Industrial Relations: Core Principle and Theoretical Foundation

Bruce E. Kaufman

Department of Economics

Georgia State University

Atlanta GA 30303

June 27, 2007

BKAUFMAN@GSU.EDU

Draft paper prepared for 2007 European Regional IIRA Congress

 Industrial Relations: Core Principle and Theoretical Foundation

What is most missing from industrial relations (IR), and its renamed version employment

relations (ER), is a theoretical framework. Without some kind of theoretical base,

science-building remains weak and dependent on other disciplines, problem-solving lacks

for conceptual structure and guidance, and the normative propositions of the field have no

apparent rationale other than a partisan ideological commitment. It is one thing to declare

that the IR/ER field covers the employment relationship, it is another to demonstrate that

the field has something unique and value-added to contribute on the subject.

After many years of investigation, I have concluded IR does indeed have a

theoretical core. In this paper I endeavor to reconstruct and outline it. In my

interpretation, IR is a form of heterodox labor economics, its central point of attack is the

model of a perfectly competitive labor market (enshrined in the labor demand/supply

curve diagram), and its central object is to provide an alternative “institutional” theory of

the employment relationship. In certain respects this theory is a complement to

neoclassical labor economics (NLE) in that it rounds-out and completes the latter, in

other respects it promotes a different method and vision of how an economy works and is

thus a substitute. I proceed to elaborate all these points.

The Core Organizing Principle for IR Theory

The subject domain of industrial relations was originally conceived as covering the

employment relationship (Kaufman, 2004a). Given this, a theory of IR must therefore

address the key features, outcomes and behaviors of this relationship. I have delineated
these in more detail elsewhere (Kaufman, 2004b). Before IR was developed orthodox

economists had already constructed such a theory. This theory portrays the employment

relationship as a species of market exchange and, in particular, the exchange of a

commodity-like entity called “labor” in a perfectly competitive labor market.

The IR critique of early NLE begins with one core principle. Everything else

flows from it. This principle is both positive and normative. Stated in the affirmative, this

core principle asserts that labor is human; stated in the negative it asserts labor is not a

commodity. In this time period, the positive way of stating this principle was most often

done by referring to labor as the “human factor” (Kaufman, 2007a).

The core principle of IR is most prominently displayed in the Constitution of the

ILO, created by the Treaty of Paris signed in 1919 to officially end World War I. As I

have discussed elsewhere (Kaufman, 2004a), it is no coincidence that the field of

industrial relations and the ILO were born at the same time for they sprang from the same

intellectual roots and social concerns. In particular, the statesmen who crafted the Treaty

of Paris were intent on ending two kinds of warfare that they regarded as a mutual threat

to democratic capitalism: political warfare and industrial warfare. Thus, it is instructive

that the first of nine principles enumerated in the Constitution of the ILO reads: “Labor

should not be regarded as a commodity or article of commerce.”

Theoretical Foundation

In original IR the statement “labor is not a commodity” is a fourfold rejection of early

NLE as a theory of the employment relationship, a practical program for running the

employment relationship in industry, a guide for labor/employment policy, and an ethical

 framework for treating people in the world of work. The statement “labor is human” was

intended to be the base for constructing an alternative theory, program of practice and

policy, and normative value statement with regard to labor. Both negative and positive

prongs of IR can be better elucidated and appreciated with the assistance of Figure 1.

Panel (i) of the diagram depicts a perfectly competitive labor market. The demand

curve D and supply curve S determine the equilibrium wage W and employment level L.

Just as the quantity variable Q in a product market demand/supply (DS) diagram

represents some uniform physical entity (e.g., bushels of wheat of the same grade), the

W1

Q = f (K, L, N)
D

L1 L
(i) Competitive Labor Market (ii) Firm (iii) Industrial Relations

Figure 1: The Industrial Relations System

variable L in the labor market also represents a uniform quantity of labor services,

measured in discrete physical units such as number of workers or work hours.

Panel (ii) depicts a firm or other type of business organization, depicted as a

hierarchical system of command and control with the chief executive officer and other

top managers at the peak of the pyramid and the employees at the bottom. The firm is
where production takes place, depicted by the production function relating the level of

output Q to the level of factor inputs capital (K), labor (L), and natural resources or

“land” (N).

Panel (iii) is a photograph taken in 1914 at the Colorado Fuel & Iron Co. (CF&I)

of employer John D. Rockefeller, Jr. (right), one of his coal miner employees (left), and

Rockefeller’s industrial relations consultant William Lyon Mackenzie King (middle). The

historic and symbolic significance of this photograph has been explained elsewhere

(Kaufman, 2004a), but suffice it to say here that, if there is a “birth photo” of IR in the

American context, this is it. [British readers can substitute industrialist Montague Burton

for Rockefeller.] The theoretical significance is that the photo represents the human

essence of industrial relations and, in particular, how the new science and practice of

industrial relations, represented by King in the middle, stands between the warring

employer and employee on the (metaphorical) right and left and restores industrial peace

(removes “frictions”), creates a more efficient and equitable employment relationship,

and saves capitalism from potential destruction by its radical enemies and/or internal

dysfunctionalities.

