Business Responsibility in Downsizing

by Professor Lawrence Klein

Impressions and Facts

During the past two or three decades, there has been considerable restructuring of the US economy, and many of the prominent trends have also appeared in other countries, especially those classified as advanced industrial economies. Broadly speaking, the shares of output and of jobs have been falling in the primary sector (agriculture, forestry, fishing, and mining) and the secondary sector (manufacturing, construction and public utilities), while these shares have been rising in the tertiary sector (direct personal services and other service-producing activities).

This is a gradual process driven to a large extent by technological change and life style taste changes that occur only gradually. Yet the technological displacement is wrenching, and induces many people to try to block it, much in the fashion of those who opposed the adjustments that occurred at the start of the industrial revolution. Also changing institutions such as the founding of the World trade Organization, the start of NAFTA, and other liberalizing regional trade groupings contribute to the international movement of jobs and people along a similar steady path of change.

At the same time that we are in the midst of this long range restructuring, we are experiencing a severe short-run adjustment that exacerbates the situation. The short-run adjustment occurs because companies–many of them quite large corporations-have found that their wage costs are large and that they feel that they have overstaffed during the past few years. The overstaffing is partly related to large fringe benefits, especially for medical care, and partly to a sudden awakening to the state of technical progress. Many of the tasks that have been undertaken, in the past, by human workers can now be performed by machine.

Machines do not bargain for fringe benefits or annual wages in the same way that organized humans do. Also, the combination of humans with machines can produce so much more, that fewer humans are needed. In the past few years, since about 1990, millions of workers have been dropped from company rosters, including both shop-floor workers and white-collar employees in middle management.

Although our overall unemployment rate stands at the modest rate of about 5.5% now, we might well ask what has happened to those who have been dropped.

Issues of Distribution

In spite of the signs of good macroeconomic performance in the US, some of the underlying distributions are trending seriously towards inequality, which is undoubtedly related to many social ills in our country. It is especially the case that the distributions of income and wealth have been becoming more and more unequal for a number of years. More recently, real wage rates have been failing; poverty abounds amidst luxurious plenty; our physical infrastructure has deteriorated; large cities have significant homeless populations. While we are making macroeconomic progress; there are few good things to say about progress in social welfare aspects.

Some of these social welfare problems are directly related to the downsizing phenomenon. When the February labor market statistics were reported on March 1st, security markets reacted violently in a negative direction because an unusual number of jobs were reported have been created in one month. The front page of the New York, Times carried a story about the financial market’s disapproving reaction, side-by-side with a series of reports about unfortunate workers who had to rearrange family lives as a result of downsizing. These latter stories were remarkable journalistic accounts of misery, dashed hopes, severe personal readjustments, family dislocations, and other human set-backs. Why were Wall Street reactions so different from Main Street reaction?

Business likes to have stable wages, but recent profit reports have been unusually strong. These fuel the financial markets. Also, from a technical point of view, Wall Street investors perceived a future change in attitudes by the Federal Reserve Open Market Committee, leaning towards relatively restrictive credit conditions as long as the economy is expanding as strongly as suggested by the report on job increases no matter that these jobs were overwhelmingly in service-producing sectors at comparatively modest wage rates. This dichotomy of interests can go on for some time, but not endlessly if we want to have social harmony in a calm environment.

How are other countries managing their economies and, in particular, with respect to their labor market conditions? Latest tabulations from the Bureau of Labor Statistics show that Japan and the United States are decidedly low, in the rate of unemployment, and the German figures are moderate, but if eastern Germany is included the unified figure is as large as 10% and growing in a disturbing pattern.

In spite of the fact that the Japanese figure is low, it has grown considerably in the past few years, and may well get close to 4%. Historically in Japan, traditional enterprises worked side-by-side with large modern corporations. When conditions became slack during a recessionary phase of the business cycle, the burden of adjustment in the labor market was placed on the small firms, while the large firms re-shuffled job assignments and kept “lifetime” workers busy. This also contributed to some degree of inefficiency and elevated costs. Later, as the Japanese economy expanded in the global market place, the adjustment was shifted, partially, at least, to export activity. From the point of view of the Japanese Corporate Community and also, probably the entire national community, the companies acted as good citizens, but from the point of view of the international community it has been regarded as unfair.

