Question

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 recieves 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 join 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

According to the question, we have a situation of bilateral monopoly which means that a single producer of goods has a single buyer for goods. In this case, labors have specific skills, they are trained to carry out a particular task that needs some specialization, in order to attain that specialization they have invested in their specialized factor. The same goes for the specialized capital here.

Before coming to the source of failure or Pareto non-optimality situation that emerges when parties do not cooperate prior to participation in production activity, let's understand what is a Pareto non-optimality situation.

Pareto optimality is a situation (economic state) where no consumer/beneficiary can be made better off without making another consumer/ beneficiary worse off than earlier. In the case of Pareto non-optimality, a consumer can be made better off with a change without making the other worse off, the initial state would be considered as Pareto non-optimal.

In this case, if [arties do not cooperate prior to engaging in production activity the division/allocation of output would be uncertain because both capital and labor are specialized here. Distribution of output as factor payments would be difficult as there would be no explicit residual claimant. Both the capital and labor owner would claim to be the residual owner. Each party mightfeel that they would be better off with a different distribution of payout.

It is important for the capital owner (the residual claimant) to contract in advance with the owner of labor services because the laborers are specialized with a particular skill set needed to aid the production and they don't have close substitutes in the labor market. Since they have to invest in their skillset to obtain the skill it givest them an added advantage to bargain. There is no competitive alternative to determine the wage rates here, so a contract in advance will help the capital owner to calculate their approximate profit and also help with keeping the labor in check by law.