Figure 1 provides insight into the early NLE paradigm with regard to theory,

practice and policy in employment relations, and why NLE is fatal to IR if not effectively

challenged and rebutted. It also illustrates the core ideas of industrial relations and the

field’s reason for being.

The DS model in a competitive labor market was the centerpiece of the orthodox

theory of the employment relation in the first half of the twentieth century (documented

shortly); whether it still occupies that place is a matter of debate and definition today. In
the competitive model the employment relation is an exchange relationship established

between buyers and sellers of labor. The buyers of labor are employers, the sellers of

labor are employees, the two meet in a perfectly competitive labor market, and the wage

rate (price of labor) adjusts DS to establish an equilibrium employment level. The firm, in

turn, is a technologically determined production set, as represented by the production

function. In this model, the labor market determines the equilibrium level of wages and

employment, this employment level determines the level of labor input in the firm’s

production function (panel (ii)), and the production function yields the firm’s output of

goods and services. The production function also yields a deterministic, well-ordered

marginal product schedule which, in turn, provides the firm’s demand curve for labor in

panel (i).

As later formally enshrined in the first fundamental welfare theorem of

neoclassical economics, the workings of a perfectly competitive market system are

predicted to lead via the Invisible Hand to the most efficient (Pareto optimal) allocation

of resources, production of goods and services, organization and management of the firm,

and terms and conditions of employment. In particular, DS establish the optimal

configuration of all terms and conditions of employment, including not only the wage

rate but also hours of work, pace of work, safety and health conditions, and non-wage

benefits. DS also effectively perform all aspects of the firm’s HRM function, such as

recruitment, compensation, training, and motivation. Although fairness is not an explicit

concern of NLE, by happy coincidence DS also lead to a fair wage outcome in the labor

market, at least as evaluated by the standard of “marginal productivity justice” (Budd,

2004). With DS coordinating efficiency in production and fairness in distribution, the

employment relationship is frictionless and problem-free and no other institution than the

market is needed.

This conclusion has mortal implications for industrial relations. A central

construct in IR, labor problems, has no theoretical grounding since competition and the

market lead to Pareto optimal outcomes. Likewise, the four major institutional tools of IR

– worker representation and trade unions, labor law and social insurance, progressive

labor management, and government macroeconomic stabilization policy -- are redundant

and value-less. That is, demand/supply handle all aspects of HRM, keep the

macroeconomy at full employment, solve all conflicts of interest without labor law (via

private bargaining and the Coase theorem), and obviate the need for unions to prevent

exploitation and injustice. In terms of Figure 1, DS in panel (1) optimally perform

everything and the Mackenzie Kings of industrial relations (IR professors, HR managers,

union leaders, labor lawyers, mediators, the chair of the Fed, etc.) in panel (iii) have

nothing to do and no value to contribute in adjusting and equilibrating the employment

relationship. Panel (iii) effectively drops out of the diagram. Not only is industrial

relations redundant, it is a detriment to the social welfare to the extent King and

colleagues interfere with DS. The import of NLE is that the firm and employment

relationship are, as a realistic matter, comprised of human beings, such as pictured in

panel (iii), but for the purpose of understanding and predicting the operation and

outcomes of the employment relationship the human aspect of these people can be

neglected without substantive harm.

The terms “neoclassical” and “perfectly competitive” were infrequently used in

the 1920s to describe the theory of labor markets in orthodox economics; the most
common term was “commodity theory of labor.” This term was derived from the work of

the founders of neoclassical economics, such as Walras, Marshall and Clark. It is also

featured in the first full-length treatise on the neoclassical theory of the labor market,

John Hicks’ Theory of Wages (1932). The concept of “friction” was also popular.

Walras (1874), for example, defines all valuable things, including labor, as a

commodity and states of his theory: “This pure theory of economics is a science which

resembles the physico-mathematical sciences in every respect” and “our task then is to

discover the laws to which these purchases and sales tend to conform automatically. To

this end, we shall suppose that the market is perfectly competitive, just as in pure

mechanics we suppose, to start with, that machines are perfectly frictionless.” Walras

also explicitly rules out institutions, management, and ethics from the science of

economics.

