A Theory of Bargaining Power
Nov15
Political Economy2

A Theory of Bargaining Power

Winner of the European Center for Austrian Economics Foundation’s fifth annual Vernon Smith Prize. The prompt is available on that page.

Introduction

Equality of persons is the fundamental principle on which the justification of democracy rests, but in what sense persons are to be equal matters a great deal for the shape of a democracy. For those who see in the state a protector only – or even a predator – the relevant sense is equality before the law. These people, at the risk of oversimplification, I will call the Right, and for them this sense is sufficient. That the state pays no respect to personal characteristics, Hayek called the rule of law.1 In his estimation, the stronger the rule of law, the larger the private sphere left free to individual choice. In short, to the Right, the rule of law is liberty.

There are others, however, for whom equality before the law does not appear sufficient. I will call these, again for simplicity’s sake, the Left. On their account, there are other factors, endemic to a system ruled by law, which lead to unrest, and – if they persist – even the collapse of that system. In these ideas we may disentangle two distinct senses of the word “equality” which are often conflated: equality of wealth, and equality of bargaining power.

The equalization of wealth is, of course, incompatible with the rule of law. This is the force of the Right’s argument against a wealth-egalitarian principle. But wealth-egalitarianism also becomes a strawman: the Left’s confusion allows the Right, in its fight against wealth-egalitarianism, to ignore inequality of bargaining power. A proper analysis of bargaining power in the context of each regime is a vital consideration for the stability of a democratic system: the rule of law will find little support from those under it who consistently gain little or nothing from trade, and a redistributive system which is consistently hijacked by the wealthy will likewise find itself in constant upheaval.

To what extent equality of bargaining power can serve as a justifying principle for democracy, and how it relates to equality in these other two senses, this paper will explore.

A Subjectivist Theory of Bargaining Power

Since Marx, analysis of bargaining power has most often proceeded in conjunction with some variant of the Labor Theory of Value. Anchored thus, it is used to ill-effect: if one assumes that trade is zero-sum, and that labor is entitled to the entirety of its product, then one will see exploitation everywhere, and in utopian zeal tear at the very foundations of society.

Wedded to a sounder theory of value, however, bargaining power becomes an illuminating concept. It is axiomatic that a voluntary trade generates surplus value (or at least is expected to do so ex ante) due to the differing valuations of the two parties. Accordingly, the terms of the trade can fall anywhere within that surplus. Bargaining power is defined thus: the party with the greater bargaining power takes the greater share of this surplus.2 It is power to determine the terms of a trade in one’s favor.

If therefore economic value is subjective, then as a function of potential value surplus from a trade, bargaining power must also be subjective,3 in the sense that the desire to make the trade (and on the other hand, the inclination to walk away) is based solely on the subjective valuations of the two parties.

choice

It follows that, as value cannot be spoken of abstractly of until it has been expressed in a choice,4 bargaining power cannot be spoken of until it has been expressed in a trade. This is no obstacle when merely speaking of valuation: to say that one prefers a new Mercedes over its equivalent dollar value in apples requires only the construction of a hypothetical choice – not a difficult exercise, even if the choice itself is difficult. However, an additional layer of uncertainty is added when constructing hypothetical transactions: without an actual trade, the terms of the trade are indeterminate. Without knowledge of the terms of trade, power analysis is nothing more than speculation. If we do not in fact make a deal, a bank telling me “take it or leave it” results in a situation no different than if I were to tell them, “take it or leave it” on terms more favorable to myself. Both parties have been willing to forego a deal on terms acceptable to the other; it is vain to speculate about who was more likely to have given in on the other’s terms if neither of us in fact did. To analyze a power relationship, there must first be a relationship.

Bargaining power is closely related to the concept of elasticity of supply and demand. A perfectly inelastic demand curve and a perfectly elastic supply curve indicate total power of the seller over the buyer, and on the other hand, a perfectly elastic demand curve and a perfectly inelastic supply curve indicate total power of the buyer over the seller. These correspond to the ideal types of “price setter” and “price taker”, respectively, and in each case one party stands to capture the entire surplus from the transaction.

In the real world, of course, these situations rarely obtain. Competition among suppliers makes the demand curve for the individual supplier more elastic (regardless of the elasticity of the total demand curve), therefore diminishing its bargaining advantage over the buyer. The same holds, mutatis mutandis, for buyers, for whom competition steepens the supply curve faced by each individual (regardless of the elasticity of the total supply curve). And it is these curves faced by individual firms and buyers which are alone important for the question of bargaining power. This being the case, total power of one party over the other could obtain only for a perfect monopoly or a perfect monopsony – and even then only if the other party faced perfect competition.

