There is a widespread belief, notably among lawyers and industrial relations specialists, that employment relationships are characterised by an imbalance of power between employers and employees.

This belief, which traces back at least to the early years of the industrial revolution, was reinforced and propagated by Karl Marx. who argued employers could and would use their stronger bargaining power to drive wages down to subsistence levels.

The alleged power imbalance is central to the view that labour markets require special regulation. The Employment Relations Act 2000 is based on the premise of an "inherent inequality of bargaining power in employment relationships."

Most contemporary labour market economists have a different view.

Elementary economic analysis suggests, as for other goods and services traded through markets, wages and other terms of employment are determined largely by supply and demand. There is no reason to suppose the employer side of the market has inherent power over the employee side.

Several empirical observations support this analysis:

* far from falling to subsistence levels (the logical consequence of inherent power imbalance) real wages have risen steadily over the past two centuries;

* aggregate labour income accounts for about 65-75% of gross domestic product and is not higher in the more heavily regulated labour markets. Indeed, the proportion seems to be relatively higher in some of the most lightly regulated labour markets, such as the US.

* if employers had inherent power to set wages above the value of labour's contribution to production, then rates of return on capital should be higher in labour-intensive industries than in capital-intensive industries, but this is not the case; and

* if employees were disadvantaged by their allegedly weak bargaining power, there are many other ways in which they could engage in productive activities (for example, self-employment, independent contracting, labour hire companies or workers' cooperatives). The fact that individual employment contracts have remained the dominant arrangement for over two centuries is compelling evidence they deliver greater net benefits for most workers.

At times there may be a sellers' or buyers' market for labour, due to supply and demand conditions, but this is so for other markets and does not reflect a imbalance of bargaining power. As for other markets, wage adjustments facilitate market clearance and the attainment of full employment.

Clear recognition of the nature of employment relationships and especially of the characteristics of the underlying employment contracts is crucial to understanding how labour markets function and the effects of labour market regulations.

Labour markets, like other markets, do not function as the textbook ideal of a spot market in which rapid price adjustments ensure prices for identical products are equalised throughout.

An employment contract is largely a relational contract ­ an informally agreed set of terms and conditions and codes of conduct that frame the transaction between employee and employer.

These terms cannot be specified precisely and therefore can neither be effectively verified nor enforced by a third party ­ unlike the formal terms of an employment contract (wage rate, holiday entitlements, etc), which are verifiable and enforceable. The relational terms of an employment contract must therefore be self-enforcing.

An understanding of the nature and role of relational contracting provides a framework for understanding why labour market regulations, either individually or in combination, often have the unintended consequence of reducing workers' welfare.

For example, employment protection laws can discourage people from starting new enterprises or from expanding existing enterprises because of increased costs.

More generally, there is convincing evidence that misguided labour market regulations have negative effects on employment (especially for youths and older workers), increase the incidence of long-term unemployment, impose unwanted but unavoidable financial risk on workers and reduce real incomes.

Employees derive power to constrain their employers' behaviour from their almost universal at-will termination right. Employment protection laws erode the power of employers to hold employees to contractual commitments, which in turn erodes the value of employment relationships and real wages.

Most societies have abandoned fault-based laws governing the termination of marriage, another important form of relational contract that cannot be sensibly enforced by a third party. For the same reason, laws aimed at controlling explicitly the behaviour of parties in employment relationships should be abandoned.

Geoff Hogbin is an Australian economic consultant and former academic at Monash University, Melbourne. His study, Power in Employment Relationships: Is there an imbalance? is published by the New Zealand Business Roundtable

This article was published published in the print edition of The National Business Review on Friday, 17 March 2006.