Other countries have good safety nets for the unemployed workers. Some have felt that they were “too good” and are trying to scale back welfare assistance: The strength of trade unions and other political institutions work against restructuring by shifting workers into service producing sectors; nevertheless, some shifts have occurred, and Japanese companies are scaling back the lifetime commitments to workers. Downsizing has not occurred elsewhere to the same extent as in the USA, but it is beginning to happen.

The Theoretical Argument for market Flexibility

The theoretical argument, runs as follows: If an economy is organized along strict free-market lines, then everyone in households and private firms acting in their own self interest, will lead the economy to an optimal situation, i.e. a Pareto-optimum, which is defined as a state of all economic agents from which they cannot move without making at least some other agents worse off. It is a state that is so good that it offers no “win-win” changes. It is not a state of maximum utility, maximum consumption, maximum production, or maximum trade activity, although it is often incorrectly described as a state of maximizing real GDP for a country or real GWP for the world.

In order that a Pareto-optimal point exist, the following conditions must hold:

i. all economic agents have access to the same information
ii. all economic agents strive to optimize their own position, and convexity conditions for reaching optima exist
iii. no individual agent is large enough or powerful enough to influence the perfect market; i.e. the market rates (wage, price, interest, exchange) are taken as given by individual agents. This is called the parametric function of price.
iv. markets are cleared at prevailing prices (or wages, or interest rates, or exchange rates) v. there is no economic discrimination
vi. the state of technology and the distributions of income and wealth are given.

The first five conditions lead to determination of equilibrium relative prices. The absolute level of prices is determined by actions of the central monetary authorities in creating money for this system. When people argue for a level playing field, they are implicitly arguing for strict enforcement of (i)-(v). The field is not level in practice; so advocates of free market capitalism claim that the major industrial countries come as close as possible to realization of (i)-(v) in practice, and it does work, in an appropriate and empirical sense.

It is easy to see that this theoretical system rules out government intervention in the economy, except for control of the money supply, and that the main task of economic policy should be to see that the rules of the game to be played on a level field are, in fact, realized. The market is assumed to know best, and all players in Free market situations should accept market decisions. This could be interpreted to mean that if corporations choose to downsize as a result of business decisions made in a free market setting, we should accept the dictates of the market and should not intervene to offset market-based decisions.

There is still a problem with this theoretical analysis. It does not provide unique results. If the income/wealth distributions change, as they do over time, the market outcomes change, but the theory does not offer a suggestion for choosing one distribution over another. Downsizing is about distribution. Where we see enormous salaries being paid to corporate executives and real wage rates trending downward for a great bulk of workers, there is a distribution issue at state. It is not only a matter of distribution between executives and workers, but also among share holders and executives and workers. Of course, these groupings are not mutually exclusive.

Much of the downsizing is taking place as a result of technological change, but the achievement of Pareto-optimality under the completely free-market environment does not necessarily prevail when technology changes, and it always is doing just that.

What Can be Done?

At a minimum, corporations should facilitate the transfer of employees to new positions within the company, to training for positions in fields that offer good wages with benefits, assistance in geographical relocation, separation pay, and similar help, much of which is already being done voluntarily.

The rules of the free market economy argue against government enforcement of company help in dealing with downsizing.

Some employers see positive feedback to the company if there is compensation or assistance for displaced employees or for the local economy.

Apart from intervention with the companies involved, governments can take action directly for the benefit of discharged workers. They may pay unemployment insurance benefits; they may extend medical care coverage; they may provide more general welfare, such as aid for dependent children.

One general action can be to install portability into retirement, medical care coverage, and other benefits so that when a worker changes jobs, much of the benefits package becomes portable and can be taken to the new job. There is significant cost to provisions of portability, but it should be on the agenda for future political wrangling about what payments to enforce.


For more on this subject, see Downsizing and Stakeholder Capitalism by Dr. Meir Tamari


Dr. Lawrence Klein, a Nobel Prize Laureate, is Professor Emeritus at the University of Pennsylvania Wharton School of Business.