The Minimum Wage and Monopsony By David Henderson

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: