Who Can Negotiate and Why?
In an ideal world, the amount that you see on your paycheck is an accurate reflection of the value that your productive work creates for your employer. But wages aren’t set in a vacuum — the amount you earn is affected by everything from how long you’ve been with the company, to the degree you hold (or don’t hold), whether you’re represented by a union, among others. And of course, your ability to bargain.
Now, when I say bargain, I don’t actually mean how persuasive you can be in that prototypical salary negotiation conversation where you’re sitting across from your to-be employer, dressed in a nice suit, making a case for why you should earn $XX wages as a starting salary.
Bargaining is a well-studied aspect of economic game theory, providing a framework to explore the dynamics that lead to divergent wage outcomes. An important topic that we will explore is the idea of outside options: the value of your alternatives. Although the analysis to follow is incredibly simplified, it’s meant as a means to build a better understanding of the effects that small individual differences can have on our ability to identify and pursue outside options, resulting in increased wage inequality.
An Introduction to Bargaining and Game Theory
In economics, game theory is used to model strategic interactions between competing parties, where each party is assumed to try to maximize its respective payoff. Abhinay Muthoo, the economist credited with unifying the theory of bargaining, defines a bargaining situation as one in which, “two or more players have a common interest to cooperate, but have conflicting interests over exactly how to cooperate.”
In the context of wages, the idea of bargaining is used to illustrate how the two parties negotiate their interests based on some known parameters. A few key sources of power in the bargaining process are:
- Patience: negotiations are time consuming, meaning the party willing to forgo a resolution for longer has an advantage. A 2009 study illustrated this in the political realm, demonstrating the role of patience in setting state budgets. The authors found that governors were more willing to endure longer budget setting meetings than legislators, which they explained as a function of professionalization. Governors are full-time and well-paid, while legislators often had second jobs and earn comparatively lower salaries. In other words, the legislators were seen as being more incentivized to get to a resolution quickly, and therefore had less power in the negotiations.
- Monopoly Power: monopoly power is a much larger topic, but refers to the idea of market control or being the exclusive provider of a good or service. When a firm has monopoly power, they are not subject to the same competitive forces that might drive down prices or improve quality of service. Firms are incentivized to keep this power, keeping barriers to entry high by deterring others from entering the market. Companies like Wal-Mart and Amazon have been labeled monopsony employers, meaning they are the only buyers of labor in certain geographic regions, giving them the power to suppress wages due to lack of competition.
- Information Asymmetries: it’s quite intuitive that the party holding more quality information would have an advantage in a negotiation. George Akerlof, Michael Spence, and Joseph E. Stiglitz won the Nobel Prize in 2001 for their work studying the effects of information asymmetries on market outcomes. Akerlof famously illustrated this with the sale of used-cars, known as the Lemons Problem. In this example, when the seller of the car has more information on its value than the buyer, the seller is more likely to get the favorable outcome.
This is not an exhaustive list, but an important takeaway is that the party that is more risk-averse is going to be at a disadvantage. They will be less likely to be able to exercise a credible threat and have more at stake for not reaching an agreement. The opposing party can leverage this in their own favor and walk away with a better deal.
One way to reduce one’s risk is through outside options, which we will explore in the next section.
What are Outside Options?
Outside options are other available alternatives, or the utility one has in leaving an agreement. In finance language this is called your Best Alternative to Negotiated Agreement (BATNA), and in labor economics it is sometimes referred to as nonemployment. Abhinay Muthoo illustrates this well with the idea of selling a house: if you put a home on the market and are negotiating with a potential buyer, your outside options are the other available offers on the house. If you have better offers on the table, then you have a more credible bargaining position, and can extract a higher price.
The concept of outside options is really interesting when discussing wage outcomes. Economists have studied the link between wages and outside options extensively (Caldwell & Harmon 2019, J¨ager et. al 2019, Lachowska 2017), concluding that the availability of alternative employment options and the means to exercise those options can have a positive impact on wage prospects. Danieli & Caldwell’s research on the German labor market has found that their outside option index (OOI) measure accounts for 30% of the gender wage gap. The authors suggest that one’s access to outside options is related to one’s skills, mobility (commuting, moving costs, density of possible jobs), and individual preferences.