Marshall (1890: 526) states, “The normal value of everything, whether it be a

particular kind of labor or capital or anything else, rests, like the keystone of an arch,

balanced in equilibrium between the contending pressures of its two opposing sides; the

forces of demand press on the one side, and those of supply on the other.” When he

applies this theory to labor, he (p. 336) notes “the habit of some economists…of treating

labor simply as a commodity and regarding the labor market as like every other market”

and concludes this practice is theoretically benign since “the differences between the two

[are] not fundamental from the point of view of theory…”

Clark (1900), the expositor of the marginal productivity theory of factor

payments, states (p. 82): “Let us use commercial terms, and speak of a ‘market for

labor’… and the action of demand and supply… and say that they, in some way, put a
price on men, as they do commodities. There is much to be said as to the accuracy of

such terms in this connection; but there is not great danger than by thus using the terms in

preliminary study we shall reach an incorrect result.” The “correct result” from assuming

labor is a commodity governed by the natural laws of competition is “free competition

tends to give to labor what labor creates, to capitalists what capital creates, and to

entrepreneurs what the coördinating function creates” (p. 3) This conclusion is arrived at

by “remorselessly…remov[ing] all of that friction which vitiates the action of pure

economic law” (p. 71).

Writing three decades later, Hicks (1932: 92-93) states, “it is perfectly possible to

treat ‘labour’ as a commodity consisting of discrete homogeneous units, for which

therefore there are well-defined curves of supply and demand.” He earlier notes,

however, that “labour markets… have certain peculiar properties, which make it

impossible to apply to labour the ordinary theory of commodity value without some

further consideration” (p. 1). After describing these peculiarities (e.g., workers are not

homogeneous in terms of work effort and efficiency), he nonetheless asserts it is useful to

model wage determination as if “all men are equal” (p. 3), which in effect treats labor as

a commodity. He concludes, “Wages, say the text-books, tend to that level where demand

and supply are equal. If supply exceeds demand, some men will be unemployed, and in

their efforts to regain employment they will reduce the wages they ask… So far as

general tendencies are concerned, wages do turn out on the whole very much as if they

were determined in this manner” (p. 5).

The position of IR scholars is that the NLE model of a perfectly competitive labor

market is theoretically suspect; its major predictions are often empirically contradicted
(particularly in the short-run and without ex post theoretical extensions); and it justifies

public policies toward labor that are neither efficient nor fair (Pierson, 1957; Kaufman,

1988, 1997). In this respect, if the competitive core and Invisible Hand (first welfare)

theorem of neoclassical economics defines orthodox theory then IR is heterodox theory.

The heterodox theory base IR principally drew from was English historical/social

economics, as exemplified by the Webbs (1897), and American institutional economics,

exemplified by Commons (1934). Both American and British branches of labor

heterodoxy rested on an amalgam of economics, sociology, law, history, psychology,

ethics and management (Kaufman, 2004c, 2007c).

The key to the IR rejection of the NLE competitive model is the maxim “labor is

not a commodity.” Theoretically, this proposition strikes at the competitive model and the

Invisible Hand story through two channels. These channels were only broadly and often

intuitively understood by the earlier generations of scholars associated with industrial

relations; with the help of hindsight and advances in theory they can now be more sharply

delineated.

First, it is well recognized that a key assumption of the competitive model is that

labor be a homogeneous quantity (per the quote of Hicks). Violation of this assumption

destroys the theoretical integrity of the competitive model in several ways. For example,

if labor is differentiated (non-homogeneous) the supply curve of labor becomes upward

sloping, necessarily so since firms are no longer indifferent to which unit of labor they

purchase. It is existentially impossible for labor not to be differentiated since the labor

service purchased by the employer is embodied in and inseparable from the employee

who sells it (a form of indivisibility not present with commodity suppliers of wheat, oil,
etc.), implying the employer and employee of necessity have a personal relationship

rather than a homogenizing market-mediated anonymous relationship. Just as no well-

defined supply curve exists for an imperfectly competitive firm (e.g., a monopolist), no

well-defined (continuous, monotonic) labor demand curve exists for the firm in an

imperfectly competitive labor market (Fleischer and Kneisner, 1980: 198). Thus, on the

plane of pure logic one-half of the DS model in panel (i) deconstructs.

Since DS in the external labor market can not provide a deterministic

wage/employment outcome, the firm through management fiat and HRM policy (possibly

modified by government regulation and/or union negotiation) closes the terms of the

wage/employment bargain. Wage rates, rather than being solely market determined, are

always managed/administered prices, albeit shaped and constrained by market forces to

varying degrees. Since employers are wage-setters and have a modicum of market power,

wages and other terms and conditions of employment are likely to be set to serve their

interests, such as wages below the competitive level for infra-marginal workers (e.g.,

salary compression for productive but immobile professors). The Webbs and Commons

referred to this imbalance in wage determination as “labor’s inequality of bargaining

power” (Kaufman, 1989). Contrary to Clark, workers are not paid their marginal product

and feelings of unfairness can creep into the employment relationship.

