David R. Henderson  

The Minimum Wage and Monopsony

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There's been a fair amount of discussion on the web lately (here and here, for instance) about the minimum wage and monopsony. As is well known in economics, a skillfully set minimum wage, in the presence of monopsony in the labor market, can actually increase employment. I don't have a graphical proof handy but I expect that many labor economics texts have such a graphical proof.

Here's the proof in words. To say that a firm has monopsony power is to say that the supply curve of labor to the firm is upward-sloping. That is, the firm is not a price-taker in the labor market. So when the firm that employs n workers and pays Wn per worker wants to hire one additional worker, it needs to pay more to each worker than it paid when it hired n workers. Call this new wage Wn + x. But that means that the cost of hiring that n + 1st worker is not the wage, Wn + x, that the firm pays the worker: it's that wage, Wn + x, plus x times n. The reason: it pays all the other n workers that increment, x, also. Because the firm recognizes this, it hires up to the point where the value of marginal product = Wn + x + x*n. Now, if the government skillfully sets a minimum wage a little above Wn + x, the firm knows that it can't reduce the wage by hiring fewer people and also knows that it won't raise the wage by hiring a few more people and so it hires more people.

The main reason people started talking about monopsony in the context of the minimum wage in the 1990s was the study, and later the book, by David Card and Alan Krueger. They were trying to explain why they found their result, which was that an increase in the minimum wage in New Jersey, while the minimum wage in Pennsylvania held constant, did not decrease employment in fast food restaurants in New Jersey relative to in Pennsylvania. Various people, most notably David Neumark and William Wascher, criticized the Card/Krueger data and, using better data, found the more-standard result. I don't want to get into that here.

Instead, I want to note something about the monopsony explanation. Here's what I wrote in my review of their book:

What would have to be true for the minimum wage not to destroy jobs? As George Stigler (1946) pointed out in his seminal article on minimum wages, if the employer has monopsony power in the labor market, a skillfully set minimum wage can actually increase employment. Card and Krueger are aware of this exception, and they speculate in Chapter 11 that the market for unskilled labor is indeed monopsonistic. How could the market for unskilled labor be monopsonistic when so many employers are competing for unskilled labor? Card and Krueger have a few answers and, at the same time, no answers. They discuss (pp. 373-83) various models in which firms set different wage rates for the same quality of labor, but they don't ever say which model they think explains their results. In two models they analyze, some firms set high wages and workers respond with lower turnover, while other firms set lower wages and accept higher turnover. A minimum wage, then, could reduce turnover at the low-wage firms. Card and Krueger claim that lower turnover implies higher average employment. I don't think so. There's reason to believe that employment would, on average, be lower. Presumably, low-wage, high-turnover employers believed themselves to be maximizing profits. That is, the loss from the increment of turnover was less than the loss from paying higher wages to avoid that increment of turnover. Given that assumption, when the government steps in and imposes a minimum wage, the net cost of an employee is higher. By the law of demand, the employer will hire fewer employees.

Interestingly, Card's and Krueger's own data on price contradict one of the implications of monopsony. If monopsony is present, a minimum wage can increase employment. These added employees produce more output. For a given demand, therefore, a minimum wage should reduce the price of the output. But Card and Krueger find the opposite. They write: '[P]retax prices rose 4 percent faster as a result of the minimum-wage increase in New Jersey...' (p. 54). If their data on price are to be believed, they have presented evidence against the existence of monopsony. David R. Henderson, "Rush to Judgment," MANAGERIAL AND DECISION ECONOMICS, VOL. 17, 339-344 (1996)


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CATEGORIES: Labor Market



COMMENTS (23 to date)
Jim Rose writes:

The monopsony argument has always been a complex joint hypothesis of increased employment, increased output and lower prices. The reviews of the Card book in the Industrial Relations Review in about 1993 are all worth attention.

Manning in monopsony in motion (2005) accepts that above normal profits will attract entry.

If we start with no excess profits, Manning puts forward two opposing effects: an employment effect as the wage rises – the oligopsony effect - and an employer exit effect where firm failures reduce employment.

Peter Kuhn in a great review of monopsony in motion pointed out that the correct title was search fictions with wage posting and random matching in motion

Balanced job matching forces wages to the competitive level and there is no monopsony.

Under random job matching, all firms receive the same number of job applicants. Under balanced matching, firms receive job applications in proportion to their size.