But bargaining power even among nominally competitive buyers and sellers can often become unequal. It is an old complaint that labor is allowed to compete away its bargaining power, whereas capital is cartelized so as to increase its power: capital has many options in labor, it is said, but labor has few options for employment. In other words, the worker faces an elastic demand for labor, but the employer faces an inelastic supply. This illuminates both the appeal of trade unionism – the defensive cartelization of labor – as well as its danger: it is all too often easier to remedy inequality of bargaining power by fighting for (and granting) privileges to the opposition than by revoking the privileges that caused the disparity in the first place. The “ratcheting effect” so often seen in the regulation-crisis cycle (Kinsella 1995, p. 164) describes the privilege-unrest cycle just as forcefully.

Bargaining Power and Wealth Inequality

It is common on the Left to speak of the toxic effects of income inequality on democracy. The complaint runs as follows: a wealthy class, far removed from the proletariat, is more able to secure for itself political favors, and in extreme situations, to actively oppress those below. To the extent that income inequality leads to rent-seeking, it is a corrupting effect on democracy. In addition, the concentration of wealth in a few hands (especially bankers) leaves the mass of people dependent on (that is, at a severe bargaining disadvantage vis a vis) the rich. These rich are then in a position to reap the majority of surplus value from their transactions, perpetuating their own wealth and holding everyone else in poverty.

There are in fact two complaints here: wealth inequality that results in inequality of bargaining power, and wealth inequality that constitutes inequality of bargaining power. Both complaints however, if they are to be construed more charitably than mere envy, have their force primarily against inequality of bargaining power, and inequality of wealth or income only so far as they abet the former.

I don't mind you being rich... Possessiveness notwithstanding,
this protestor has the right idea.

In turn: wealth inequality results in bargain inequality when that wealth is used to seek political privilege – that is, when it co-opts the coercive apparatus of the democratic state. Bargaining advantage becomes coercion once the first party is able to make the second party worse off than nonassociation would have left him; coercion represents the extreme form of bargain-inequality. Bargaining inequality can be thus engendered in two ways: directly (e.g. subsidies and special favors, giving favored entities more wherewithal going into other bargains), and indirectly (e.g. regulations leading to cartelization, which stifles competition and increases relative bargaining power vis a vis more competitive sectors with which they trade).5 Bargaining inequality naturally begets wealth inequality, and wealth inequality can beget bargaining inequality when the state is empowered to bestow privileges.

That this is corrupting to democracy, the ideological Right and Left are agreed.6 The use of political power to secure economic privileges violates any conceivable justification for democracy, for it treats men unequally by the law, in addition to placing them on unequal footing, and making them more unequal in wealth.

donuts

Practically speaking, it is more realistic to disempower the state than to tell an empowered state to have more self-control, and certainly more realistic than ameliorating rent-seeking on the demand side by redistributing wealth. This would be akin to setting fire to the pastry shop in order to help one’s diet: pastries will always be there, as will moneyed interests. Nevertheless, if the second complaint proves valid – if wealth inequality does indeed constitute bargaining inequality, in addition to its previous effects – the benefits of state action may outweigh its occasional indiscretions.

To separate this complaint from the rent-seeking complaint, let us imagine an economy with a state disempowered to bestow privileges, but which makes no effort to ameliorate income inequality: in short, a system under the rule of law. We can then imagine monopolies might arise – not indeed as rampant as a Marxist might predict of “late capitalism,” for that term includes those monopolies arising from state privilege – but from market features (e.g. high fixed costs) or from exceptional entrepreneurial acumen.

A privileged monopoly enjoys its status because it has, as the result of some intervention, been freed from the necessity of competition. To the extent that this is true, it will possess a bargaining advantage over more competitive sectors with which it trades: it has other options, where its trader does not. This is not true of a “natural monopoly,” however. As Joseph Schumpeter argued (1976, ch. 8), “a monopoly position is in general no cushion to sleep on. As it can be gained, so it can be retained only by alertness and energy.” So far as an enterprise has achieved monopoly without erecting barriers to entry after itself, it can only retain its position by acting as if it were not a monopoly – that is, by renouncing its bargaining advantage over the consumer. Even if it faces no extant competition, potential competition will suffice to check its exercise of bargaining power.7 8

