare the marginal benefit of safety (MBs) against the marginal cost (MCs). In so doing, it will
use the decision rule: Provide additional job safety so long as the marginal benefit exceeds the
marginal cost. In fig 7.2, we see that the profit-maximizing level of job safety is Q s units, at which
MBs = MCs. Even in the absence of government intervention, this firm will find it cost effective
and profitable to provide some degree of job safety (i.e. Qs units of safety).

Another observation merits comments here. The perception that some jobs, say coal mining and
construction, are inherently dangerous while others, say accounting and teaching, are innately safe is

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slightly misleading. A more accurate statement is that given present technology, it is inherently
more costly to provide job safety in some occupations than others. Therefore, firms with similar
marginal benefit schedule but different marginal cost of safety will offer differing level of job
safety.

Marginal cost &

Benefit of Job Safety

MCs

b
C
a MBs
’
d MBs

O Q’s Qs Quantity of Job Safety

Fig 7.2: The Optimal Level of Job Safety

A firm with the same marginal benefits curve as that in fig 7.2 but with significantly higher
marginal cost of providing job safety than those shown by MC s would provide much less job
safety than Qs units.

 Society’s Optimal Level of Job Safety

A firm’s profit-maximizing level of job safety may or may not be society’s optimal level of job
safety. In addressing this topic, let’s first assume that there is perfect information and assessment
of job risk, and then examine a situation where this is not the case.

(a) Perfect Information and Assessment

If workers have full information about possible work hazards and accurately assess the likelihood
of occupational fatality, injury, or disease, then the amount of job safety offered by employers
will match the level required to maximize society’s well-being. Where workers have full
knowledge of job risk, employers providing hazardous work environments will have to pay a
wage premium to attract a sufficient number of employees. The existence of compensating wage
differential will ensure that the employer’s extra benefit from providing a safer workplace

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(including a reduced wage premium) will match the extra benefit of job safety from society’s
perspective. In fig 7.2, we are saying that given our assumption of perfect information and
assessment, curve MBs depicts both the private and social marginal benefits of job safety. The
number of units of job safety shown as Qs will maximize the firm’s profits and optimizes
society’s well-being.

(b) Imperfect information and Assessment

Where information about job hazards is limited and/or workers underestimate the personal risk of
occupational fatality, injury, or disease, employers will provide less job safety than is socially
optimal. To demonstrate this, suppose workers mistakenly judge the job in question to be
riskfree, when in reality one of the substances handled by workers is highly hazardous. Because,
employees are unaware of the long-term danger, the job hazard will not reduce labor supply to
this occupation and employer. The market wage therefore will not contain a wage premium
required to compensate workers for the added job risk.

Consequently, the firm’s marginal benefit from reducing the health hazard-that is, from providing
a safer workplace-will be smaller than it would be if workers had full information about the job
danger. Extra units of job safety will fail to reduce the wages paid by this firm because the labor
market has not dictated payment of a wage premium to compensate workers for their true risk.
From the firm’s perspective, the marginal benefit from providing job safety is less than it would
be if full information about the long-term health consequences of the job were known.

The marginal benefit schedule of job safety as viewed by the firm in this situation is shown in fig
7.2 as curve MB‟s. The firm compares MB‟s with its marginal cost of providing safety (MCs) and
settles for Q’s units of job safety. The result is that job safety is underprovided from society’s
viewpoint. Suppose the true marginal benefits of each added unit of safety are those shown as
MBs rather than BM s.

Given full information and accurate assessment by workers of the job danger, the firm’s relevant
marginal benefits curve would be MBs, and both the profit maximizing and socially optimal level
of job safety would be Qs units. As we can observe by extending a vertical line upward from Q’s
to MBs, and observing the triangle abc, the Q’sQs units of job safety generated marginal benefits to
society that exceed the marginal cost costs MCs. But under conditions of incomplete information
or underestimation of risk by workers, and, therefore, no market wage premium, the firm has no

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incentive to provide these extra units. From its perspective, the marginal benefit is less than the
marginal cost. We conclude that a firm’s profit-maximizing level of job safety may not always
conform to society’s optimal level of job safety. In the above example, society’s welfare loss
from this inefficiency is area abc.

7.5: Occupational Licensing

In many occupations, individuals must be licensed by a country or state in order to work. The
occupations covered by licensing requirements are many and varied, ranging from high-income
professionals such as doctors and lawyers, pharmacists, craft occupations such as electricians and
beauticians. In many instances, licensing of occupational groups is held to be necessary to protect
consumers against incompetents who might do irreparable damage. In these circumstances,
governmental licensing may be the most efficient way to minimize the costs of obtaining
information needed by consumers to make optimal buying decisions. Sometimes, the occupational
groups themselves, not consumers, generate the demand for licensing. These groups may wish to
restrict access to licensees as a way to obtain economic rent for licensees.

Depending on the country, licensing may require among other things:

• Payment of large fees,
• The passing of exams, or completion of specific educational or experience
requirements.

Regardless of the mechanism used, analysis the impact of licensing is the same and is quite
straight forward: restrict supply. Specifically, the requirement that, say, real estate agents be
licensed will reduce the supply of agents below what it would otherwise be. In the market for the
licensed occupation, the effect is to raise the equilibrium wage above the competitive equilibrium
wage that would exist in the absence of licensing.

Fig 7.3 demonstrates how occupational licensure can confer economic rent. Suppose the pre-
licensing equilibrium wage and employment level are $8 and 10,000 workers respectively. Next,
assume that licensing has the effect of restricting the total number of licensed workers to 7,000. In
effect, the post-licensing labor supply curve is SgS1, compared to the old curve of SSo. Notice that
licensing increases the market wage to $11 an hour and that total employment falls from 10,000 to
7,000. The $11 wage attract another 4,000 workers (= 14,000-10,000) who would like to work in
this occupation. These 14,000 workers see 7,000 licensees, and those who get licensed receive

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increases in economic rent of $3 for every hour worked. As a consequence, the government’s action
raises the total rent to those employed by $21,000 (7,000 x$3). This can be determined by noting
that the total rent was area Saf prior to the licensing. Following licensing, the total economic rent
increases to Sbcg. Thus, the gain in rent is abce- and the loss of rent to the workers displaced by the
licensing is area gef.

Fig.7.3: Rent Provision through Occupational Licensing

From this, one can notice those occupational licensures that restrict labor supply create an
efficiency loss for society-in this case, triangle gcf. The 3,000 additional employees who would
have been employed in this occupation would contribute more the value of society’s output in this
employment (as shown by segment cf of the demand curve). Additionally, the true efficiency loss to
society may be greater than area gcf. To secure the licensing law and thus the added economic rent,
this particular occupational group most likely had to spend large amount for political lobbying,
public relations adverting, and other activities. From society’s perspective, these expenditures
diverted resources away from potentially higher-valued uses, adding to the overall efficiency cost of
the occupational licensing.
To summarize, occupational licensure of the type restricting labor supply increases the market
wage, confers economic rent to the licensees, and causes economic inefficiency. We might add that
it is possible that the competition for the limited number of licenses will cause the new licensees to
expend dollars in an amount equal to the expected rented. Thus, those who are automatically
granted licenses when the law is passed and those who train potential licensees will be the major
beneficiaries of the law.

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