Likewise, if labor is human then labor supply is volitional. While the BTUs from

a ton of coal and the tensile strength from a steel beam (both commodities) are

determinate, the work effort of human labor is discretionary and highly variable --

ranging from zero (sleeping on the job) to some maximum that differs from person to

person. Hence, the well-defined neoclassical labor demand curve degenerates and
becomes unstable, greatly reducing its predictive content. The labor demand curve (the

mapping between the wage rate and firm’s demand for homogeneous units of labor, such

as employees or work hours) becomes an ill-defined band because a given unit of labor

(employee or work hour) entered in the production function (panel (ii)) yields a highly

variable marginal product, depending on factors such as morale, treatment, supervision,

etc., and may be upward sloping at places if an increase in the wage generates a large

increase in work effort (as shown in certain modern efficiency wage models).

The human essence of labor also means that labor demand and supply curves are

not independent functions, wages are likely to have a large degree of rigidity, and labor

markets are no longer self-regulating (Slichter, 1931; Kaufman, 2007c). Because labor is

embodied in human beings, and human beings are uniquely endowed with consciousness,

emotional/ethical considerations of fairness, respect, morale, and security play a

significant role in determining an employee’s labor supply. A wage reduction or round of

layoffs necessitated by a leftward shift of the labor demand curve may result, for

example, in a leftward shift of the labor supply curve (say from a strike) if the process of

wage cutting or lay-off is perceived as unfair. Likewise, firms are reluctant to cut wages

in a situation of excess labor supply since doing so harms morale and often reduces work

effort and productivity more than proportionately. Persistent unemployment may

therefore result, not due to minimum wage laws, unions or other such institutional

impediments, but from the hard-wired (but perhaps theoretically inconvenient) facts of

human nature. Even if completely flexible, the wage rate may not be able to achieve an

equilibrium since the wage performs a dual function in labor markets – its allocates labor

and motivates labor (commodities do not need to be “motivated”). The wage that meets
one objective (e.g., a market wage that balances DS) may not meet the other (e.g., an

above-market efficiency wage that spurs work effort), leading to non-market-clearing

outcomes.

The human essence of labor compromises the theoretical integrity of the NLE

competitive model through a second channel. Commons argued that ownership, and

therefore property rights, is the foundation of institutional economics. Given this, he

made the transaction – the legal transfer of property rights -- the fundamental unit of

economic activity (Commons, 1934: 55). The implication is that in the labor market,

such as panel (i), what is bought and sold (the variable L on the horizontal axis) is not

physical units of labor but property rights to the services of that labor.

For a labor market to be perfectly competitive and yield an efficient outcome, all

margins on the labor service sold by the employee must be completely specified, priced

and delivered to the employer, which only happens if all dimensions of the property

rights are fully covered in a complete and fully enforceable contract. (Any un-priced

dimension of a property right leads to an externality or public goods-type problem.)

Perfect competition, therefore, requires complete contracts and complete contracts arise,

in turn, only in a state of zero transaction cost (Dow, 1997). In Commons’ theory, zero

transaction cost means exchange in markets takes place without cost or friction, which is

exactly the model Walras stipulated, and is the key assumption that makes market

exchange the preferred mechanism for allocating and coordinating economic activity. It is

also the key assumption that allowed Walras to eliminate all institutions but the market

from his model; it is also the assumption that makes the model of perfect competition

both “institution-free” and “institution-neutral” (e.g., general equilibrium theory has no

place for the institution of money; in perfect competition it makes no difference if capital

hires labor or labor hires capital) and allows NLE economists to claim that the study of

labor markets can proceed largely independent of the study of industrial relations

(Furubotn and Richter, 1997; Hamermesh and Rees, 1984). Positive transaction cost and

incomplete contracts, on the other hand, lead to a divergence between the private and

social cost of labor, harmful firm practices for workers (e.g., over-work, firing at-will),

and a rationale for institutional intervention (Stabile, 1993).

Since markets are always the lowest (zero) cost coordinating device, economic

activity devolves into a market structure usually called perfect competition but which can

more accurately and insightfully be called “perfect decentralization,” or what Commons

called “extreme individualism” (Kaufman, 2003c). In this economy all economic

coordination takes place through markets, implying firms disaggregate into single person

entities, such as sole proprietorships, individual artisans and family farms. (Multi-person

firms rely on management to coordinate resources but this is inefficient since markets do

it at zero cost, causing all firms to vertically dis-integrate into the lowest unit of

aggregation, a sole proprietor-type operation. All multi-person firms are therefore market

imperfections or “frictions;” the Fortune 500 are giant frictions.)

