Question

2. When productive factors (the services of capital and labor, for example) are combined to produce a unit of output, and the production requires the participation of both inputs, a problem arises as to how to distribute the output as factor payments (wage and rental payments) to reward the owners of the participating inputs. The issue of how to fairly distribute the output as factor payments has preoccupied economists for generations. The most common solution that emerges in competitive markets is that labor is paid a wage equal to its competitive alternative while the owner(s) of capital receives the residual (profit"). If labor and capital are specific (labor has specific skills and capital is specialized) to the production activity, then we have a bilateral monopoly situation. Assuming that the owners of labor and capital had to make prior specific investments in their specialized factors, explain the source of "failure" (or Pareto non-optimality) that emerges when the parties do not cooperate prior to participating in the production activity. If the specific capital owner becomes the residual claimant (receives the future joint surplus) and hires the labor services, why is it important for the capital owner to contract in advance with the owner of the labor services? Carefully explain.

Answer 1

In bilateral monopoly situation, both the owners of land and capital need to collaborate equally making both better off or if in other words if both dont coooperate to terms which are mutually non agreeable then it makes any one entity worse off and hence non Pareto Optimal situation which ultimately causes failure in reaching an agreement or contract.

Thus it is important to contract with owner of labor service in advance to refrain them in participating from other owners whatsoever in collective Bargaining and thus refrain them reaching potential tacit collusion which may hamper the owner of capital and cause serious damages to productivity.