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Monopsony in Motion
Imperfect Competition in Labor Markets
By Alan Manning Princeton University Press
Alan Manning
All right reserved. ISBN: 0691113122
Chapter One
INTRODUCTION
What happens if an employer cuts the wage it pays its workers by one cent? Much of labor economics is built on the assumption that all existing workers immediately leave the firm as that is the implication of the assumption of perfect competition in the labor market. In such a situation an employer faces a market wage for each type of labor determined by forces beyond its control at which any number of these workers can be hired but any attempt to pay a lower wage will result in the complete inability to hire any of them at all. The labor supply curve facing the firm is infinitely elastic.
In contrast, this book is based on two assumptions about the labor market. They can be stated very simply:
The implications of these assumptions can also be stated simply. The existence of frictions means that there are generally rents to jobs: if an employer and worker are forcibly separated one or, more commonly, both of the parties would be made worse off. This gives employers some market power over their workers as a small wage cut will no longer induce them to leave the firm. The assumption that employers setwages then tells us that employers exercise this market power. But, with these two assumptions, it is monopsony, not perfect competition, that is the best simple model to describe the decision problem facing an individual employer. Not monopsony in the sense of there being a single buyer of labor, but monopsony in the sense of the supply of labor to an individual firm not being infinitely elastic. The actions of other employers (notably their choice of wages) in the market will affect the supply of labor to an individual firm so, if one wants to model the market as a whole, models of oligopsony or monopsonistic competition are what is needed.1 The usefulness of the monopsonistic approach rests on the two assumptions so they need some justification.
That important frictions exist in the labor market seems undeniable: people go to the pub to celebrate when they get a job rather than greeting the news with the shrug of the shoulders that we might expect if labor markets were frictionless. And people go to the pub to drown their sorrows when they lose their job rather than picking up another one straight away. The importance of frictions has been recognized since at least the work of Stigler (1961, 1962).
What are the sources of these frictions in labor markets? In the Economics of Imperfect Competition, Joan Robinson argued that:
there may be a certain number of workers in the immediate neighbourhood and to attract those from further afield it may be necessary to pay a wage equal to what they can earn near home plus their fares to and fro; or there may be workers attached to the firm by preference or custom and to attract others it may be necessary to pay a higher wage. Or ignorance may prevent workers from moving from one to another in response to differences in the wages offered by the different firms.
(Robinson 1933: 296)
It is ignorance, heterogeneous preferences, and mobility costs that are the most plausible sources of frictions in the labor market. The consequence of these frictions is that employers who cut wages do not immediately lose all their workers. They may find that their workers quit at a faster rate than before or that recruitment is more difficult, but the extreme predictions of the competitive model do not hold. The labor supply curve facing the firm is, as a result, not infinitely elastic. The existence of frictions gives employers potential market power over their workers. The assumption that firms set wages means that they actually exercise this power. Let us now consider this assumption in more detail.
Given the existence of rents caused by frictions one needs to specify how they are divided between employer and worker. The existence of the rents makes the relationship between workers and employer one of bilateral monopoly (in part) so that we need a theory of how the rents are divided. The development of such a theory is an old problem in economics in general, and labor economics in particular, going back to the discussion of Edgeworth (1932) who argued that the terms of exchange in bilateral monopoly were indeterminate. This indeterminacy has never been resolved.2
Given this problem at the heart of economics, which this book is going to make no attempt to solve, there seems little alternative but to grasp the nettle and make some assumption about the way in which the rents are divided. One should choose an assumption that is a reasonable approximation to reality. This is made difficult by the fact that there is no universally right assumption for how rents are shared in the labor market: there are different mechanisms in different labor markets, perhaps even co-existing in the same labor market. In spite of this, we focus on one mechanism for most of this book.
In this book, it is assumed that employers set wages.3 This is a more appropriate assumption in some labor markets than others. For example, it would not seem to be appropriate when workers are organized into a union (the consequences of this are discussed in chapter 12), or for senior management who often seem to have considerable ability to set their own wages, or for the self-employed, or (most importantly of course) for academic labor economists. But, for the average worker in a non-union setting, this does seem to be the appropriate assumption. Open the pages of a newspaper and one sees firms advertising jobs at given wages. One also sees advertisements saying "salary negotiable" though typically only for higher level jobs and the extent to which they are actually negotiable is often rather limited. But it is very rare to see advertisements placed by workers setting down the wage at which they are prepared to work.
This view that the relationship between the employer and worker is one-sided has a long tradition. In the Wealth of Nations, Adam Smith (1976: 84) wrote that "in the long run the workman may be as necessary to his master as his master is to him; but the necessity is not so immediate." And Alfred Marshall in his Principles of Economics (1920: 471) wrote that "labour is often sold under special disadvantages arising from the closely connected group of facts that labour power is 'perishable', that the sellers of it are commonly poor and have no reserve fund, and that they cannot easily withhold it from the market." To these arguments that a worker is typically more desperate for work than an employer is desperate for that particular worker, Sidney and Beatrice Webb (1897: 657-58) added the argument that
the manual worker is, from his position and training, far less skilled than the employer . . . in the art of bargaining itself. This art forms a large part of the daily life of the entrepreneur, whilst the foreman is specially selected for his skill in engaging and superintending workmen. The manual worker, on the contrary, has the smallest experience of, and practically no training in, what is essentially one of the arts of the capitalist employer. He never engages in any but one sort of bargaining, and that only on occasions which may be infrequent, and which in any case make up only a tiny fraction of his life.