In an economy of perfect decentralization, the Commons/Coase logic of

transaction cost, carried to its logical conclusion, implies that the competitive labor

market model is a logical non sequitur and does not and cannot exist even on the plane of

pure theory (Kaufman, 2007d). This means, in turn, that panel (i) in Figure 1 is empty, or

disappears altogether. The reason is that with complete labor contracts a firm no longer

finds economic value in having employees, since the buyer’s ability to control and direct
labor during production (the legal criterion that distinguishes an employee from an

independent contractor) has no economic value in a regime of perfect information and

complete contracts (Coase, 1988; Dow, 1997). All labor services, therefore, are obtained

through the product market from independent contractors and other single-person firms

doing business as (for example) John Jones Pilot Services Inc. and Susan Smith

Registered Nurse Corp. Firms may still have large factories and thousands of “workers,”

but with zero transaction cost they rent out portions of the capital stock to their individual

labor suppliers and all labor suppliers are self-employed (e.g., a restaurant owner rents

tables to self-employed waiters). The implication for labor theory is profound: that is, the

neoclassical competitive model provides no theory of the employment relationship or

labor market because its implicit assumption of zero transaction cost precludes the very

existence of an employment relationship and labor market; institutional economics, on

the other hand, has a theory that not only explains the existence of the employment

relationship (positive transaction cost) but also rests on assumptions (e.g., bounded

rationality) that are consistent with the existence of such a relationship (Kaufman,

2007d).

Highlighted so far are a large number of theoretical problems and inconsistencies

with the model of perfect competition in labor markets, all originating with the

commodity conception of labor. These might be considered harmless curiosums if the

model nonetheless served well as a predictive device and guide to practice and policy (the

“useful tool” function of theory). On this matter, IR proponents have never denied there

are forces of demand and supply and have never rejected the DS model in totality (or

underlying concepts, such as optimization, marginalism, and equilibrium); rather, they

recognize this model insightfully explains certain features, regularities and outcomes,

particularly of an aggregative and more long-run nature, but claim that in most cases,

particularly in the short-run, demand and supply are not strong enough to yield

approximately competitive outcomes (a function of both significant frictions and

alternative channels of adjustment). Commons’ (1919: 17) position on this matter is well

summed-up by his statement “The commodity theory of labor… is not false, it is

incomplete.” But this “incompleteness,” depending on the subject and time frame, is

frequently fundamental and often quite damaging. The competitive model predicts, for

example, that a uniform “one wage” prevails among closely competing firms for a

common type of labor; wages readily fall in the presence of excess labor supply; labor

markets gravitate toward full employment; DS gives rise to fully compensating wage

differentials for risks and disamenities; workers are paid a wage commensurate with their

marginal product; and a rise in the wage (ceteris paribus) leads to a decline in

employment.

From these NLE predictions flow, in turn, a stance toward policy that is skeptical-

to-hostile toward most forms of institutional intervention in labor markets, such as

minimum wages, safety and health regulation, affirmative action, and collective

bargaining. If, for example, DS cause fish to have a higher price than children, and the

children work fourteen hour days in foul and dangerous canning plants, this outcome is

nonetheless efficient from a purely market (commercial) point of view and provides no

economic grounds for government (or union) interference; indeed, such good-intentioned

actions would only in this view hurt the people they are meant to help by raising the price

of labor and causing some children to lose their jobs. In this spirit, economist Arthur
Perry (1878: 200) declares the best protection for the worker is “to look out for his own

interest, to know the market value of his own service, and to make the best terms for

himself which he can; …[T]he remedy…is not in arbitrary interference of government in

the bargain, but the intelligence and self-respect of the laborers.” Based on similar

competitive reasoning, orthodox economists in the late 19th and early 20th centuries

opposed workers’ compensation laws because injured or killed employees had (allegedly)

already been paid a compensating differential for risk, while the courts struck down state

laws that banned paying workers in scrip (rather than cash wages) because workers could

either quit or bargain for a higher compensating differential payment in scrip.

