Monday, April 22, 2013

The Labor Market As Ultimatum Game

Introduction: Labor Market as Ultimatum Game

In the standard neo-classical economics that I was taught in college, labor contracts are assumed to be negotiated between parties who have an equal ability to refuse the terms of any proposed contract and walk away from the agreement. Each party to the contract is also assumed to have the same amount of information available to them; for instance, the working conditions and the amount of surplus created by the production process. It follows from these assumptions that each party to the labor contract (i.e. the worker and the employer) will only agree to contracts which provide each with the value of their contribution to the production process. So long as there is competition among both employers and employees, capitalists will not be able to exploit workers (by paying them less than they are worth) and workers will not be able to exploit capitalists (by demanding more than they contribute).

Of course, this description of the labor market sounds patently absurd to anyone who has spent time toiling in the low-wage sectors of our economy. The statement that both parties to a labor contract have an equal ability to walk away from the agreement recently elicited a well deserved guffaw from one of my friends.

An alternative model of the labor market is offered by scholars such as Prof. Ellen Dannin1, who describe at-will employment as a “dictator game2” in which the employer tells the worker the terms of the agreement and the worker has no choice but to accept3. While Dannin's description is closer to lived reality for most of us, it too, like the neo-classical description above, fails to capture the nuanced real-life interaction of employers and their employees (at least, to this humble observer).

A better description can be had, I think, by conceptualizing the labor market as a variety of ultimatum game4. In a standard ultimatum game, two players are given the task of dividing a sum of money between them. The first player (the 'proposer') makes an offer to the second player (50/50, 60/40, 99/1, etc) and the second player decides whether to accept or reject that offer. If the second player accepts the offer both keep the amounts agreed upon, but if the second player rejects the offer neither receives anything. Usually, the game is only played once by any test subject or pair of subjects and both players know what the stakes are (that is, they know what the total amount being divided is). The ultimatum game bears many resemblances to my experience working in low-wage sectors (janitorial, retail sales, food service); however, there are a number of tweaks that could be made to the standard ultimatum game that would make it much more closely resemble what people like myself face when we go out to look for a job.

First, and most obviously, the ultimatum game is only played one time by any given individual in an experiment, while employment negotiations are (for most of us) a 'repeated game.' Not only do workers seek employment at multiple establishments and employers interview multiple job candidates, but the 'ultimatum game' continues even after employment as workers and employers negotiate for adjustments of wages, benefits and working conditions/requirements. Besides being a repeated game, labor contract negotiations also have distinct 'informational asymmetries.' Workers and employers do not have the same amount of information regarding what the actual value of the product or service that the worker will be making or providing is; nor do they have equal information regarding the relative share of revenue that labor is responsible for creating. Workers and employers bargain for shares of revenue created by the productive process, but only the employer knows what that revenue actually is. Contrariwise, employers have no way of knowing for sure ex ante what the individual characteristics of an employee are, and therefore what their productivity will actually turn out to be.

Another difference between the actual labor market and the standard ultimatum game experiment is that players in the ultimatum game do not suffer any personal economic consequences if the game ends in refusal, both players simply walk away in the same economic position that they were before. No one had gained, but neither has anyone lost. In the real world, on the other hand, people seeking employment are often in no position to refuse any offer, however small. This is why my friend laughed at the notion that workers and employers are on equal footing in negotiating labor agreements and why Prof. Dannin has characterized the at-will labor market as a dictator game. Different individual workers will have differing degrees of ability to refuse low proposals, based on things like their accumulated savings, strength of social and familial 'safety nets,' relative slack or tightness in the labor market, and their individual psychologies. Because these factors (and many others) are unique to each individual 'player' in the labor market ultimatum game, generalizations about workers abilities to refuse proposals must be made with a great deal of caution. My preference is to assume some sort of distribution of player's ability to reject low offers, random or otherwise. I have tried to encapsulate these realities into two concepts which I will explain in more detail later: ability to refuse (ATR) and economic effects of refusal (EER).

So, we might conceptualize the labor market (or at least large portions of it) as a modified ultimatum game; one in which players repeat the game indefinitely with multiple other players in an environment of informational asymmetry, and in which players experience differing consequences as a result of games that end in refusal. It is on this basic conceptual framework that I will build in what is to follow.

Differential Ability to Refuse

We start with the last difference between the standard ultimatum game and real life that I mentioned above, i.e. that in the ultimatum game neither party suffers economic consequences for a refusal to accept the offer. The worst-case scenario for either player is that they leave the experiment in exactly the same economic condition as when they entered it. In real life, on the other hand, the refusal to accept an offer of employment can have very real economic consequences for the players involved. Failing to reach an acceptable arrangement with another party in the labor market can lead players to lose not only money, but homes, families and self-respect as well.

