Internal Rent Seeking, Works Councils, and Optimal Establishment Size

Using a microeconomic model and data from the Establishment Panel of the German Institute for Employment Research, we analyze the optimal establishment size against the background of rent-seeking workers and the influence of works councils. The theoretical part shows that establishment size has a discouragement effect on the level of individual rent seeking but also a quantity effect as the number of rent seekers increases.  The interplay of both effects – together with  technological considerations – determines whether the employer chooses an inefficiently small or large establishment size. Introduction  of a works council restores efficient  establishment size although it is purely used as rent-seeking  device. Whether the employer benefits from a works council or not, depends on the  degree of contract incompleteness and the degree of worker coordination via a works council. The empirical part indicates dominance of the discouragement effect over the quantity effect in establishments without works council. As theoretically predicted, works councils are beneficial by disentangling rent-seeking and production issues,  thus eliminating the influence of the two  rent-seeking effects.