The empirical evidence accumulated by early industrial relationists revealed to

them that the predictions of competitive theory were in many cases only partially-to-

weakly supported and in others not at all (Lester, 1946; Freeman, 1988; Kaufman, 1988;

Kerr, 1994). These economists also concluded than many labor outcomes, even if

competitive, were anti-social, particularly when “competitive” was embedded in an

environment of substantial unemployment and excess capacity (leading to “destructive

competition”). Given these conclusions, they rebelled at simple-minded and dogmatic

applications of the competitive model to labor markets and labor policy (an exemplar is

Stigler, 1946), and noted how use of the competitive model to judge interventions such as

unions and minimum wage laws is not scientifically neutral (a comparison of a perfect

institution versus a human institution) but inherently biased against the latter (Dunlop,

1984: Kaufman, 2007e). Illustrative of their position, Paul Douglas (1934, 94-95)

concluded “the assumptions which depart most from reality [in the competitive model]

are those which describe more power to workers than they actually possess…It can thus
be said…the forces which operated against labor’s receiving its marginal product were

stronger than those which tended to prevent capital from securing its margin. An

increased activity by the state in behalf of labor, or further unionization…, would have

helped to redress this balance.” Similarly, Lloyd Reynolds (1954, 549) observed: “Only

in theory, then, does the ‘competitive labor market’ provide an alternative to wage

determination through collective bargaining. The practical alternative is collective

bargaining versus wage-setting by employers with rather weak competitive checks.”

All of the discussion has so far been oriented around theoretical and empirical

problems with the competitive labor market model in panel (i). But equally important are

similar problems with the orthodox treatment of the firm in panel (ii). The employment

relationship, after all, is composed of markets and firms. These problems also arise from

the orthodox practice of treating labor as a commodity rather than a substantively human

person.

In IR theory, firms are more than production functions; they are also governance

structures (what Commons called an “industrial government”) that design and enforce the

rules of the workplace. In NLE, competition forces firms to adopt a governance structure

that is efficient; competition also ensures that these rules are fairly implemented and

enforced. Competitive firms have no power over workers (Alchian and Demsetz, 1972),

and if workers are dissatisfied they can voice their displeasure by quitting (voting with

their feet).

From an IR perspective, however, the governance of the traditional capitalist firm

is likely to be neither efficient nor fair and it is certainly not democratic in form or

substance (Webb and Webb, 1897). Coal and wheat do not care if the rules that govern
their purchase and usage are arbitrary or harsh; workers do. Rules that violate procedural

and distributive justice, therefore, lead in a world of incomplete contracts to a conscious

withdrawal of labor supply. They also violate widely held notions of human rights. With

positive transaction cost, impediments to mobility, and a reserve of unemployed workers

in the market, this withdrawal of labor supply cannot costlessly and efficiently be done

through quitting. Hence, three adverse consequences open up – first, firms gain power

over workers and can design and enforce rules that result in non-competitive terms,

conditions and treatment; second, efficiency suffers as workers withdraw labor supply in

other forms, such as absenteeism, shirking, striking and poor citizenship behavior; and,

third, impeded exit along with various internal contracting problems (e.g., principal-

agent, moral hazard, public goods nature of working conditions) creates a suboptimal

amount of voice in the workplace (Kaufman, 2001). As a science, therefore, IR makes the

study of alternative regimes of workforce governance a central topic; in the area of

practice and policy IR advocates institutional reengineering of the traditional capitalist

governance system to provide greater employee protection, representation and voice; and

in the realm of ethics IR maintains that efficiency cannot be the only criterion in

evaluating firm governance and, in particular, every governance system must meet

minimum standards in human rights and democratic processes.

The commodity theory of labor has yet other ramifications with respect to firms.

As described earlier, IR had a large contingent of business practitioners. They were

united in the opinion that following the commodity theory of labor leads to deteriorated

firm performance and poisoned employer-employee relations. Three examples illustrate

the point. One of the first published documents to use the industrial relations term in the
title was Report on Industrial Relations, issued by the Merchants Association of New

York (1919). It lists (p. 6), “three features of our industrial system, which are not

compatible with satisfactory industrial relations” and gives as the third one “The law of

supply and demand as the determining factor in fixing wages and conditions of

employment.” The report continues, “Many of the results of this economic law are unfair

and prejudicial to the interests of both employers and employees, and are socially

undesirable.” Two other statements are apropos. One early 20th century employer

observed, “In a general way, labor discontent has grown out of the competitive system,

which, when carried to the extremes as it has been in this country, as well as in other

countries, results in disaster to every interest whether employer or employee” (Blackford,

1982: 66). Another observes “the majority of works and factories are still conducted on

the ‘laisser faire’ principles of the Manchester school of economists. The teaching of this

school results in paying the worker the smallest possible wage, and in making none but

the legally necessary provisions for his social or physical comfort. Under these conditions

of employment, the usual relation between employers and employed is one of

antagonism” (Kershaw, 1903: 334).

As is suggested in the last quotation, the problem with the commodity model of

labor is that it leads to adversarial “low trust” employment relations and poor firm

performance. The reason these business people became involved in industrial relations,

therefore, was to discover and implement new HRM/governance procedures that would

increase firm performance by fostering positive employment relations, high trust and the

most desired of all workplace behaviors – cooperation in production.