Bill Woolsey writes:

I think the most serious problem with monoposony arguments is that wage descrimination is possible for firms that have that sort of market power.

With perfect wage discrimination, a minimum wage would increase the pay of many workers at monopsony firms, but the impact on employment would be the same as with perfect competition in the labor market.

Difficulties with price discrimination, like reselling, don't seem like a problem with employment and pay.

While we can imagine paying new workers more than existing workers, realisticially, workers become more productive due to experience and there are a variety of benefits to paying workers less to start and then giving them raises as they become more productive.

If an employer wants more workers, he might need to increase starting pay relative to what starting pay had been. But there is no need to raise all existing workers' pay (which is greater than starting pay) at all, much less in proportion.

It is called wage compression.

In my view, labor markets don't clear very well. Usually, there will be some labor markets with shortages. Firms only gradually respond with increases in starting pay. Some may be waiting to see if more employees show up, consider improving working conditions, consider shift to lower quality workers, and so on. An increase in the minimum wage in that particular market solves the "problem" for the employers of how to respond to the shortage. They pay more, quantity supplied rises, and so, employment rises.

There are other markets, however, already in surplus and some that are exactly clearing. Employment decreases in those markets when there is an increase in the minimum wage.

The net effect depends on which particular markets are impacted in which way.

And any classical monopsony markets have an entire range where the higher minimum wage increases employment. Don't forget that employment constrained by demand at a "too high" minimum wage might be greater than employment at the monoposony's market wage. The minimum doesn't have to be set at the competitive, employment maximizing level to increase employment relative to what the monosponist would provide.

If markets mostly clear most of the time, a higher minimum wage would usually decrease employment on net. (Leaving aside any monopsony markets) But is it any surprise that one could find some industries in some areas at some times where a higher minimum wage has little effect on employment or even increases it?

Well, I suppose it would be surprise if you ASSUME perfect market clearing.

In my view, during an economic expansion, labor demand grows briskly, and there is a "seller's market" in labor. (Not a smoothly increasing equilibrium wage so that markets always clear.) Increasing the minimum wage would move towards the market clearing wage in many markets, though without the increase, the same improvements in over all worker conditions would happen more gradually.

On the other hand, raising the minimum wage when the econony is going into recession will likely exacerbate the decrease in employment. And in a weak recovery, when there is already a "buyers" market in labor, raising the minimum wage will likely slow the increases in employment, and might reverse them for a time.

If we assume that all workers are the same and all jobs are the same, then getting wages to the market clearing point is all the counts. If instead, there is entrepreneurship in the labor market, and so the best response to shortages of labor is not obviously higher pay, then mandating that higher pay clear the market is not obviously the best solution.

I think having a sellers market in labor is a good thing. It is good for employers to always be thinking about how hard it is to find a good employee and that replacing the current ones will be difficult.

I also think having employers thinking of ways to fill jobs with less productive workers as an alternative to paying more is good.

Daublin writes:

@Bill Woolsey: outstanding. That is the most cogent summary of price theory applied to the labor market I have ever seen.

Ken B writes:

DRH:

To say that a firm has monopsony power is to say that the supply curve of labor to the firm is upward-sloping.

This puzzles me a bit. I think I can convince myself it will be true in equilibrium, because otherwise the monopsonist would have kept buying. Is this correct?

DRH:

But that means that the cost of hiring that n + 1st worker is not the wage, Wn + x, that the firm pays the worker: it's that wage, Wn + x, plus x times n.

Again I wonder. This assumes that the firm has to pay more to the ealier empolyees, and that doesn't seem like it has to be true. I can see it would be true of a large block of low skilled labor. (This clearly applies to the case Bob Murphy analyzes. I'm just working through the logic looking for implicit assumptions.) It's not clear to me that if the NPGS hires a new economist at a high wage that they have to pay David more even if it were the only school in town. David might for instance have a contract.

David R. Henderson writes:

@Ken B,
This puzzles me a bit. I think I can convince myself it will be true in equilibrium, because otherwise the monopsonist would have kept buying. Is this correct?
I don't know because I don't understand your statement. Can you reword?
This assumes that the firm has to pay more to the earlier empolyees, and that doesn't seem like it has to be true.
You're right. See Bill Woolsey's excellent comment above.