We can illustrate how outside options interact with bargaining power in what’s called the Nash Bargaining Wage Model. In the model, productivity is included to represent what’s called the “inside option,” which is the utility from staying with the current agreement. You might notice, for instance, that a worker with no outside options will have wages just set as a function of their productivity and bargaining power.
It’s important to note that outside options are only relevant when you can exercise a credible threat to use them. For example, it doesn’t matter how many lucrative job offers you have in another city if you are committed to staying in your current city until your child finishes school.
Restrictions to Outside Options — Three Stories
To illustrate how outside options affect wages, let’s look at three theoretical cases: Ava, Brylee, and Celeste. For the purpose of this thought-experiment, we’re going to assume that these hypothetical women are exactly the same in every way, except along two dimensions. They have the same education background, have been working in marketing for 7 years, are currently employed making the same salary, live in the same city, with the same family obligations and savings. Here’s how they are different:
- Ava signed a non-compete clause (Brylee and Celeste did not)
- Brylee is new to the city (Ava and Celeste have a well-connected local network)
Now let’s explore how these two small differences impact their outside options, and wage outcomes.
Limited Search to Discover Outside Options: The Power of Networks
Even though Brylee might not be happy with her job or her salary, because she is new to the city, she doesn’t have many long-distance ties. She knows the people who work at her company, and maybe a few other friends. She is less likely to find out about interesting job opportunities through a network, and instead relies on internet searches. This is problematic because 70% of jobs are not even posted online.
The majority of people find out about jobs through their networks. So what kinds of networks actually enable the best job outcomes? Studies of network dynamics can provide insights on how information, behaviors, and technologies travel between individuals and across communities. Mark Granovetter’s groundbreaking article The Strength of Weak Ties quantified this counter-intuitive notion with a survey of job-seekers, noting that from those who found out about their job from someone in their network, 56% reported that they only saw that person occasionally, and 28% reported that they saw that contact rarely. In other words, being connected across a network is incredibly important, even if you don’t have a “strong” relationship with that person.
Ava and Celeste know people within and across their industry, and making them more likely to hear about possible job opportunities that they might not have found out about otherwise.
Restricted Credible Threat to Exercise Outside Options: The Effect of Non-Competes
Through her network, Ava found out about a great job opportunity at a competing firm that has a higher starting salary. She wants to use this information in her next performance review to try to negotiate a higher salary. Her boss takes note of the discrepancy, but doesn’t change her salary. Why didn’t this tactic work for Ava?
Ava signed a non-compete agreement, which states that she is not allowed to accept a position with a firm in the same industry for at preset period of time after leaving her current company. Non-compete agreements might have sympathetic intentions — they ensure that employees can’t quit one job, only to get hired by a competitor and share trade secrets. But they are also criticized for negatively affecting wages and employee satisfaction. And they’re not uncommon — a study from the Economic Policy Institute suggests that between 27.8% and 46.5% of private-sector workers are subject to noncompete agreements.
Even though Ava is not an executive, and doesn’t have any access to her firm’s confidential reports, this contract restricts any credible threat she has to take alternative positions in her industry. If Brylee and Celeste come across other job opportunities, they could would not be restricted in taking the offer.
The Power of Unrestricted Options
Although Ava has a strong network, and knows about many potential outside options where she could earn a higher salary, she can’t exercise a credible threat due to her non-compete agreement. And although Brylee can credibly threaten to leave her job, she doesn’t know of any outside options that are better than her current situation.
Celeste uses her network to find out about a higher paying job opportunity and because she does not have a non-compete agreement, she can effectively use that information in salary negotiations, resulting in better wage prospects.
There are myriad of other privileges that can influence a person’s wage prospects (student debt might make you more risk averse, restrictions on mobility might keep you physically isolated from other job opportunities. Of course we must consider differences skills, education, family obligations, etc.). But what we have started to illustrate is the ways small changes between workers can limit their ability to identify and exercise outside options, resulting in lower bargaining power in wage negotiations.
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