Frictions, Monopsony Power, and Entry

Don Boudreaux has written a long post challenging me by name on monopsony power and the minimum wage. I've addressed all the points in his comment section before, although he does not speak to those directly. Rather than bury responses in another one of Cafe Hayek's comment sections I thought I'd provide them here. I'd encourage people not to take Don's word for what my claims have been - he says I've made a lot of claims that I actually haven't. So if you don't read me claim something please confirm with me that I actually think it before attributing it to me!

The issue at hand is whether market entry can dissipate the monopsony power that is often cited as a reason why we don't see big disemployment effects associated with the minimum wage. Don has repeatedly asserted that people who don't think there are major disemployment effects should go out and hire a bunch of underpaid workers. They would enrich themselves and help low income workers. If they're not willing to do this, Don actually suggests that is evidence in and of itself against the empirical work! There are some obvious problems with this challenge, and Don seems to assume that entrepreneurship is a simple affair (he calls it "easy"). I disagree, but let's leave those issues aside. The question is, would mere entry even have any impact on the sort of frictions that we think cause monopsony power? I don't think so. If that was all it took, we wouldn't see much evidence of monopsony power. I'm going to tackle this in three parts: First, the nature of the frictions people normally point to, second examples of precisely what Don is looking for and what we expect from market entry, and third other sources of the disemployment result.

1. Frictions

Don't consider this an exhaustive list, but when we're thinking of the low wage labor market a lot of the frictions I generally have in mind are (1.) hiring and firing costs, (2.) asymmetric information about the worker's productivity, (3.) firm-specific human capital, and (4.) liquidity constraints and various other factors that make search costly for a low income worker. Competitive pressure from entry is extraordinarily important in the market process but merely entering a market doesn't obviously address these frictions. If I provide more demand for low wage workers I've done nothing to change the fact that the current employer of a high productivity low wage workers has private information about that worker's productivity that I don't have. Although this is less related to monopsony power, I also haven't done anything to change the asymmetric information between me and the worker herself about her productivity. In a sense you can think of the labor market (any labor market, not just the low wage labor market) as a market for lemons. Entry in the market for lemons does not fundamentally change the problem (neither, for that matter, does imposing a minimum price). The same goes for hiring and firing costs. Competition of course grinds down all costs to some extent but it doesn't change the fact that employment is going to be associated with fixed costs, and as Walter Oi pointed out decades ago (at the start of this dynamic monopsony literature) fixed costs associated with labor lead to workers being paid lower than their marginal product (similar insights structure Gary Becker's work on human capital). Firm specific human capital also gives your employer some control over you. Your know-how developed on-the-job is partly general but much of it is also specific to your employer. And again, if a competitor wants to make you equally productive they're going to have to make their own (fixed cost) investments in you.

A lot of this has focused on the relationship with the employer, but workers in general - and low wage workers in particular - often face search frictions that contribute to their employer's monopsony power. Search is costly and it's particularly costly if you're a low wage worker. These workers face liquidity constraints, many are young and supporting families, and transportation limitations are likely to raise the costs of search. All of this reduces separation rates and contributes to an incumbent employer's monopsony power.

Don is presenting a very naive/classic understanding of market power where it's purely a numbers game. Market power is caused by sparse markets under this view, so entry should solve the problem. I don't think this cuts it. For a long time - really going back to Edward Chamberlin at least - economists have understood that firms, products, workers, capital, etc. are not homogenous or undifferentiated entities. Product differentiation provides market power even when there are many firms in the market. The same goes with workers. The heterogeneity of labor leads to many of the asymmetric information problems I highlighted above. In these monopolistic and monopsonistic competition situations additional competition of course erodes market power, but it does not eliminate it. These are not just abstract theories - workers and capital really are heterogeneous and differentiated. When we do price theory, we can't just ignore that and construct more convenient models that don't acknowledge it.

What might matter more for eroding monopsony power is entrepreneurship targeted at the sources of monopsony power. Innovation and entrepreneurship in private accreditation or other methods for revealing more information about workers' productivity or for connecting employers to workers could help. But mere entry into a market that employs low wage workers doesn't have any obvious benefits unless we simply have charity in mind (which is not Don's point).

2. What to expect from entry and paying higher wages

The ironic thing is we see examples of what Don is demanding in the news all the time. He seems so fixated on Paul Krugman (and, weirdly, me) that he doesn't seem interested in these cases as evidence. Costco, Wal-Mart recently, Trader Joe's, In-N-Out Burger, etc. are all regularly cited as doing what Don suggests. I think an interesting exercise would be to look into their hiring process because they may be innovating along the margins I've mentioned above. Another possibility is that these firms may be on a higher equilibrium in a multiple equilibrium. Labor economists often note important interactions between turnover and productivity that allow for the co-existence of low-turnover, high productivity and high-turnover, low productivity firms that are both profitable but at different equilibria. In any case, these are clear examples of what Don is looking for.

I think when we think about entry it's important to remember that competitive pressure and entry threat is always operating and always pushing markets toward their equilibrium point - that's the market process - but there's no necessary reason for that to be a "competitive equilibrium" as it's defined by economists. Competitive pressures could push firms toward an equilibrium with market power too. In a sense it's unfortunate that the word "competitive" is even used to describe these cases, since competition is in play in all markets. Nomenclature often fails us, but that's no excuse for bad analysis.

3. Other arguments besides monopsony

So one thing that bugs me about Don's post is this line: "Mr. Kuehn implicitly asks us simply to assume that the studies that he favors do in fact capture and accurately measure all of these aspects of the employment arrangements or contracts of low-skilled workers. But, in reality, there is good reason to reject Mr. Kuehn's implicit claim". Why does Don keep using the word "implicit"? Because he's making things up and knows he can't say that I ever actually claimed it. There are a lot of options besides monopsony for explaining the empirical results, and there's a lot of work left to do to figure all this out. One of them is other margins of adjustment besides employment. This is central to the work on the minimum wage in Berkeley - both the arguments they've provided to date and the work they're doing now (Michael Reich, of Dube, Lester, and Reich (2010) fame, asked me to apply to a post-doc at Berkeley to study precisely these alternative margins of adjustment - I declined because I've got plenty of work here and am very happy with it). Instead of adjusting the employment margin, firms may reduce other benefits or increase prices or reduce turnover (to cut Walter Oi's fixed costs). These are different from the monopsony argument but not unrelated (for example, they have a turnover margin of adjustment to work on precisely because they have monopsony power). In some ways I actually prefer these arguments, although I imagine all are in play. In the only published work I've ever done on the minimum wage I'm pretty straightforward about it and I haven't ever said monopsony is the only game in town. This is what I wrote in my EPI paper:

"There are many different explanations for the lack of substantial disemployment effects in matching studies. One suggestion is that employers exercise “monopsony power,” or bargaining power associated with being one of a small population of buyers in a market (an analog to the monopoly power exercised by sellers). Just as a monopoly will not reduce its output in response to an imposed price reduction, a monopsonist can absorb a price increase (such as a minimum-wage increase) without reducing demand for workers. Although such theoretical explanations are possible, a more straightforward argument is that an increase in the minimum wage does not have a disemployment effect because the increased labor costs are easily distributed over small price or productivity increases, or because fringe benefits are cut instead of employment levels. Less work has been done on the impact of the minimum wage on these outcomes than on the employment impact. Alternatively, disemployment effects might be avoided due to reduced fixed hiring costs as a result of lower turnover."