Of course, to say that political privilege is the most important source of bargaining inequality is not to say that none would exist in the absence of privilege. A natural monopoly arising from high fixed costs of entry would be less competitive, and possess a greater bargaining advantage vis a vis a trading partner, than would a monopoly which had simply outclassed its rivals – at least in the short run. It is easy to imagine that wealth would again be self-perpetuating in such circumstances, even if less strongly than in a rent-seeking situation: the initial wealth required to enter the market leads to a bargaining advantage, which increases wealth, etc. However, it is the function of robust financial markets to mitigate this effect.9 A clear opportunity to outcompete an entrenched rival represents a profitable loan opportunity. If the opportunity is not so clear, then the barrier to entry amounts simply to risk: that opportunity being restricted to the wealthy is no more unjust than a worker who cannot bet millions he does not have at the casino. And if financial markets are not indeed sufficiently robust to take advantage of obvious opportunity, then the blame lies on the retarding factor, not on wealth inequality.10

This amounts to a claim about markets falling between that of the Right and that of Market Anarchists, who claim that a market without legal privilege will tend to equalize wealth. The latter claim rings utopian, but would be undesirable in any case.11 A market without privilege will not tend to equalize wealth, but neither will it leave intact the persistent bargaining disparities we see today between the wealthy and the poor. Over time, and to the extent that financial markets are well-functioning, free markets will tend to erase these disparities.

We can see then that the cause-and-effect relationship from bargain inequality to wealth inequality becomes a feedback loop only in the context of an empowered state or a withered market, which are more often than not two sides of the same intervention. This is the unfortunate irony of the redistributive state: its empowerment is justified in order to prevent the cause-and-effect from proceeding in the direction it would not otherwise go, and it becomes the problem it was instituted to solve.

Democracy and Dependence

Having determined that the rule of law is more conducive to bargaining-equality than is wealth-egalitarianism, we turn now to considerations of bargaining-inequality in a mixed economy – that is, in a democracy unconstrained by the rule of law.

coercion

Earlier it was stated that bargaining power becomes coercion once the first party is able to make the second party worse off than nonassociation would have left him. The force of drawing the line at nonassociation, however, is probabilistic, not absolute. It applies most strongly to large societies with formal relationships, where the options for association are many: though association in general is natural, one’s default relationship to any particular person is nonassociative, which is to say nothing more than that competition prevails in such a society. This is not the case in tribal, informal, or severely monopolistic/monopsonistic arrangements – especially coercive arrangements – where there is a high likelihood that a particular association is necessary.

In such a situation, bargaining power can look very much like coercion. This is dependence, where a particular association has become the new norm, from which standpoint nonassociation (or the threat thereof) looks like the sort of active harm that is typical of coercion.

Thus, in an empowered state, dependence corrupts democracy in the same manner as wealth-inequality, but for the benefit of a different faction. An angry multitude is at least as effective as a wealthy minority at acquiring political privilege. In doing so, they increase their bargaining power vis a vis those on whom they depend, but only by becoming dependent in turn on the state. Their dependency is not lessened, but simply transferred into hands unconcerned with profit. This is perhaps more tolerable for those dependents, but there is no equilibrium: each turn of the ratchet further imperils the stability of the system.

It is the very function of the rule of law to halt the ratchet – to provide a bright and recognizable line beyond which the exercise of coercive power can be called illegitimate. Being subjective and (therefore) immeasurable, bargaining inequality could not be deliberately fought ex post in anything better than an ad-hoc fashion – the very antithesis of the rule of law.12 Like happiness (which is, not coincidentally, also subjective), bargaining equality cannot be pursued directly without destroying the conditions for its emergence. Rather, it results only from the conscious and intentional pursuit of the rule of law. This consciousness is itself the rule of law; it is cultural as much as institutional. It will not survive unless it is defended, and it cannot be defended unless it is consciously recognized – hence the necessity of a bright line, obvious to the entire polis.

In addition to the futility of ex post equalization of bargaining power, the very attempt is self-contradictory. To empower the state to aim at bargaining inequality sets up a class of administrators with a far greater relative advantage: the power of coercion. “She swallowed a spider to catch the fly,” it was said of the Old Lady who Swallowed a Fly. Do we suppose the spider to be more benevolent than the fly?

Bargaining equality is therefore not a justifying principle of democracy, but a corroborating one – not the definition, but the result of a healthy democracy. The existence of bargaining inequality is not the problem itself, but a symptom that the justifying principle has been violated. Whether the equalization of bargaining power is best achieved by equality of wealth, or by the rule of law, we have already seen: it is unlikely that a permanent underclass, benefiting little from trade, should develop under the rule of law, whereas it is extremely likely that a redistributive apparatus will be hijacked by those with means. What comes down, can also go up, as the experience of the modern welfare state has shown.