 Cooperation is a moot issue in the orthodox competitive model. Critical

assumptions are threefold: labor services are embedded in a complete contract, the firm’s

production function is separable in the labor input, and the workers’ utility functions are

independent. A regime of complete contracts means that all aspects of cooperation are

already agreed to ex ante to the commencement of production and the amount of labor

services purchased by the firm exactly equals the amount the workers deliver. Likewise,

the standard assumption in the competitive/commodity model is that the production

function is separable in the labor input, implying absence of any kind of “team” form of

production (Alchian and Demsetz, 1972). As a result, the marginal product of each

worker is independent of the job performance and behavior of other workers, greatly

reducing employer concern with cooperation. Further reducing the salience of

cooperation is that workers have independent (individualistic) utility functions, an

assumption that eliminates the influence of one worker’s labor supply behavior on that of

others. Production in the competitive model is thus resolutely individualistic and

deterministic and, indeed, it must be since in this model cooperation introduces an

externality and strategic element of behavior that interferes with competitive equilibrium

and efficiency.

From the perspective of IR, cooperation is central to production and NLE is

defective because it takes cooperation for granted or assumes it away (per the earlier

quote of Commons). Thus, IR can be interpreted as an attempt to fill in this missing

(incomplete) part of NLE. At the level of theory, the key amendment to the competitive

model is, again, to incorporate the human dimension of labor or, more generally, to

substitute a heterodox behavioral/social model of the human agent for the orthodox
rational actor model. With such a model, bounded rationality gives rise to positive

transaction cost and incomplete labor contracts and the worker’s labor power committed

to the production function shifts from a contractual datum to the outcome of an ongoing

strategic bargaining game (a perspective also central to labor process theory and radical

economics). The workplace becomes “contested terrain” (Edwards, 1979) where

competition and self-interest drive employer and employee to gravitate to the non-

cooperative Prisoner’s Dilemma outcome. Both profits and wages suffer.

The task of the firm is to use institutional change, in the form of an engineered

HRM system and set of practices, to motivate the workers to move to the cooperative

outcome and provide maximum labor supply. Cooperation, however, can be coerced

(workers can be “made” to cooperate) as well as induced, opening up a range of

alternative employment (or control) systems and associated packages of inducements and

sanctions (carrots and sticks). As exemplified in Commons’ book Industrial Goodwill,

part of the theoretical core of IR is study and discovery of alternative HRM systems, the

alternative package of carrots and sticks each uses to motivate and control labor, and the

effect of each on firm performance and worker welfare. IR, accordingly, partook of a

1920s version of strategic HRM and included within its purview all types of employment

systems, including low road and high road. But, as exemplified in the same book, part of

IR is also a normative-based program that seeks to move employers and workers to the

cooperative outcome through positive and constructive inducements. The flagship

employment system of IR, therefore, is what Commons called the goodwill/citizenship

model (a model emphasizing employee commitment and democratic governance), since it

relies on positive methods, such as job security, collective voice, and fair treatment, to

induce cooperation. Today this model is called an HPWS (or “high involvement” model).

IR was founded, therefore, partly to fill in and promote the element of cooperation

in production that was omitted in orthodox economic theory. But, examined more deeply,

IR theory does more than simply “fill-in” a missing piece of NLE; it goes further and

reveals the central tension -- even contradiction -- in capitalist employment relations that

NLE assumes away. This tension is built into what may be called the competition-

cooperation trade-off, a trade-off inherent to real-life employment relationships.

Competition and cooperation are both required for efficiency – competition in

market exchange and cooperation in firm production. NLE achieves both by using

restrictive assumptions (e.g., zero transaction cost) that effectively eliminates cooperation

as an active variable. However, these assumptions also eliminate the employment

relationship, as earlier described, since multi-person firms vanish from panel (ii). As I

have shown in an earlier paper using Commons’ theory of institutional economics

(Kaufman, 2003c), the same outcome obtains if the process is taken in the opposite

direction. That is, rather than a regime of perfect competition, consider a regime of

“perfect cooperation.” Without going into detail, perfect cooperation gives rise to exactly

the opposite form of economic organization: that is, the national economy becomes one

giant “firm” (hence, a shift from “perfect decentralization” to “perfect centralization,” or

what Commons called “extreme collectivism”), all production and exchange are

coordinated by management command (an omniscient central planner, rather than an

omniscient auctioneer), and the Visible Hand of state management replaces the Invisible

Hand of the price system and works out the Pareto optimal allocation of resources. In
such a world, cooperation is “perfect” (everyone does exactly as directed) and

competition and markets in panel (i) are no longer needed and disappear. But without

markets, the capitalist employment relationship also disappears.