I say “can” because the degree to which failing to accept an offer (or failing to make an acceptable offer) will effect a particular player is dependent on all sorts of things, many of which are not susceptible to economic analysis, even of the rather “soft” variety I am attempting here. We can, however, sketch the broad outlines of what conditions, at least here in the United States, we might expect to diminish or enhance a person's ability to refuse any given offer (hereinafter, ATR). Strictly speaking, only workers should have an ATR, since they are the ones who accept or refuse the labor contract offered by the employer. However, we might also speak of the employer's ATR as their ability to refuse to increase their offers as a result of not finding any takers at their current offer level. ATR then, for both employers and workers represents their ability to wait for a better deal to come along.

Many different variables, so to speak, go into an individual's ATR. The one that we will be most concerned with here is the economic effects on an individual of refusal to accept an offer or to make an acceptable offer (hereinafter EER, economic effects of refusal). By economic effects, I mean real effects on an individual's standard of living and their ability to maintain that standard into the foreseeable future. While we would expect an individual's EER to have a relatively strong negative correlation to an individual's ATR, even extremely high EERs can be overridden by other constituents of a person's ATR. As a dramatic example, I offer the experience of my homeless friend Dave (known to the transient community in Missoula, MT as “Crazy Dave”). Dave used to work as a cook at a local restaurant. The sheer quantity of food wasted by the establishment became increasingly troubling to him until one day he decided that he would rather live off the incredible waste of our society than continue to contribute to it. He walked off the job and never looked back (although he has done a fair bit of work since then, just not paid work). For Dave, the economic effects of his refusal to accept any wage offered, dramatic as they were, were far outweighed by the negative psychological effects that he experienced as a result of acceptance. Most of us, however, do not posses David's ethical rectitude, and so our ATR will likely largely reflect our EER.

As a general proposition, we might expect workers to have higher EERs than employers, and low-wage workers have higher EERs than high-wage workers. Labor market conditions will also differentially effect players' EERs. A tight labor market (low unemployment) will tend decrease EERs for workers, since the odds of finding another at-least-as-good offer in a relatively short period of time will be high. Coversely, tight labor markets will tend to increase EERs for employers, since it will be relatively harder for them to find additional players to make their offer to. However, this will only be true for some employers, i.e. those that require a continual stream of revenue to maintain their standard of living. Employers with large personal fortunes may have an EER of zero, regardless of labor market conditions; the same is true for wealthy workers. Accumulated savings and assets are what largely determine a players' EER, since they are what must substitute for an income or profit stream in the absence of achieving a 'successful' ultimatum game outcome (which is why we would expect EERs to be highest for poor workers and lowest for rich employers).

One last thing that seems pertinent to this analysis is that workers and employers face different 'transaction costs' in finding opponents (or, perhaps, partners) with whom to repeat the labor market ultimatum game. While workers generally must seek out potential employers, employers can generally wait for potential employees to come to them. For many low-wage employers, even the simple expedient of a classified ad is unnecessary as unemployed workers will regularly present themselves for consideration whether the business is advertising a vacancy or not. The result is that these kinds of transaction costs will tend to lower the ATRs of workers more than of employers.

Having a high EER means having a low ATR, and having a low ATR means that you will accept pretty much any offer that is made to you. If your bank account is flirting with zero and rent is due in a week, you are much more likely to accept wages and conditions that, in other circumstances, you would not even consider. In the labor market ultimatum game then, having a low ATR means being ripe for exploitation. For all of the reasons stated above, it seems reasonable to assume that, on the whole, a worker will have a lower ATR than an employer in any given iteration of the labor market ultimatum game.

Informational Asymmetries

In the standard version of the ultimatum game, both players are aware of the full amount being divided. This informational symmetry has obvious implications for the outcome of the game. If I am in the position of player two, i.e. I have to decide whether to accept or reject the offer, and I know that the ten dollars being offered to me is only 10% of the total amount at stake, I may reject the offer to punish my opponent/partner for their unfairness. However, if I am offered the ten dollars without knowing the full amount in play, i.e. without knowing whether my opponent/partner was given $20 or $1000 to divide, I will be more likely to accept it, since I cannot judge the “fairness” of the deal.

In the labor market ultimatum game, the total amount to be divided between the employer and the employee is any revenue left over after all of the non-labor operating expenses (inventory, rent, power, licensing, etc.) have been covered. In general, employees and potential employees can have only a weak grasp of what the total amount in play actually is. Because the firm's accounting is not usually made available to employees either before or after being hired, employees are placed at a necessary disadvantage in wage negotiation ultimatum games. Employers will always be able to claim that “we can't afford” increases in wages or benefits and employees will not be in a position to verify, much less gainsay, these claims. The workplace taboo against employees discussing their relative wage levels creates further informational asymmetries, as only employers know what the total wage bill for the firm is, while employees are left to speculate. In the absence of this taboo, workers might be able to piece together some idea of the company's overall accounting, but in it's presence this is almost impossible5.

