Journal Issue

Workers Need Open Markets and Active Governments

International Monetary Fund. External Relations Dept.
Published Date:
January 1995
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NEARLY everywhere, countries are moving toward greater use of markets. This change can expand opportunities for workers, but only if they are equipped to make use of them. Governments retain a key role in a market-driven world, not least in the design of labor policy.

Few today question the superiority of an economic system based on markets, but does this leave workers at the mercy of cold market forces? Using markets does not mean abandoning government—effective government policy is central to ensuring both that countries make use of markets to achieve growth and that workers reap the benefits. Government policy matters for workers in many areas: achieving good growth; setting the framework for unions; determining workplace standards; and providing income security. But government policies reflect domestic political realities and the relationship between politics and labor outcomes may not always produce the best results.

Governments and workers are adjusting to a changing world. The legacy of the past can make change difficult. Yet realization of a new world of work, in which all groups of workers are included in a dynamic of rising incomes, better working conditions, and enhanced job security, is fundamentally a question of sound choices—in the international and the domestic realm. The right choices involve using markets to create opportunities, taking care of those who are vulnerable, and providing workers with the conditions to make their job choices freely, bargain over their working conditions, and take advantage of better educational opportunities for their children.

Good growth

Workers benefit from “good” jobs in the formal sector (Charts 1 and 2). Higher wages in fast-growing economies are the consequence of economy-wide expansion in output and rising labor productivity, which cause firms to compete for workers by offering them more income and better working conditions.

Chart 1.As the economy grows, so do wages1

Sources: World Bank data: United Nations Industrial Development Organization data.

1 Growth rates of GDP per capita and real wages in agriculture and manufacturing. The sample consists of 22 low- and middle-income countries over a period extending from the 1960s to the 1990s Actual years vary by country

Chart 2.Higher productivity enlarges formal employment1

Sources; International Labor Organization, various years; and Robert Summers and Alan Heston, “The Penn World Table (Mark 5): An Expanded Set of International Comparisons, 1950-1988,” Quarterly Journal at Economics. Vol. 106 (May 1991), pp. 327-68.

1 GDP per worker and share of the workforce in non-agricultural wage employment. The sample consists of 57 low- and middle-income countries. Each unlabeled point represents a single country in the last year for which data were available. GDP data are in 1935 international prices.

What role is there for governments in this process? To achieve the productivity changes that are needed to underwrite higher incomes, they have to take place in an environment that allows skills and capital to be effectively used. Government policy plays a critical role in creating such an environment. There are many examples of countries that did not grow despite high rates of investment in physical and human capital. In the 1970s, China, the former Soviet Union, and Tanzania regularly invested more than 20 percent of GDP annually, but did not experience anything near the impressive growth of the Republic of Korea and Malaysia. Growth not only depends upon how quickly inputs are accumulated, but also on their quality, the technology embodied in them, and how efficiently they are employed. Fast-growing economies did not simply invest more, but combined physical capital and educated workers in ways that increased output per head.

The impact of the quality of government policy on worker welfare is particularly evident in the area of human development. One of the tragedies of development is the rapid expansion of schooling in sub-Saharan Africa—at a substantial cost to households and governments—that brought, on average, almost no increase in labor productivity and wages. Investing in people pays off only in an environment of expanding opportunities. But, as the East Asian experience abundantly shows, in a favorable environment, investing in people can boost living standards by expanding opportunities, raising productivity, attracting capital investment, and increasing earning power. Investments in human development are often highly complementary. Adequate nutrition and health increase the ability of children to learn, and better-educated individuals tend to learn the nutritional and hygienic habits that are necessary for good health.

Higher spending on the social sectors is often needed, but here, also, quality matters a great deal. Expenditures on school construction need to be complemented by qualified teachers, effective curricula, and adequate learning materials. Similarly, having excellent doctors does not ensure adequate health services if nursing staff and the necessary equipment and drugs are not available. Improving the quality of social services requires changes in the way governments act as employers. Employment, pay, recruitment, and promotion policies need to be reformed, and spending on complementary inputs needs to be increased.

Labor markets and unions

Market-based growth is key for labor welfare, but it is not enough. Labor markets set wages and employment conditions that profoundly affect the quality of life for workers and their families—often in ways that may seem harsh or unfair. Hence, it is not surprising that governments are heavily involved in labor markets the world over.