Ken B writes:

@DRH:
I am a monoposonist in something, say empty candy wrappers. Your claim is that I face an upward sloping supply curve for candy wrappers. I don't see why that must be true UNLESS I have been at it for a while, and have purchased all I can get until the curve starts bending upwards. For the first few months I was in clover, I could get all the wrappers I wanted, and cheap. Eventually I have nearly all of them, and face only those sleers who really value their wrappers. An equilibrium is reached because the curve is upward sloping. So I can see this being true in equilibrium, but I don't see why being the only buyer means ipso facto I face an upward sloping curve. I bet that if I do start buying used wrappers I will initially face a downward sloping curve as news spreads of my folly.

Am I right or am I missing something?

David R. Henderson writes:

@Ken B,
If the supply curve is upward sloping, the purchaser has some monopsony power. You can challenge whether the supply curve is upward sloping, but you can't challenge whether an upward slope leads to monopsony power.

Ken B writes:

@DRH: OK, I see the disconnect. I thought you were talking about monopsony being ineluctably connected to an upward slope. To me that makes little sense because it ignores what the item purchased is, and what sellers want, but I can see why it would hold in equilibrium. But you actually mean that for the monopsonist to have *power* from the monopsony the curve must be upward.

Is that correct?

David R. Henderson writes:

@Ken B,
I thought you were talking about monopsony being ineluctably connected to an upward slope.
I am.

Glen writes:

"Presumably, low-wage, high-turnover employers believed themselves to be maximizing profits. That is, the loss from the increment of turnover was less than the loss from paying higher wages to avoid that increment of turnover. Given that assumption, when the government steps in and imposes a minimum wage, the net cost of an employee is higher. By the law of demand, the employer will hire fewer employees."

I'm not following your logic here. The monopsony logic that you explained correctly in the previous paragraph shows that minimum wage (if set just right) will raise the average cost per employee but *lower* the marginal cost per employee. This is so because the minimum wages causes the x*n component of the (n+1)th worker's cost to be imposed anyway, even if the (n+1)th worker isn't hired. So showing that average cost per worker will rise isn't sufficient to show -- via the law of demand -- that the employer will hire fewer workers. Am I misunderstanding your argument?

David R. Henderson writes:

@Glen,
Am I misunderstanding your argument?
There are two arguments. The one of mine that you quote in your first graf is challenging their thinking on turnover, not on monopsony. The one that you quote in your second graf is about monopsony.

Brian writes:

I don't understand the connection between monopsony and the need to increase everyone's pay when hiring a new worker. Does this follow logically from the monopsony itself, or is it just an assumption of the model? Bill Woolsey mentions raising only the starting pay while keeping it below the pay of experienced workers, but even that seems like an unnecessary restriction. Why not just pay new workers more (i.e. let the starting pay exceed the pay of experienced workers)? Doesn't the logic of a minimum wage increasing employment in a monospony rest entirely on the idea of having to increase everyone's wage?

David R. Henderson writes:

@Brian,
Doesn't the logic of a minimum wage increasing employment in a monospony rest entirely on the idea of having to increase everyone's wage?
Yes. That's why Bill Woolsey's statement above is so important:
With perfect wage discrimination, a minimum wage would increase the pay of many workers at monopsony firms, but the impact on employment would be the same as with perfect competition in the labor market.

MingoV writes:

My experience with low wage, high turnover positions is that employment falls due to the time required to advertise the position, review applications, interview applicants, offer the position to the best applicant, offer the position to the second best applicant if the first declines, etc. During that time the business is one employee short. This happens again when another employee leaves.

I oversaw a section that needed twelve (low wage) employees, and we typically had only ten. It would have taken a big pay raise (that wasn't possible in a VA hospital) to reduce turnover.


@Brian: Scenario: A business has newbies at minimum wage ($7.75 per hour), not-so-newbies at $8.75, and old-hands at $10. Minimum wage rises to $9.00. The not-so-newbies will be miffed if their pay only rises to $9.00 because it's the same as the newbies. The not-so-newbies would expect to be paid $10.00 to maintain their $1 per hour differential. But, the old-hands are now being paid the same as the not-so-newbies. The old hands expect $11.25 to maintain the previous differential.

Glen writes:

"There are two arguments. The one of mine that you quote in your first graf is challenging their thinking on turnover, not on monopsony. The one that you quote in your second graf is about monopsony."