The asymmetries also flow in the other direction, so to speak, although to an apparently lesser degree. Employers, as noted above, have no way of knowing ex ante whether a worker will be more or less efficient than average. Having been on a couple of hiring committees in my day, I know from experience: the description of goods given in a job interview does not necessarily have anything to do with the actual goods that will eventually be delivered.

However, employers can mitigate this problem, especially in low-wage jobs, through routinization and automation; something the fast-food industry seems to have refined to an exact science. Employers can also monitor the productivity of the worker after hiring, which will be discussed below.

Looking for a Job/Employee as Repeated Ultimatum Game

As I said before, unlike the usual ultimatum game experiment, players in the labor market ultimatum game play repeatedly, both with different partners, while in the search mode, and with the same partner, after hiring has occurred. The manner in which this repetition is performed differs for employers and employees. While employees tend to entertain employment offers sequentially (one at a time), employers generally make their offers in batches, interviewing many candidates for a position and selecting from a group of interested individuals. This makes “comparison shopping” easier for employers than for employees and thus serves as another advantage for employers (although this might not be the case in a tight labor market).

Another disadvantage faced by employees is that difficulty in comparing different wage and benefit packages (if one is lucky enough to have multiple options). Suppose a worker is offered three jobs: one with a relatively high wage but no health benefits and inconvenient hours, a second with some health benefits but a lower wage, and a third with an even lower wage but full health coverage and convenient hours. How is the worker to estimate the relative values of the different health plans, or determine how to weigh wages and benefits against being available for family members, friends and children? It becomes a matter of trying to compare apples with oranges, bananas and pomegranates.

Employers, however, do not face this conundrum, since they are the ones structuring the offers. If an employer cannot find any takers for a given wage and benefit package, they can simply increase the wage by a given amount and try another iteration. Once again, we find that informational asymmetries inherent in the structure of the game tend to favor employers over employees.

Repeating the Game After Acceptance

In a sense, the labor market ultimatum game is continually repeated even after employer and employee have reached a mutually acceptable division of revenue. This is true because the effective offer from the employer goes down if pay-raises do not keep pace with inflation, work requirements are increased ex post, or rises in productivity are not reflected in wage and benefit gains. Here again we have informational asymmetries that favor the employer, since workers do not have direct knowledge of the revenue created or their overall contribution to it.

Conversely, an employer's effective offer goes up if pay increases outstrip inflation, if workers successfully “slack off,” or if workers can bargain for a greater percentage of revenue (through unions, exploiting the value of their personal experience to the firm, etc.). In general though, it would seem that employers will be able to get a better idea of a worker's productivity than the worker him/herself, and thus ensure that the employee's remuneration never exceeds their contribution to the value of the finished product or service. Workers, however, have no direct way of observing their own contribution to said value and thus no easy way of knowing what percentage of the value they create that they are receiving.


The labor market can be conceived of as a modified, repeated ultimatum game between employers and employees. Most the of the divergences between the real-life labor market and the idealized experiment, serve to advantage employers and disadvantage employees. As a result, in the labor market ultimatum game it's easier to get away with under-paying than it is to get away with under-working.

1Professor of Law, Wayne State University Law School
5Some of these asymmetries, of course, can be addressed through union tactics in workplaces where workers are organized. Trade union representation, however, seems to be decidedly on the decline and, at any rate, cannot ameliorate all of the asymmetries and disadvantages that workers face under the current, capitalist arrangement.


Anonymous said...

Diptherio, I have a question and this is the only way I know to reach you. You recently appended a comment to a Naked Capitalism article ("Parsing") that includes a quote taken from NPR. Is that quote accurate and if so could you possibly give me the link? Thanks so much. Harry O. Cloice

Diptherio said...

Oh boy...just saw your question. Sorry about that, no one ever comments. If you see this, you can email mahankhal(at) and I'll see if I can come up with something for you. I don't recall off hand what story/comment you're talking about (there are so many) but I'll give it a shot.

Diptherio said...

Ok Harry, I think I figured it out. B. Obama did indeed say that "most [or many] of the activities engaged in by the banks were unethical but not illegal." I heard that particular bit of legalese from the Prez while listening to Democracy Now! I can't remember who the guest was (some lawyer guy), but yes, that was a almost verbatim quote and the guest on DN pointed out that the statement implies that some of the activities of the banks were illegal.