Much of the labor policy that was implemented in the past has failed. In many developing countries, policies designed to reduce income insecurity, protect the vulnerable, and improve working conditions have all too often helped only the small minority of workers in the formal sector and have tended to choke off formal sector employment growth. Often, a new approach is needed that recognizes, but does not exacerbate, the intrinsic dualism of labor markets in low- and middle-income countries. For the formal sector, governments need to set the rules but not the outcomes, and to rely more on bargained solutions between firms and independent unions. For rural and informal sector workers, rules rarely function as intended. Governments need to make more use of direct action to improve the environment in which people work and to reduce insecurity. Sometimes a combination of legislation and direct action is needed to protect the vulnerable.

Uneven market power—the fact that individual workers are usually in a weak position relative to employers—is one of the most common reasons for labor market intervention. Traditional societies deal with the problem through informal arrangements. In such societies, employers have to respect certain norms of fairness or face social sanctions. But such arrangements break down as enterprise size increases and as communal links between workers and employers diminish. Modern societies resolve the problem of uneven market power by allowing workers to organize into unions. By balancing power between workers and managers, unions limit arbitrary employer behavior. By establishing grievance and arbitration procedures, unions promote stability in the work force, which, when combined with an overall improvement in industrial relations, enhances worker productivity. Some empirical support is provided by the work of Guy Standing, who shows that in Malaysia, unionized firms were more likely than non-unionized firms to adopt productivity-raising innovations.

Unions can also help increase wage equality and reduce discrimination, at least for their own members. The reduction in wage dispersion in unionized firms is well documented for industrial countries. There are indications that the same effect occurs in developing countries as well. A study by Joung-Woo Lee and Sang-Sup Nam found that Korean unions place a great value on wage equalization and that the degree of wage dispersion in the unionized sector was 5.2 percent lower than in the non-unionized sector. When union members are women or belong to ethnic minorities, unions may also fight discrimination. The work of Alexis Panagides and Harry Patrinos indicates that unions in Mexico helped reduce discrimination against women and indigenous people.

But unions can also have negative effects. They often act as monopolists, improving conditions for their members at others’ expense. Higher wages for union members either reduce business profits or are passed on to consumers in the form of higher prices. This leads unionized firms to hire fewer workers, increasing the supply of labor in the non-unionized sector and depressing wages there. The difference in compensation between otherwise similar workers that is attributed to union membership ranges between 10 and 31 percent in developing countries, between 5 and 10 percent in Europe, and is about 20 percent in North America (see table).

Monopolistic behavior by unions can have negative distributional implications. In most developing countries, only a small fraction of the working population belongs to unions (Chart 3), and it tends to be better off than nonunion workers. In such settings, unions determine pay differentials between the lucky few in the modern sector and the vast informal and rural population.

Chart 3.Trade union membership rarely includes a majority of workers1

Source: World Bank data.

1 Years vary by country from 1986 to 1995.

The union wage premium1
YearEstimated union premium

South Africa 2198510-24
United Kingdom1985-8710
United States1985-8720
Source: Table 12.2, World Development Report 1995, Oxford University Press, New York (June 1995).

Percent increase in union wages over wages of non-union workers.

Black unions only.

Source: Table 12.2, World Development Report 1995, Oxford University Press, New York (June 1995).

Percent increase in union wages over wages of non-union workers.

Black unions only.

Policymakers can create an environment that minimizes unions’ negative effects while maximizing their positive contributions to growth and equity by fostering competitive product markets and implementing labor market regulations that support the process of collective bargaining. Competitive product markets limit unions’ ability to achieve monopolistic increases in wages. Raising wages would force unionized establishments out of business unless the higher wages could be justified by increased productivity. In less competitive environments, unions will attempt to exploit their monopoly power and will ally themselves with employers and politicians who promise to perpetuate it. This behavior is evident in industrial countries, where union wage premiums are highest in regulated sectors and concentrated industries. In developing countries, this behavior manifests itself as union opposition to trade liberalization and privatization. Promoting domestic competition and opemness to international markets will help curtail these negative effects.