Conclusion

Bargaining power is poorly treated in most ideologies. The Left notices it, but exaggerates its import and pursues it directly, by any means available. The Right, on the other hand, tends to ignore it completely, leaving a conspicuous hole in their ideology which the Left rightly points out. A correct approach, paired with a subjectivist understanding, will recognize the importance of bargaining equality for social stability, and its usefulness as a democratic barometer. It will at the same time recognize the interplay of the concept both with wealth distribution and the rule of law. For this reason, it will pursue not bargaining equality as such, but bargaining equality in the rule of law. For it is not only the efficiency of the system that matters, but also its tolerability. The concept of bargaining power, by bringing these two considerations into harmony, is uniquely well-suited to be the foundation of a new liberal consensus that brings together those ideologies which have been too willing to sacrifice one consideration to the other.

Footnotes

  1. He approvingly quotes Algernon Sidney as saying “Laws that aim at the public good make no distinction of persons” (Hayek 1960, p. 464). Cf. also (Hayek 1979, p. 143): “[I]n whatever manner the government restrains (or assists) the action of one, so it must, under the same abstract rules, restraint (or assist) the actions of all others.”
  2. Needless to say, equality of bargaining power is not the same as that amorphous term “equality of opportunity.” Despite its benevolent sound, to substantially equalize opportunities across time, space, and income would require a more forceful homogenization than even wealth-egalitarianism. In any case, the Left generally means by that term no more than wealth-equality, and the Right no more than the rule of law. It is for this reason an unuseful term.
  3. This has nothing at all to do with the claim that actual power depends on subjective perceptions of the other party’s power. The subjectivity does not arise from perception (which is perhaps interesting psychologically, but irrelevant praxeologically), but from valuation.
  4. “The scale of values or wants manifests itself only in the reality of action. These scales have no independent existence apart from the actual behavior of individuals” (Mises 1963, p. 95).
  5. It is on this point as well that the failings of the Right become clear: if their ideology is to be construed more charitably than simply a front for the interests of the rich, they must acknowledge their failure to give attention to (and even at times their justification of) real and toxic disparities in bargaining power. This is the theme of Roderick Long’s 2008 essay, “Corporations Versus The Market; Or, Whip Conflation Now.” Though it focuses primarily on corporatism, it could just as easily be speaking of bargaining power in general.
  6. In the American context, rent-seeking is the common complaint of both the Tea Party and Occupy Wall Street, all the more notable given their ideological animosity.
  7. Cf. Hutt (2011, p. 95): “Natural monopoly can be observed in practice to be of relatively small importance in comparison with collusive monopoly. In the absence of collusive monopoly . . . there can be little withholding of capacity.” This withholding of capacity (and consequent raising of prices) is the means by which a monopoly’s bargaining power is exercised. The upshot of his argument (along with his later argument that collusive monopolies can only be sustained under state privilege) is that natural monopolies cannot exercise the same degree of bargaining power as privileged monopolies.
  8. Keep in mind that it is impossible to speak of its potential exercise of bargaining power; we can only speak of trades that have in fact occurred.
  9. Cf. Alchian & Kessel (1962), who then argue that the distinction between privileged and natural monopolies is illusory because “it behooves an unregulated monopoly, if it wants to remain one, not to appear to be too profitable,” for “all monopolies are subject to regulation or the threat of destruction through antitrust action.” This may be true for all practical purposes in the present world. Nevertheless, as political costs have been ruled out by construction in our hypothetical state, we may still fruitfully distinguish between the two sorts of monopolies.
  10. One could also imagine robust financial markets mitigating the bargaining disparities arising indirectly from legal privileges that erect barriers to entry. This is true so far as that barrier is a monetary cost. However, the protective barrier is in many cases an intervention in the financial market, especially when the protected firm is itself within that sector (hence the Left’s suspicion of banking and finance). The sector is therefore ill-equipped and ill-disposed to deal with the disparities from which it benefits. Additionally, the barrier is not always simply monetary: if the state denies entry into a licensed market, a loan will not suffice to break in.
  11. Hayek (1960, p. 43f) argues that the progress of civilization depends on inequality of wealth, so long as “all the steps on the income pyramid are reasonably occupied” (Ibid., p. 46).
  12. We can, however, imagine a rule in conformity to the rule of law which would not purport to remedy bargaining inequality generally, but merely limit the disadvantage with which a person might enter a trade. Not an ad-hoc regulation inspired by a particular disparity, but a general, impersonal benefit. A policy like a universal basic income would, by ensuring at least survival, put a floor on the desperation with which a person might make a trade. Even Hayek (1979, p. 55), whose definition of the rule of law we are using, supported such a measure of redistribution.

Tags

Bargaining PowerInequalityRule of LawArmen AlchianF.A. HayekJoseph SchumpeterLudwig Von MisesRoderick LongW.H. Hutt

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