The view that the relationship between employer and worker is not one of equals was the origin of pro-labor legislation in many if not all countries. Section 1 of the US National Labor Relations Act of 1935 says "the inequality of bargaining power between employees who do not possess freedom of association or actual liberty of contract, and employers who are organized in the corporate and other forms of ownership association substantially burdens and affects the flow of commerce." Our assumption that employers set wages is in this tradition.
The claim that labor markets are, in the absence of outside intervention, pervasively monopsonistic probably comes as something of a surprise to readers of labor economics textbooks. Table 1.1 documents the number of pages devoted to a discussion of monopsony and the total length in a selection of popular textbooks. As can be seen, monopsony does not figure prominently and, where it is mentioned, the discussion is generally not favorable: the final column of table 1.1 contains a selection of quotes, some of which capture the idea that frictions give employers some market power but most of which do not.4 There is a noticeable trend in the most recent textbooks towards less hostile views5 and a recognition that it is the existence of labor market frictions that is the main argument for the relevance of monopsony. But, while the overall perspective on the plausibility of monopsony may be changing, the range of labor market issues that contain some discussion of the implications of monopsony remains very limited. The first two volumes of the Handbook of Labor Economics (Ashenfelter and Layard, 1986) contain only two references to monopsony out of a total of 1268 pages, one in the chapter on dynamic labor demand by Nickell and the other in the chapter on discrimination by Cain. The three subsequent volumes published in 1999 (Ashenfelter and Card, 1999) contain three references in 2362 pages, in the chapters on labor market institutions, minimum wages and matching.
These statistics might be thought to be a little unfair as many of these textbooks interpret monopsony literally as being a situation of a single employer of labor rather than the interpretation of an upward-sloping supply curve of labor that is used here. But, mentions of oligopsony are even fewer than mentions of monopsony, and the general impression given by most textbooks is that employers have negligible market power over their workers or that this is, at best, a trivial side issue.
This situation contrasts strongly with the situation in another part of economics, industrial organization, where the standard assumption is that all firms have some product market power, although some are thought to have more market power than others. As a result, the bulk of the Handbook of Industrial Organization is about imperfect competition in product markets and virtually every chapter has some reference to monopoly or oligopoly. This contrast between labor economics and industrial organization is odd given that one might think frictions are more important in the labor market as it is more costly to change one's job than one's supermarket.6 The premise of this book is that labor economics should adopt a similar attitude to that in industrial organization and start analysis from the position that all employers have some labor market power.
This book discusses most if not all of the issues in labor economics from the starting point that the labor market is monopsonistic. Given the evidence cited above on the paucity of references to monopsony in textbooks, one might expect a radical reworking of labor economics. Such an expectation will, more often than not, lead to disappointment. Often, we will be able to draw heavily on existing work and simply look at issues from a different angle. Many explanations of labor market phenomena implicitly assume that the labor market is monopsonistic without articulating that fact. Perhaps the best example of this is search theory, an approach used to analyze a wide range of issues. The early developments, following Stigler (1962), were one-sided, treating the distribution of wage offers in the market as exogenous. Stigler (1962) provides a careful and interesting discussion of why the "law of one wage" is likely to fail in the labor market but does not consider the process of wage setting from the perspective of employers. But, when the process of wage determination was considered, the early models often seemed to collapse, and were incapable of explaining the existence of a non-degenerate wage distribution, a point made forcefully by Diamond (1971) and Rothschild (1973). All of the models then developed to explain the existence of equilibrium wage dispersion (e.g., Butters 1977) essentially assume that firms have some market power. It would be an exaggeration to say that all coherent models of frictions imply firms have some market power but it is close to the truth.7
1.1 The Advantages of a Monopsonistic Perspective
The main advantage of the monopsonistic approach is that the way one thinks about labor markets is more "natural" and less forced. Currently, labor economics consists of the competitive model with bits bolted onto it when necessary to explain away anomalies. The result is often not a pretty sight. A good example is the analysis of the returns to specific human capital. If one is a strict believer in perfectly competitive markets, one should believe that workers get no return from firm-specific human capital: as Becker (1993: 41-42) puts it "one might plausibly argue that the wage paid by firms would be independent of training." But, Becker goes on to argue that employers need to give workers some share to "deter quits," an idea formalized by Hashimoto (1981) which is the standard reference for this conclusion. But (and this is discussed in more detail in chapter 5), Hashimoto simply assumes that the supply of labor to the firm is not perfectly elastic, that is, he assumes the labor market is monopsonistic, a rather helpless fudge that has sown only confusion ever since.
Assuming labor markets are monopsonistic also brings the thinking of labor economists in line with the way in which agents perceive the workings of labor markets. Workers do not perceive labor markets as frictionless and changing, getting, or losing a job are routinely reported as major life events: for example, in the UK British Household Panel Survey (BHPS), job-related events are the most common category of self-reported important life events after births, deaths, and weddings. And, employers perceive they have discretion over the wages paid. Human resource management textbooks routinely state that the choice of the wage affects the ability of the employer to recruit and retain workers (see, e.g., Jackson and Schuler 2000, chapter 10) and the choice of a wage is a very real one.8
It is simple to give examples of how a monopsonistic perspective makes life more comfortable for labor economists. The existence of wage dispersion for identical workers can readily be explained as the natural outcome of a labor market in which the competitive forces are not so strong as to make it impossible for low-wage employers to remain in existence: no recourse is needed to "unobserved ability" to deny the existence of the phenomenon.
Continues...
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