Ensuring that unions play a positive role is more difficult when they operate in noncompetitive markets, such as in the public sector and natural monopolies like electricity and telephone companies. The costs to society of an interruption of work by firefighters, police officers, teachers, nurses, utility workers, and public transport operators can be very high. The special features of labor negotiations in the public sector create a difficult dilemma. Governments must weigh the consequences of protecting public sector workers’ right to strike against the general public’s right to uninterrupted essential services.

Labor standards

Governments also intervene directly in the labor market to achieve certain social goals, such as protecting the vulnerable or ensuring adequate health and safety conditions. Some of the more common ways that government policy affects the labor market directly are through bans on child labor, protection for women and minorities, and minimum wages. These policies are currently the focus of debate in many countries.

Child labor. Nearly all countries have laws against child labor, but they are virtually impossible to enforce in very poor countries. Probably well over 100 million children below the age of 15 work at some point during the year. The vast majority are unpaid helpers on family farms. A minority of children work in urban areas—they are the most visible politically, evoking images of the “dark satanic mills” of the industrial revolution. High rates of child labor are clearly linked to poverty and underdevelopment and to the poor quality or availability of education. Legislation against child labor alone cannot offset those factors. It must be accompanied by measures to shift incentives away from child labor and toward education. Governments can do this by providing safety nets for the poor and broader opportunities for quality education, and by gradually expanding the institutional capacity to enforce legislation prohibiting child labor. Moreover, governments need to associate other groups with the fight against child labor. Success in reducing child labor has often been achieved through government cooperation with nongovernmental organizations (NGOs) and other civic organizations. NGOs often do important work by identifying and solving problems. For example, NGOs, working in concert with government, were instrumental in reducing child prostitution and the employment of children in dangerous deep-sea diving in two locations in the Philippines.

Discrimination. Women and ethnic minorities are also protected by special regulations in many countries. Standards to help female workers can be divided into two groups. The first type provides women with special protection, usually in the form of maternity benefits and limits on night work, because of their role in bearing and raising children. The second type seeks to end discrimination by establishing equal pay for work of equal value or by prohibiting the exclusion of workers from certain jobs based on their gender. The use of antidiscrimination standards is not limited to the protection of women workers—in many countries, they also cover ethnic and religious minorities.

Nearly all countries have legislation fixing maternity leave and other special benefits for women. Typically, such legislation effectively increases the cost of hiring women and may depress female wages or discourage firms from employing women. Such legislation sometimes has other unwelcome effects. For example, the International Labor Office’s committee of experts noted that many Austrian firms employ young women only on fixed-term contracts to avoid paying maternity benefits. Some garment manufacturers in Bangladesh hire young women only on a daily basis for the same reason. Only a minority of working women in low- and middle-income countries are affected by protective labor laws, as most working women are employed in the rural and informal sectors. This implies that the focus should be on policies that increase women’s access to good jobs—in other words, policies that directly tackle discrimination.

Countries as different as the United States and India are attempting to eradicate discrimination from their labor markets. The US Civil Rights Act of 1964 renders discrimination in the employment process illegal and covers all types of discrimination—on the basis of ethnic or religious background as well as gender. Enforcement depends upon lawsuits against discriminators, which can be quite difficult, given the high cost of litigation and the fact that women or minorities excluded from certain jobs are rarely in a position to make a complaint, or even to know that they have been discriminated against. Those difficulties have given rise to affirmative action plans, which focus on increasing the proportion of minorities and women employed in certain positions. But the usefulness of affirmative action is still being debated.

Minimum wages. Whether or not to set a minimum wage remains one of the most controversial labor market policy dilemmas governments face. Proponents believe that, appropriately applied, minimum-wage legislation can raise the income of the poor at little or no cost in overall employment. Opponents argue that minimum wages make things worse by raising production costs in the formal sector and reducing employment. More workers are then forced to seek jobs in the unregulated informal sector, pushing the wages of the working poor below their previous level.

Both sides are partly right. The impact of minimum wages depends on their effect on employment which, in turn, depends on market structure, the level at which the minimum wage is set, and government’s ability to enforce it. In a fully competitive labor market, a binding minimum wage will always reduce employment. But if employers have some market power, a small increase in the minimum wage could lead to higher employment. Of course, if the minimum wage is too high, employers with market power will choose to hire fewer workers. In low- and middle-income countries, raising the minimum wage often increases employers’ and workers’ incentive to avoid adhering to it—so there is little effect on employment.

