Yellow Envelope Law: Market Economy Concerns & Analysis

Three months have passed since the yellow envelope law was promulgated. As half of the six-month grace period until the law goes into effect has passed, the outlines of enforcement methods, including the announcement of enforcement ordinances, are gradually becoming apparent. However, there is still great uncertainty about how this law will work in practice and what impact its results will have on the labor market and business activities.

No matter how irrational the law is, market participants rationally adapt to the law. As some fear, there will not be an extreme outcome such as hundreds of subcontractors requesting negotiations. As with all negotiations, conflicting and wasteful situations will develop at times, but on the other hand, there is a clear possibility of creating a virtuous cycle of improved productivity and wage increases through consultation between workers at the main contractor and subcontractors.

Wages determined by productivity and job characteristics

But the problem is that it is not clear what kind of situation will emerge. The cost of uncertainty is greater than you think. Even if there is a possibility that a dispute may arise in just one out of 100 suppliers, a company may try to reorganize the entire supply chain structure. Recently, the number of applicants for the Certified Public Labor Attorney exam has increased significantly, and law firms are said to be preparing for the opening of the yellow envelope law market. This cross-section shows the anxiety in the field ahead of the enforcement of the law. An uncertain law with an unknown outcome can sometimes bring worse results than a bad law. This is the first reason why the author views the yellow envelope law as anti-market.

The critical awareness that became the driving force behind the Yellow Envelope Act lies in the differences in working conditions between contractors and subcontractors, especially the wage gap. The logic is that subcontractors are at a disadvantage in negotiating contract prices with the main contractor, and as a result, the subcontractor’s decision-making power and ability to pay wages are limited, so workers’ wages are set low. Since the subcontractor’s workers make a significant contribution to the main contractor’s performance, some argue that it is unfair for the performance to be distributed only to the main contractor’s workers.

However, the above argument makes the mistake of not considering the product market in which primary contractors and subcontractors transact, and the labor market in which subcontractors hire workers. The fact that subcontracting companies are at a disadvantage compared to the main contracting companies in negotiations and the fact that the wages of workers in subcontracting companies are low are not logically deductive.

Fundamentally, wages are determined in the labor market, not in inter-company transactions. A company cannot pay its workers lower wages than the market wage just because a subcontractor signed a contract at a low contract price. In the labor market, wages are determined by factors such as worker productivity and job characteristics. If the wages of workers at subcontracted companies are low, it is because the market valuation of the labor in question is different from that of workers at main contracted companies.

Of course, the wage gap between primary and subcontractors cannot be explained solely by differences in the market value of labor. Even if two workers with the same productivity do the same job, their wages may differ depending on which company they work for. The wages of the primary contractor may be higher than the market wage, resulting in a wage gap between the primary and subcontractors. This is a case where a company with a monopoly in the product market enjoys monopoly profits, while a portion of those profits are transferred to workers through a strong labor union. When this type of union premium exists, workers at a subcontracting company can receive higher wages than workers at a subcontracting company without a monopoly and without a union, even under the same labor market conditions.

There is also a study that revealed the wage premium for workers at contract companies. This study, which looked at the process of outsourcing in the security, cleaning, and logistics sectors that has progressed rapidly in Germany since the mid-1980s, found that wage increase rates tended to decline after the same workers changed their affiliation from a main contractor to a subcontractor (‘The emergence of in-house subcontracting and changes in wage structure: the case of Germany’, 2017). This study followed and observed the same group of workers from the time they worked at the main contractor until after they were separated into subcontractors and converted to belong to the subcontractor company. Therefore, it can be said that the decline in their wage growth rate shows that they were enjoying profit sharing and union premiums when they were directly employed by the main agency.

Yellow envelope law blocks price competition

In this context, let us consider a case where subcontracted workers negotiate directly with the main contractor through the Yellow Envelope Act. As a result of negotiation, the wages of subcontracted workers can also be higher than the market wage, just like the wages of main contract workers. The main contractor will reflect the cost in the contract price and pay it to the subcontractor.

