What you’ll learn to do: explain how wages are determined when employers or employees hold labor market power

In the labor market, employers often hold most of the power in determining wages. This could especially happen if the firm has little or no competition in hiring employees, so workers have little alternative to accepting the wages that are offered. This is call a monopsony, and results in a lower level of employment and a lower equilibrium wage than what would be preferred by the competitive labor market.

Sometimes, however, the employees hold more of the power in determining wages. This is the case with labor unions, who negotiate wages through collective bargaining.

In the modules on market structure (i.e. perfectly competition, monopoly, oligopoly, and monopolistic competition), we observed that while economists use the theory of perfect competition as an ideal case of market structure, there are very few examples of perfectly competitive output markets in the real world. What about labor markets? How many labor markets are perfectly competitive? There are probably more examples of perfectly competitive labor markets than perfectly competitive product markets, but that doesn’t mean that all labor markets are competitive.

When a job applicant is bargaining with an employer for a position, the applicant is often at a disadvantage—needing the job more than the employer needs that particular applicant. John Bates Clark (1847–1938), often named as the first great American economist, wrote in 1907: “In the making of the wages contract the individual laborer is always at a disadvantage. He has something which he is obliged to sell and which his employer is not obliged to take, since he [that is, the employer] can reject single men with impunity.”

To give workers more power, the U.S. government has passed, in response to years of labor protests, a number of laws to create a more equal balance of power between workers and employers. These laws include some of the following:

• Setting minimum hourly wages
• Setting maximum hours of work (at least before employers pay overtime rates)
• Prohibiting child labor
• Regulating health and safety conditions in the workplace
• Preventing discrimination on the basis of race, ethnicity, gender, sexual orientation, and age
• Requiring employers to provide family leave
• Requiring employers to give advance notice of layoffs
• Covering workers with unemployment insurance
• Setting a limit on the number of immigrant workers from other countries

Table 1 lists some prominent U.S. workplace protection laws. Many of the laws listed in the table were only the start of labor market regulations in these areas and have been followed, over time, by other related laws, regulations, and court rulings.

There are two sources of imperfect competition in labor markets. These are demand side sources, that is, labor market power by employers, and supply side sources: labor market power by employees. Let’s begin by discussing demand side sources.

Labor Market Power by Employers

A competitive labor market is one where there are many potential employers for a given type of worker, say a secretary or an accountant. Suppose there is only one employer in a labor market. Because that employer has no direct competition in hiring, if they offer lower wages than would exist in a competitive market, employees will have few options. If they want a job, they must accept the offered wage rate. Since the employer is exploiting its market power, we call the firm a monopsony. The classical example of monopsony is the sole coal company in a West Virginia town. If coal miners want to work, they must accept what the coal company is paying. This is not the only example of monopsony. Think about surgical nurses in a town with only one hospital. Employers that have at least some market power over potential employees is not that unusual. After all, most firms have many employees while there is only one employer. Thus, even if there is some competition for workers, it may not feel that way to potential employees unless they do their research and find the opposite.

How does market power by an employer affect labor market outcomes? Intuitively, one might think that wages will be lower than in a competitive labor market. Let’s prove it. We will tell the story for a monopsonist, but the results will be qualitatively similar, although less extreme for any firm with labor market power.

Think back to monopoly. The good news is that because the monopolist is the sole supplier in the market, it can charge any price it wishes. The bad news is that if it wants to sell a greater quantity of output, it must lower the price it charges. Monopsony is analogous. Because the monopsonist is the sole employer in a labor market, it can offer any wage that it wishes. However, because they face the market supply curve for labor, if they want to hire more workers, they must raise the wage they pay. This creates a quandary, which we can understand by introducing a new concept: the marginal cost of labor. The marginal cost of labor is the cost to the firm of hiring one more worker. However, here is the thing: we assume that the firm is determining how many workers to hire in total. They are not hiring sequentially. Let’s look how this plays out with the example in Table 2.

There are a couple of things to notice from the table. First, the marginal cost increases faster than the wage rate.  In fact, the marginal cost of hiring an additional worker (beyond the first one) is always greater than the wage necessary to pay them. This is shown in Figure 1, where the MC_L is above the supply curve of labor for any quantity of workers (again, beyond the first). This is because to hire one more worker requires paying a higher wage rate, not just for the new worker but for all the previous hires who would have accepted the lower wage. We can see this graphically in Figure 1.

Figure 1. The Marginal Cost of Labor. Since monopsonies are the sole demander for labor, they face the market supply curve for labor. In order to increase employment they must raise the wage they pay not just for new workers, but for all the existing workers they could have hired at the previous lower wage. As a result, the marginal cost of additional hiring labor is greater than the wage, and thus for any level of employment (above the first worker), MC_L is above the Market Supply of Labor.

If the firm wants to maximize profits, it will hire labor up to the point L_m where D_L = VMP (or MRP) = MC_L, as Figure 2 below shows. Then, the supply curve for labor shows the wage the firm will have to pay to attract Lm workers. Graphically, we can draw a vertical line up from L_m to the Supply Curve for label and then read the wage Wm off the vertical axis to the left.

Figure 2. Labor Market Outcomes Under Monopsony. A monopsony will hire workers up to the point L_m where its demand for labor equals the marginal cost of additional labor, paying the wage W_m given by the supply curve of labor necessary to obtain L_m workers.

How does this outcome compare to what would occur in a perfectly competitive market? A competitive market would operate where D_L = S_L, hiring L_c workers and paying W_c wage. In other words, under monopsony employers hire fewer workers and pay a lower wage. While pure monopsony may be rare, many employers have some degree of market power in labor markets. The outcomes for those employers will be qualitatively similar though not as extreme as monopsony.

Figure 3. Comparison of labor market outcomes: Monopsony vs. Perfect Competition. A monopsony hires fewer workers L_m than would be hired in a competitive labor market L_c. In exploiting its market power, the monopsony can also pay a lower wage W_m than workers would earn in a competitive labor market W_c.