Evidence exists to support both sides of the debate. On the one hand, high minimum wages for male workers in Mauritius’s export-processing zone prior to 1984 may have discouraged their employment. After noticing that demand for female workers in the zone exceeded supply—minimum wages were lower for women—while male unemployment was high, the government eliminated the male minimum wage in December 1984. As a result, male recruitment rose sharply, and more than 95 percent of workers recruited in January 1985 were paid less than the old minimum. On the other hand, recent evidence from the United States and the United Kingdom supports the view that small increases in the minimum wage do not hurt employment.

Minimum wages may help protect the poor in industrial countries, but they clearly do not in developing countries. Those who may be affected by minimum wages in developing countries are never the most needy. The real poor operate in rural and informal markets, unprotected by minimum wages or other labor regulations. The workers that minimum wage legislation tries to protect—urban formal workers—already earn much more than the less-favored majority. And to the extent that those regulations limit formal employment by increasing wage and nonwage costs, they hurt the poor who aspire to formal employment.

Political considerations

Governments’ labor policies are influenced by political attitudes as well as by economics. There are two sharply contrasting points of view about the link between efficient labor market policies and political systems. One view is that authoritarianism is needed in developing countries to offset trade union power. According to this view, in societies with a high level of civil liberties, unions inflate wages, encourage industrial unrest, and discourage investment and employment creation. Hence, this view would conclude that democracy, which implies free unions, is incompatible with labor market efficiency.

This view can be supported with examples from the episodes of authoritarian regimes in Chile, Korea, Singapore, and Turkey. During the authoritarian period—the 1970s and 1980s—these regimes repressed trade unions and denied basic rights to workers. Korea, Singapore, and Turkey experienced spectacular growth in the manufacturing sector and increasing demand for labor while the repression was occurring. Rising profitability and labor demand in manufacturing increased the welfare of workers as a whole. Although similar results were not immediately apparent in Chile, it is believed that the labor reforms undertaken during authoritarian rule laid the foundation for the strong resurgence of the economy in the 1990s.

An alternative view is that authoritarian regimes are more likely to have inefficient labor legislation that benefits “insiders.” Lacking the broader base of democratic governments, such regimes may use labor policies to gain the support of powerful groups such as the urban labor elite. Support for this view comes from the fact that labor market distortions persist in many nondemocratic countries. A number of countries, at different times, have provided examples of this phenomenon. Overstaffing in the public sector, high minimum wages, and restrictions on firing—for example, the policies introduced in the Congo, Kenya, Sudan, Tanzania, and Zambia in the 1960s—reflected the political realities of the time. Authoritarian postindependence governments needed to appease urban populations—at the expense of millions of poor informal-sector and rural workers—to avoid political unrest. In Egypt, in the 1950s and 1960s, the Government’s promise of a public sector job upon college graduation contented the middle class. In Bangladesh, during military rule in the 1980s, the Government obtained the support of the labor elite by increasing public sector wages and doubling severance pay, allowances, and nonwage benefits.

Proponents of the argument that repression is not needed point to Hong Kong, which has long had a democratic system and free trade unions yet maintained very flexible and competitive labor markets. Chile’s return to democracy has not led to significant changes in labor policies, and labor regulations there continue to avoid rewarding insiders. The end of repression in Korea in 1987 was initially associated with labor conflict. However, since 1990, collective bargaining has become an established institutional arrangement, with no negative impact on the functioning of the labor market and on wage competitiveness.

Recent empirical work indicates that arguments in favor of labor repression and authoritarianism are probably wrong. Studies by Gary Fields and by Richard Freeman conclude that Korea and Singapore would have achieved the same results without repressing labor. A study by Arup Banerji and Hafez Ghanem found that countries with fewer civil liberties also tend to have more distorted labor markets—the ratio of formal to informal wages is higher and the share of formal employment in total employment is lower—even after accounting for factors like per capita income, education, and urbanization.


Workers need markets to expand the opportunities available to them, both domestically and internationally. But they also need effective and active governments to set in place the policies that will deliver rapid, job-creating growth; to provide the framework in which wages and working conditions can be set; and to step in where markets fail to meet society’s needs, help the vulnerable, reduce insecurity, and deal with shocks.

For a full listing of references, see World Development Report 1995, Workers in an Integrating World, Oxford University Press, New York, June 1995.

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