In Card & Krueger's model, the turnover and monopsony issues are connected. They use the high rate of turnover to explain why the firm faces an upward-sloping labor supply curve. The firm has to set a wage such that the number of new-hires equals the number of quits, thereby giving them a steady-state number of workers. The steady-state workforce is an upward-sloping function of the wage, and that function is effectively the labor supply curve.

Thus, C&K conclude: "The implicit constraint posed by having to equate monthly hiring and quit rates plays a role that is just like the supply function in the traditional, static monopsony model.... In a dynamic model, the question of whether the firm has any monopsony power is equivalent to the question of whether either the elasticity of the hiring function or the elasticity of the quit function is infinite." Mathematically, they show that the elasticity of the supply curve is equal to the difference between the elasticities of the hiring function and the quit function.

Do you disagree with their analysis on this point?

Brian writes:

David,

Thanks for that confirmation. But what I really want to know is what monopsony itself has to do with any of this. Wouldn't the same effect of the minimum wage hold in the case of multiple competitive employers who, for some reason, have to raise the wages of all when they make a new hire at an increased wage? If monopsony doesn't logically require this condition, then isn't monopsony irrelevant to the argument? And if it DOES require the condition, why?

Brian writes:

MingoV,

I agree that employees would be miffed. Whether the employer CARES that they're miffed would depend on how inclined the employees are to leave or to reduce their productivity over the issue. That would vary from job to job. I know of at least one example where the company routinely gives new hires a larger hourly wage than the established employees.

Putting that aside, however, your scenario doesn't quite touch my point. I wasn't asking about what would happen with a minimum wage increase, but why a uniform wage increase is required by a monopsony. I would expect just the opposite--a monopsonistic employer, as the only one in that category, would be free to offer current employees whatever wage he wants. Where would they go?

Ken B writes:

Ok, one more try! This is just the cartel argument for monopoly. If all employers banded together they would collectively face an upward supply curve, since they are facing the total supply, which by diminishing returns must slope up, and if they could cartelize could hire fewer at a lower wage but greater profit. With competition they could not make the cartel stick. With monopsony "they" can.

Monopolists produce less than the efficient amount, and monopsonists "produce" less hours of labor demanded. Hence the power.

As for why the curve is up, the key point is that the total supply must curve up, but in a competitive market no employer faces the total supply, so he faces a flat curve (first approximation). A monopsonists does face the total supply.

Correct?

David R. Henderson writes:

@Glen,
Do you disagree with their analysis on this point?
No.
@Brian,
Wouldn't the same effect of the minimum wage hold in the case of multiple competitive employers who, for some reason, have to raise the wages of all when they make a new hire at an increased wage?
Yes, but to say that is to say that each of the competing employers has some monopsony power.

David R. Henderson writes:

@Ken B,
Correct.

Ken B writes:

@DRH: I guess the old saying is true, third time's the charm!

Mark V Anderson writes:

It seems to me that all this discussion relates to the short term demand for labor. Over the course of a few years, I think the direction of labor demand in the face of a minimum wage has to be downward. Over that time period, workers have the chance to change professions and industries adjust to get around those companies with excess market power. Over this longer period the quirks of monopsony and such have little effect.

Also, minimum wages actually lower the workers' market power. Bill Woolsey alluded to this. When minimum wages and other labor laws make it more expensive for firms to hire workers than it would be in a free market, then the labor market will not clear, leaving some willing workers with no position. This makes it much easier for employers to mis-treat their workers and makes the employment situation more stressful for workers. The ideal state would be if workers always had positions available with a small amount of effort to find the employers. I think this would be the normal state of our economy if labor laws disappeared. Labor laws make the workers' life much more difficult.

Jim Rose writes:

Ken B, monopsony depends on whether it is balanced matching or random matching.

Manning’s general-equilibrium monopsony model assumes random matching: regardless of size, every firm— from local bakery to Microsoft—receives the same absolute number of job applications per period.

the only way for a firm to expand in size is to offer a higher wage to ensure a larger share of its fixed flow of job applicants accept the firm’s wage offer!!

An alternative to balanced matching: a firm’s contact arrival rate (at a given wage) is proportional to its level of employment.

if matching is balanced (i.e. constant returns to scale in recruiting new workers), all elements of monopsony disappear from the model and the neoclassical equilibrium again prevails.

it is absolutely critical to the search-based monopsony model at the core of this book that there be diminishing returns to scale in the technology for recruiting new workers

HT: http://www.econ.ucsb.edu/~pjkuhn/Research%20Papers/Manning.pdf

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