Rhineland exit: Workers should not bear firm-specific risks

Coen Teulings, Lans Bovenberg 11 September 2008



Harry Truman is supposed to have asked for a single-handed economist. Whenever he asked for an economist’s advice, the answer invariably would be: "on the one hand..., but on the other hand…” This is indeed how economists often reason. They think in terms of trade-offs, and the optimal policy response is almost always a combination of various sides of the trade-offs. Extremes usually do not work that well and compromises do better.

One should thus expect a similar response on issues of corporate governance. Should the management of a company take account of the interests of all of its stakeholders (that is, its workers, customers, suppliers and shareholders), as in the Rhineland model? Or should the management further only the interest of the shareholders, as in the Anglo-Saxon model? The Rhineland model aims to give all stakeholders their fair share of the firm’s surplus, and therefore seems to be preferred in view of the economists’ tradition of compromises between extremes. We argue, however, against a fair compromise between labour and capital and advocate the radical solution of putting the long-run interests of shareholders first in corporate governance.

Shareholders rather than workers should bear firm-specific risks

The main reason for making shareholders the ultimate owners of the firm is that this allows for diversification of firm-specific risks. Firm-specific risk can be well diversified on the capital market. By holding equity of a large number of different firms whose risks are imperfectly correlated, shareholders can ensure that the bad luck of one firm cancels out the good luck of another. Since capital markets provide a much better device for diversifying firm-specific risks than labour markets do, this risk should not be assigned to risk-averse workers.

By bearing firm-specific risks, shareholders are the residual claimants on the surplus of the firm; the ultimate goal of the firm is thus to maximise shareholder value. The other stakeholders collect only their outside option and are thus not exposed to firm-specific risks. Diversification of firm-specific risk on capital markets by shareholders is an efficient form of social insurance. This mitigates the risk of job loss due to globalisation. Whereas international competition on product markets has increased this risk, globalisation of capital markets has expanded the scope for diversification.

Workers face a commitment problem

At first sight, relinquishing a claim on the profits of the firm may seem to contradict the interest of workers because in this way workers give up part of their remuneration. Although this may indeed be so ex post (after a worker has been employed by the firm), it is not true ex ante (before being hired). Firms invest in new jobs to maximise profits. The expected returns on the investment in the marginal job must be sufficient to offset the costs of the investment. If workers are expected to capture part of the future profits in case demand evolves favourably, then the firm’s expected return on investments in new jobs is lower – the firm will create fewer jobs. Hence, the demand for labour will be lower, as will starting wages. For workers as a group, the adverse effect of less job creation on wages more than outweighs the positive effect of capturing part of the firm’s profits.

The desired outcome, in which incumbent workers give up their claim on profits, is not easy to realise in an economy with decentralized bargaining. The reason is that workers face a serious commitment problem. When being hired, workers are likely to be willing to accept an agreement that combines a high starting wage with the promise not to share in the firm’s future profits in good states. But after the firm has sunk its investments, workers are likely to see no point in giving the firm excess profits. This time-inconsistent behaviour gives rise to a so-called hold-up problem. Workers cannot credibly commit ex ante to not capture part of the excess profits ex post, so employers forego investments in new jobs. As a direct consequence, workers end up bearing too much firm-specific risk; they make up for a low starting wage only if they are lucky enough to work for a firm that performs well.

Collective action may address the commitment problem…

Addressing this commitment problem requires some form of collective action in order to encourage incumbent workers to account for the impact of their wage claims on the labour-market prospects of marginal workers. In particular, collective wage bargaining may reduce the impact of firm-specific risk on wages. Collective wage contracts do not specify the wage rate for each individual worker, but they do provide a norm for wage negotiations at the individual level. To the extent that this norm is common to all firms, it restricts the impact of firm-specific factors. In this way, coordination and some shared norms regarding what constitutes proper compensation help address the commitment problem faced by workers as a group.

…but may also worsen it

Unfortunately, collective action is a mixed blessing. The reason is the limited capacity of politicians to commit when pursuing collective action. Resolving the commitment problem requires a long time horizon but politicians often exhibit only a short time horizon. They are therefore tempted to support the claims of incumbent workers on the excess profits of the firm while ignoring the costs of these claims in terms of reduced future employment prospects and lower wages for marginal workers.

In this connection, politicians may find employment protection legislation (EPL) an attractive instrument to transfer resources from shareholders, who usually have limited voting power, to workers, who are the backbone of the electorate. By strengthening the position of incumbent workers, however, EPL worsens the hold-up problem. It therefore weakens the labour-market position of those who are not lucky enough to work for a well-performing firm. The net effect is that workers face more risk as their income depends more upon the performance of the specific firm for which they happen to work. The paradox of EPL is thus that it creates exactly the feeling of job insecurity that it is meant to cure.

Denmark’s example

Subtle institutional differences between countries may explain whether collective action alleviates or exacerbates the commitment problems faced by workers. Denmark, for example, seems to have been able to sail between Scylla and Charibdis. Collective norms affecting wage bargaining there constrain the claims of workers on profits. At the same time, politicians have resisted the temptation to strengthen the position of insiders through EPL. As a result, workers change jobs easily, their wages do not strongly depend on the tenure in their current job, and workers who lose their job find another job with about the same wage rather easily.

Transitional problems

Although giving up the moral claim on the surplus of the firm may be in the long-run interests of workers, it may give rise to difficult transitional issues. While society reaps efficiency gains, in the short run a generation of insiders has to give up their rights without benefiting from increased job creation and higher starting wages. These insiders already have a job and have paid their dues in the past in terms of a low starting wage. The claims of older workers on the surplus of a firm may thus have some moral legitimacy. These transitional problems require extreme political skill to solve. Among other things, they may require some grandfathering provisions or explicit transfers from younger to older generations (e.g. by giving elderly workers fiscal privileges).


In any case, political rhetoric and ideology should no longer give legitimacy to new claims of workers on the surplus of the firm. These claims should gradually be phased out. The flattening of seniority wage profiles is a cultural change involving collective norms and political rhetoric. Reducing the claims of workers on the surplus of the firm can be seen as the next step in the emancipation of workers. Workers derive their security not from the firm that employs them but from the value of their own human capital. In this way, free international trade in corporate control, free international competition, and the associated creative destruction become more legitimate.


Bovenberg, Lans and Coen Teulings (2008), “Rhineland Exit?” CEPR Discussion Paper 6645.



Topics:  Labour markets

Tags:  Shared capitalism, Anglo-Saxon model

Professor of Economics, University of Cambridge; and CEPR Research Fellow

Professor of Economics and Scientific Director Netspar, Tilburg University and CEPR Research Fellow