Why would modern economies benefit from cooperation and codetermination?

Conventional economic theory suggests that a bargaining process between workers and the representatives of firms simultaneously determines average employment rates and wages in the long run.  This is illustrated in the following plot, where a representative firm's bargaining curve is downwards sloping (i.e. they will only agree to hire more workers at a lower wage), and a representative worker's bargaining curve is upwards sloping (i.e. they will only agree to work more at a higher wage).  In addition, a labour supply function is included, which is also upwards sloping:


Average employment rates and real wages are determined by the intersection of the firm's and worker's bargaining curves, and the hypothetical full employment level is determined by the intersection of the firm's bargaining curve and the labour supply curve.  This is consistent with various theories of the labour market, including the union bargaining and efficiency wage approaches, and is discussed here (among other places).

As things stand, there is only one way to increase both wages and employment: shift the firm bargaining curve up.  This requires some change in the economy that makes any given level of employment more profitable for firms, allowing them to pay higher wages, or reduces the desired markup.  In the short run this might be achieved by increasing the amount of competition between firms, but in the long run it is only possible by an increase in labour productivity.  Thus an increase in labour productivity has the following effect:


In comparison, if one were to introduce a policy that increased workers' bargaining power without affecting the degree of competition or level of labour productivity, the employment rate would likely reduce.  This is because workers are able to demand higher wages at any given level of employment, reducing firms' profitability and reducing new hires.  Thus an increase in workers' bargaining power has the following effect:


While there are indirect effects of higher wages on consumption and output that mitigate falls from employment resulting from increases in bargaining power, and hysteresis effects mean that long run averages can be affected by things other than bargaining power, this basic model of the labour market is a useful partial equilibrium benchmark.  This is particularly true when we combine it with the simple Phillips curve,


which states that the difference between price inflation and expected future price inflation over some period of time is proportional to the difference between the employment rate and its long run average plus some supply shock process.  Intuitively, firms are likely to be paying a higher real wage than they would like to when the employment rate is above its long run average, so inflation will rise as they raise prices in an attempt to bring the real wage back down again.  As such a process is (in theory) only temporary, current inflation should be higher than expected future inflation during such a process.

As we can observe both actual and expected inflation, and we can observe employment rates, our Phillips curve allows us to compute an approximate path for the long run average n.  A 99% prediction interval for the UK "natural rate" (as it is usually referred to) over the 8 years either side of the 2008 financial crisis is shown below, along with the actual employment rate, with actual and expected retail price inflation in the second plot:


The actual inflation rate is the solid black line in the second plot, and expected inflation rate is the dashed line.  From around the beginning of 2000 to the beginning of 2008 actual and expected inflation were similar to one another, and thus our prediction interval for the natural rate is very close to the actual rate.  During the financial crisis and subsequent recession - a large negative demand shock - actual inflation was considerably lower than expected future inflation, which is what one would expect.  This suggests that the actual employment rate must have been much lower than our prediction interval for the natural rate,  which subsequently falls over 2011 and 2012 (presumably due to hysteresis effects).

After 2012 the employment rate increases quite dramatically.  This is clearly not due to any unforeseen demand expansion, as actual and expected inflation are more or less equal over this period, and in any case fiscal austerity after 2010 acted as a significant drag on aggregate demand.  As a result our prediction interval for the natural rate also increases.  We also know that labour productivity was flat over this period.  As a result, the only explanation consistent with our conventional labour market theory is that workers' bargaining power must have fallen.  As implied by the graphs above, this should have been accompanied by falling real wages, which was indeed the case up to the end of 2014, after which real wages recovered slightly:


So the conventional theory does appear to be a useful starting point for interpreting labour market dynamics in the United Kingdom, and we can be reasonably confident that the policy trade-off described above exists.  So what does this imply for economic policy?  Put simply, it means that we cannot create a high wage, high employment society just by increasing the bargaining power of labour ceteris paribus.  While this would certainly increase real wages and the wage share, it would run this risk of increasing unemployment, and would certainly increase underlying inflationary pressure in the economy.

The post-1980 response to this problem is usually summarised as "supply-side economics", which recommends wholesale deregulation of the labour market, forcing workers' bargaining power down.  While this can increase employment, as we have seen, it forces real wages down along with it, and is partly responsible for the substantial increases in household inequality observed during the last four decades and increases in in-work poverty seen since 2010.  If we cannot achieve a high wage, high employment society simply by readjusting the bargaining power of labour relative to capital, what can we do?  One potential solution is to change the nature of the bargaining process itself.

Cooperation and codetermination are important candidates for institutional changes of this form.