How Labor Markets Work in Practice

In the idealized version of a perfectly competitive labor market, many employers freely compete to hire workers from a large pool. Thus, neither employers nor workers have “market power,” meaning the ability to dictate terms of employment that differ meaningfully from the terms offered (or received) by others to workers with comparable skills. In this world, employees can freely (and costlessly) change jobs when better opportunities arise. For their part, employers are able to seamlessly fill job vacancies by simply offering the going wage rate. This wage is determined by the market — by the intersection of the supply and demand curve for labor; nobody has discretion to set pay. Thus, in econ jargon, the supply curve to any firm is “infinitely elastic,” implying that if it paid just a penny below the going wage it would lose its entire workforce, and if offered just a penny more it would be inundated with able job applicants. An individual employer in a competitive labor market is not subject to the usual law of supply, as there is no upward-sloping supply curve to the firm: paying the going wage attracts all the workers the firm demands.

The opposite of a competitive labor market is one with a single employer. That employer, called a monopsonist, is in a peculiar position because she is subject to the law of supply in the way that an entire industry is in a competitive market. If she wants to hire an extra worker, she must pay a somewhat higher wage since the supply curve she faces is sloped upward. And, as a practical matter, she will need to pay that higher wage to the rest of her workers, too. Thus a monopsonist with, say, 100 employees who finds it necessary to pay an extra dime an hour to hire one more worker, must shell out a total of $10 an hour (100 times 10 cents) more to the existing workforce as part of the price of hiring that additional worker.

Note the critical difference: an employer in a perfectly competitive market, who is one among many, can always hire more workers at the currently competitive wage. So, for this employer, the added cost of one more worker is exactly what she pays that worker. A monopsonist’s marginal cost of hiring a worker, however, is higher — perhaps much higher — than the wage paid to that additional worker.

Thus, paradoxically, while a monopsonist is likely to pay less, on average, for labor, than an employer in a competitive market, the monopsonist’s cost of labor at the margin is likely to be higher. So, in aiming to maximize profits, a monopsonist will hire less labor and make do with vacancies. And an economy full of monopsonists will be less productive because employers will fail to hire workers who could contribute more value to output than they received in wages.

If the government forces a monopsonist to increase the wage that it pays — by, say, imposing a minimum wage that is modestly above the wage it currently pays — the monopsonist’s marginal cost of labor will fall. And this cost at the margin may become low enough to give the monopsonist an incentive to hire more workers. In other words, without a minimum wage the monopsonist operates with vacancies, unwilling to raise the wage it offers to hire additional workers because it would have to pay that higher wage to existing workers as well. However, with a binding minimum wage — that is, a minimum wage above the rate the monopolist was already paying — a monopsonist can fill its vacancies without worrying about having to increase everybody else’s wages, because that was already required by the minimum wage. A monopsonist would not be happy with this situation because the minimum wage would cut its profits. But once there is a minimum wage, the firm would find it possible and in its interest to fill its vacancies, provided the minimum wage wasn’t set too high.

The canonical example of monopsony is a one-company town — say, a remote coal mining town. While few labor markets are characterized by pure monopsony today, if employers collude to suppress competition — either by restricting labor mobility or conspiring to fix pay — they jointly exercise monopsony power. This should be evident because employers are exercising discretion to set pay, and in a perfectly competitive labor market, employers have no discretion whatsoever to set pay.

Although it remains unclear how pervasive or effective employer collusion is in restricting competition, recent economic analysis suggests that employers often have monopsony-like power over workers even when there are many employers who operate independently. In part, that’s because employers have some discretion over what they pay because of labor market frictions, such as job search costs.

For example, in the “wage-posting job search” model pioneered by the economists Kenneth Burdett at Penn and the late Dale Mortensen, and expounded on in Alan Manning’s book Monopsony in Motion, employers consider the tradeoff between their position on the wage ladder and their employee turnover rate. Employers can choose a low-wage strategy and make do with high turnover and chronic vacancies, or a high-wage strategy with low turnover and few vacancies. Requiring employers who choose the low road to increase their pay would raise total employment by making jobs more attractive and reducing turnover.

In another model of the labor market developed by Mortensen, Chris Pissarides of the London School of Economics and Chris Flinn of NYU, firms and workers bargain over the value that each unique worker-firm match creates. Factors that determine their relative bargaining power, such as the ability of workers to take other job opportunities, influence where the bargain ends up.

Yet other models recognize that, even absent search frictions and idiosyncratic value of worker-firm matches, individual workers value nonwage features of jobs differently. For example, some workers may live very near a McDonald’s where they work. Those who live close by would presumably be willing to work for a lower wage at that outlet than those who live far away and must spend time and money on commuting.