The upshot is that maximum efficiency can be obtained through two “utopias,” an

economy organized in the form of perfect competition or perfect cooperation. Industrial

relations arose in the first third of the twentieth century as a reaction against these

economic utopian schemes and endeavored to work out a more realistic and useful

“middle road” theory. In this theory, people are imperfect and hence all human

institutions are imperfect. In this imperfect world, capitalism is a mixed economy with

imperfect markets and imperfect organizations embedded in an imperfect legal regime.

As part of its organizational design, a mixed capitalist system has to evolve a method of

acquiring and allocating labor for production across the market/firm interface. This task

is accomplished by another imperfect institution – the employer-employee relationship.

The employment relationship is imperfect, and thus problem-prone, because its

two vital forces -- competition and cooperation – conflict and threaten to undermine each

other. The stronger are the forces of competition in external labor markets the greater is

wage/employment instability and short-run cost-cutting pressure, both of which undercut

cooperation. Workers, for example, withdraw cooperation and erect protective barriers

(including unions) in direct proportion to perceived employment insecurity (Perlman,

1928); likewise, firms see fewer reasons to foster cooperation and cut back expensive

fixed-cost investments in HRM and positive employer-employee relations (e.g., stable

wages, secure jobs, health insurance, pensions). Conversely, the stronger are the forces of

cooperation in internal labor markets the more immobile and sheltered are firms and
workers, both of which undercut market competition. Workers, for example, become

complacent and develop an entitlement mentality; likewise, firms face less external

pressure to minimize cost, innovate, and adopt flexible employment practices.

Institutional economics predicts, therefore, that the optimal (“perfect”) amount of

competition is not the maximum possible, which orthodox economics unquestioningly

assumes (has any neoclassical economist ever said less competition is better?); rather, it

is predicted to be at some intermediate level featuring an optimal combination of

competition and cooperation (Kaufman, 1999b). From an IR perspective, therefore, the

challenge of industrial relations is to use institutional design and human engineering to

achieve a workable balance between markets and organizations, efficiency and equity,

and competition and cooperation (Budd, 2004).

Conclusion

The modern field of industrial relations is in trouble, partly because it has become too

narrowly defined around the study and promotion of trade unions and collective

bargaining. A rejuvenated industrial relations needs to return to the broader subject

domain that characterized it in earlier decades: the study of the employment relationship.

This does not mean rejecting trade unions; it does mean framing the field more broadly

so it covers all the major actors and institutions in the employment relationship, gives

normative sanction to all approaches that promise improved employment relations, and

recognizes in a more balanced way that “union failure” and “government failure” have to

be weighed against market failure.

 The broader and more inclusive paradigm of industrial relations advocated here is

not a new idea; rather, it is a return to the original model advanced by the Webbs,

Commons and other founders of the field in the early 20th century. As framed here,

original industrial relations was a reaction against the commodity conception of labor that

informed economic theory, management practice and public policy in the late 19th and

early 20th centuries. Every person in early IR recognized that labor inevitably has

characteristics of a commodity since it is valuable and traded in markets; their point of

departure is to insist that labor is also distinctively and uniquely human and this

elemental fact must be taken seriously in theorizing about the employment relationship

and formulating and implementing practice and policy.

The most visible consequence of the commodity theory of labor was the Labor

Problem, widely considered the #1 domestic threat in the industrialized world a century

ago. Industrial relations was invented to save the industrial countries and the democratic

capitalist system from the dysfunctional and potentially revolutionary repercussions of

the Labor Problem through a series of institutional reforms meant to humanize, stabilize,

professionalize, democratize and balance the employment system. In this endeavor,

industrial relations was opposed to both classical/neoclassical economics and the more

radical streams of Marxist/socialist economics for both were regarded as utopian-based

theories of economic determinism that in practice lead real-life economies to disaster and

then seal the outcome through a corollary doctrine of policy fatalism that holds all efforts

at institutional change are useless or counterproductive because they conflict with the

“laws of economics” So viewed, one sees that original industrial relations and Keynesian

macroeconomics, and their chief intellectual architects Commons and Keynes, are in
broad principle theoretical and policy soul mates for both advance a vision of a

“managed” and “socialized” capitalism.

The core proposition of IR is that good science and good practice in labor markets

and employment relations requires substantive attention to the fact labor is embodied in

human beings and is not a commodity. The human essence of labor is not a “detail,” it is

fundamental. The human essence of labor leads to the heterodox denial of the Invisible

Hand doctrine and, hence, denial that the market system is self-regulating; it also

suggests that, while a market economy may well be superior to all other known

alternatives, its performance can be made even more efficient and fair by a reasonable,

balanced application of social management and regulation. The vision of industrial

relations is some form of a social market economy in which the virtues of individualism

and competition are balanced with cooperation and social responsibility.

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