Saturday, August 15, 2015

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."


  1. Just a comment on the use of the term "competitive" markets. I had a professor in grad school who referred to markets usually called "competitive" as "atomistic" markets. She argued that there is in fact more "competitive" behavior in monopolistically competitive and oligopoly markets than in what the profession generally calls "competitive" markets. Seemed right to me then, seems right to me now.

    1. Can you elaborate? Is this simply because to attain monopolist or oligopolist status, one must have done a great job of outcompeting? In that case, I'm not sure the word "competitive" necessarily applies once the status is achieved, although I can also see where there might be a lot of competitiveness involved in maintaining such status.

    2. I presume that what she meant by that is that in monopolistically competitive and oligopoly markets firms actually "compete" by making choices. In the "competitive market" they have no ability to make a (meaningful) choice since their set of choices is constrained by the nature of competition itself.

      I actually like this point a lot.

    3. YouNotSneaky got the point. Firms in what are usually called "competitive" markets are price-takers (which begs the question of where those prices come from) and typically not innovators in terms of products or of technology or anything else. Changes in markets typically come from firms with some freedom of action.

  2. Daniel
    Interesting, but I am not sure what it proves or is intended to prove, if anything.
    Referring to your three parts:
    1. All the frictions you mention exist equally in markets where monopsony power has been overcome, don't they?
    2. How does any equilibrium, dynamic or otherwise affect the discussion? A cup of room temperature tea is at equilibrium, but that doesn't mean that it stays that way as I stir sugar into it.
    3. If you are not intending to respond directly to the basis of Don's challenge to identify a specific monopsony and demonstrate how to exploit it, may I suggest you make this explicit so as to clear up any confusion on the point for us readers?

  3. Daniel,

    I particularly liked this post, as it brings up many of the arguments that I have read about the possible reasons for monopsony power by employer, as well as the potential for multiple equilibrium for low-productivity and high-turnover labor markets vs. high-productivity and low-turnover labor markets. If you have a couple minutes, I would love to hear your thoughts on a couple of issues that I have.

    First, you mention that a firm could have monposony power due to firm specific human capital. While I find this convincing for other types of occupations, I must admit that I find this less convincing for low-skill, low-wage jobs. I don't think it takes a considerable amount of firm specific skill to run a register, or make a hamburger. That is, to some extent, why it is called a low-skilled job. Wouldn't this reduce the fixed cost of hiring a new worker? Do you actually think this is a significant factor in the minimum wage level labor market?

    I have a similar issue with the search fictions that you mention for potential firm monopsony power. I would agree that low-wage workers have fewer resources to deal with employment search costs. That being said, I think the search costs for low-wage workers are also significantly lower than other occupations. If you are a fast-food worker and located in an area with even a small population, there are likely to be a large number of potential employers within a small area. In addition, the employers also advertise their open positions very publicly. As a result, I would think that the search costs for these positions is likely to be quite small. The transportation costs between jobs are likely to be very similarly small as well. Again, do you actually think that these search costs are a significant factor, or are you simply providing a possible explanation for why a firm could have monopsony power that may not be impacted by new firms entering the market?

    Finally, I find the idea of the potential for low-productivity but high-turnover vs high-productivity but low-turnover idea to be interesting. However, my concern when looking at higher paying firms that have lower turnover relative to lower paying firms is the following question: Is the higher pay resulting in lower turnover and higher productivity for the same type of workers they were employing previously, or is the higher pay resulting in the employer employing a different type of worker? If the higher pay is resulting in the firms employing a different type of workers, then minimum wage increases may not result in significant total employment declines, but it could result in a significant number of the lowest skilled workers no longer able to find employment at the higher wages. Has there been empirical work done to determine which of the two factors mentioned above are having the larger impact on turnover?

    Any thoughts you may have on these issues would be appreciated.

  4. I've said this several times already but there's a logical fallacy in the presumption that frictions in the labor market automatically imply "monopsony power" and there's a logical fallacy even in the presumption that "firm facing upward sloping labor supply curve" is equivalent to "monopsony power" and finally there is definitely a fallacy in the presumption that "just because in classic monopsony minimum wages can increase employment, minimum wages will increase employment in any labor market with "frictions" or any market where firms face upward sloping labor supply curves".

    None of these conclusions actually follow from the premises.

    Show me the model. Math and all.

  5. Some thoughts:

    Assuming Don actually says "entrepreneurship is easy" I think he needs to seriously re-think his reading of Kirzner, Mises, and others. It's a bizarre statement IMO. Otherwise I pretty much agree with him. In the real world (not the silly world of blackboard equilibrium theory), firms seek to operate in such a way that they can earn economic profit. They may do this by cost cutting or differentiation. The market operates such that these opportunities are fleeting. I can't imagine anyone who has ever worked in a real business would deny this, unless they have some kind of ideological ax to grind.