However, the market does not just leave wages artificially deviated from the market wage. Other subcontractors can participate in the bidding by offering a lower contract price, using market wages as the standard for labor costs. This is natural competition in a market economy.

The yellow envelope law cannot and should not fundamentally prevent such competition. It is not fair to exclude companies that want to deliver at lower costs and the workers who work for those companies from the transaction. If an anti-market alliance is formed between the main contractor and some subcontractors and external competitive companies are blocked from entering, the principle of competition, the driving force of the market economy, will be seriously damaged. This is the second reason why I think the yellow envelope law is anti-market.

In fact, being incorporated into a large company’s supply chain is a very important opportunity for growth and leap forward for small and medium-sized businesses. Companies that begin supplying to large corporations not only see increased sales, but also improve their reputation and have the opportunity to learn about the management practices of large corporations. According to a study by Alonso Alfaro-Urena, Isabela Manelici, and Jose P. Vasquez (‘Effects of Incorporation of Multinational Supply Chains’, 2022), not only do domestic companies’ sales significantly increase after they begin supplying to multinational companies (33% increase in the 5th year of delivery in graph (a)); We found that sales from companies other than the main contractor, the multinational company, also decreased due to a shortage of supplies when supplies began to the multinational company, but increased significantly thereafter (20% increase in graph (b)). This suggests that by supplying to excellent companies, we have been able to secure new and better customers. As sales increased, employment also increased by 26% (graph (c)), and productivity also improved by 9% (graph (d)).

The benefits of specialization and division of labor may disappear

Outsourcing or outsourcing, which creates a primary-subcontractor relationship, is a strategy of companies that want to enjoy the benefits of specialization and division of labor. Therefore, through outsourcing, companies can efficiently reorganize production and expand supply. As seen in the previous study, the benefits of specialization and division of labor are distributed not only to the main contractor but also to the subcontractors through market principles rather than negotiation. As the overall market grows, the demand for labor increases, which can lead to more jobs and higher wages for workers.

The Yellow Envelope Act is a law that considers the relationship between a primary contractor and subcontractors as a labor-management relationship. However, this relationship is formed indirectly through contracts between companies. These legal and logical inconsistencies can lead to problems that are difficult to predict. If the Yellow Envelope Act is interpreted in a way that overwhelms the order of transactions between companies, there is a risk that the operating principles of the market economy will be damaged and inefficiencies will accumulate.

Recently, a large company announced plans to strengthen quality evaluation of its partners and, if necessary, replace them with competitive external partners. This is a normal management activity to maintain corporate competitiveness. However, in a situation where companies are required to take responsibility for wages and working conditions from their partners’ workers after the Yellow Envelope Act, it is questionable whether companies will be able to properly manage their partners to improve competitiveness.

Concerns about rising outsourcing costs hindering corporate competitiveness

Outsourcing is now the norm, not the exception. Increasing technological complexity and expansion of global supply chains have made outsourcing inevitable. It has become not only inefficient but also impossible to complete the start and end of production within the boundaries of one company. If the yellow envelope law excessively increases the cost and uncertainty of using outsourcing, this may ultimately reduce corporate competitiveness.

Some say that the law has been passed anyway and that we just need to coordinate on the spot. Others say they believe that if a problem arises, the court will make a reasonable decision. It is a complacent idea that does not know the cost of market disruption and uncertainty. It is said that it is the fastest when you think it is too late. Now is the time for a cool-headed inspection of the yellow envelope law.

〈References〉

1) Deborah Goldschmidt & Johannes F. Schmieder, The Rise of Domestic Outsourcing and the Evolution of the German Wage Structure ‘The emergence of in-house subcontracting and changes in wage structure: the case of Germany’, Quarterly Journal of Economics, 2017

2) Alonso Alfaro-Urena, Isabela Manelici, Jose P. Vasquez, The Effects of Joining Multinational Supply Chains, Quarterly Journal of Economics, 2022

Lee Jeong-min, professor of economics at Seoul National University