    As to your (admittedly short) list of frictions:
    1) Some hiring and firing costs exist because the world is imperfect, others exist thanks to gov't policy. In the world of unskilled (or low wage) labor, real world hiring and firing costs are probably lower than they are in more skilled industries. Those costs imposed by gov't policy are clearly a problem, but by definition can't be diminished by firm entry.
    2) Asymmetric information... eh maybe... but we have reputation mechanisms to deal with this. To the extent that those mechanisms aren't used, they probably aren't necessary. Again, we're talking about unskilled or low-skilled labor. This also applies to your commentary on the market for lemons issue.
    3) Firm-specific human capital in low-skilled labor markets is probably not prevalent in real world labor markets.
    4) Firm entry would definitely help lower search costs. More firms => competition for workers => advertisements to attract workers.

    "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."

    Accusing Don or any of us who take a disequilibrium/market process approach to the world of claiming that "market power" can be eliminated entirely is just absurd. We're the ones who caution against comparing the real world to abstract models (blackboard theory). Prominent left-wing economists like Thoma and McQuiggin do this all the time and we consistently argue that they need to ditch the Nirvana fallacy under which they operate.

    Just to round this out, I'd like to reiterate something Don said. These studies are destined to improperly measure impacts of the minimum wage because total compensation simply can't be measured and implemented.

    Equilibrium doesn't happen in reality, and pretending that imperfections in markets can, or should, be fixed by gov't policy is just another instance of the Nirvana fallacy that still plagues policy discussion. This comment isn't directed specifically at you, but it really is an epidemic in the economic policy world.

    1. *implemented in an econometric study.

      I should have said John Quiggin, not McQuiggin.

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  7. Dan, I'm not sure you're addressing any of the comments/problems Don talked about. For example:

    "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. "

    It's true you may not know a person's productivity (and that is the perfect argument against minimum wage), but that's exactly why people enter a market. They see an opportunity to exploit. An argument for minimum wage is that workers are not paid according to their productivity. If a person enters a market and offers higher wages because he thinks workers are underpaid, then he is attempting to overcome one of the frictions you noted, specifically #2: asymmetry. He may guess right, leading to profit, or wrong, leading to loss.

    In fact, all the frictions you listed can be overcome by an open market and experimentation. Entry into a market allows new ideas to enter as well. That's the key point Don makes and you seem to miss.

  8. I'm not convinced by most of your arguments....

    * "Easy" Entrepreneurship.
    What I think Don is trying to say is that it's easy *to someone*. Not to everyone, or to him. For example, in the city I live there are no Starbucks coffee shops. Starbucks have said they will open two new coffee shops. The manager responsible for that could easily offer higher wages than minimum when looking for staff.

    * Asymmetric Information on Worker Efficiency.
    What we're interested in here is the average minimum wage worker. We're not interested in an unusually efficient worker who is paid minimum wage. How is the average worker supposed to be harmed by asymmetric information? Surely that's dealt with by firm behaviour and by competition between firms. Suppose the foocorp have a business plan that makes very efficient use of minimum wage workers. Foocorp are likely to expand until their advantage diminishes and others are likely to enter their market and copy their business plan. For what you're saying to be true in general it seems to me that all firms have to be above average.

    * Hiring and Firing Costs.
    I don't think this affects the point Don was making. New entrants have to pay hiring costs anyway, it's an inevitable cost to them and akin to a sunk cost. The cost of hiring is unlikely to be affected by the wage rate, if anything it could be cheaper at a higher wage rate. Employees don't pay the firms hiring and firing costs directly. What they pay is relocation and search costs.

    Also, I agree with Levi and Aaron McNay....
    * Search Costs.
    Every city has many low paid jobs. These jobs aren't particularly specialized. I know many people myself who have minimum wage jobs in the fast food industry or in clothing retail. They regularly talk to each other, pay and conditions are often compared.

    * Firm specific knowledge.
    This is low-skill, low-paid work. Often there's very little training or need for it. One of my friends works in clothing retail. She has changed jobs several times in the past year and she usually has several jobs at once. There's no long period of training during these changes. Often she's working helping customers and using the tills the first day she arrives.

    1. Current--I would argue that every one of your points--including the entry point (Starbucks is not the same as Caribou Coffee is not the same as...)--imply markets that are not "competitive"--not competitive in the sense that all of these actions imply firms with some (even if limited ) degree of control over price.

    2. But, is that limited control over price enough to make any actual difference? It doesn't sound very plausible in the cases I mention, does it?

      Specifically, I'd split the list into two parts. For:-
      * Search cost
      * Firm specific knowledge and
      * Ease of entrepreneurship.
      I'm arguing that the company has market power, but it's small.

      For Asymmetric knowledge of efficiency and hiring & firing costs I don't see Daniel's point. I don't see how they generate market power in the general case.

  9. I think frictions are important in practice. But most economists are about half a century out of date on the theory of competitive markets. Given competition, a higher wage is not necessarily associated with firms wanting to employ less workers per unit output. Here is an interesting example:

  10. Daniel, has there been work using microfoundations to attempt to approximate the level of monopsony power employers of low-skill labor might have? So maybe some sort of simulation that takes into account search costs and fixed costs of hiring that shows that constraints of size X can lead to monopsony power that can be used to depress wages by amount Y. This would be more convincing evidence, because once the microfounded model is specified, we can truly hammer out those details instead of hand-waving over how strong search frictions might be. Moreover, if would force everyone to be constrained by mathematics - the market power calculated can't be too low, and it can't be too high, or it won't conform to some basic facts we know about the world.


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