Monopsony and Minimum Wage Logic

Monopsony models of labor markets can be used by economists to provide a theoretical justification for the minimum wage. One criticism of the theory, that I’ve read, is something akin to if the firms’ demand curve is downward sloping this somehow should hurt the positive case for a minimum wage. But, this simply isn’t true. Or, alternatively, what am I missing?

Labor Monopsony

To avoid controversy that might divert attention from this posts’ point, I am not saying that the simple monopsony model is a good theoretical justification for the minimum wage. And, of course, a theoretical justification is not an empirical justification. I, personally, do not think the minimum wage is a good welfare program (I think something like basic income is better).

The above graph uses completely arbitrary numbers. I took a textbook example of monopsony (I copied the figures from their table) and then I built another table with the minimum wage. This is what it looks like (minimum wage on the right; the highlighted row is where MC=MRP, or is just below it, because we’re dealing with finite and discrete units),

monopsony and min wage tableThe intuition behind a profit maximization model is that the firm will employ one additional unit of labor, if and only if the marginal benefits (marginal revenue product being the marginal increase in productivity) exceed or are equal to the marginal costs. If the marginal benefits are less than the marginal costs, the firm is earning a net loss on that additional employee. Because the minimum wage implies constant marginal costs on some segment of the marginal cost curve, if this segment crosses the demand (or marginal revenue product) curve, total employment will increase, despite the rise in wage, all else equal (if there are other factors that determine employment, including the availability of funds through, say, the stock market, how will an increase in the total wage bill affect these functions?). See also the second paragraph in this post by David Henderson for a verbal explanation of the intuition behind monopsony and the minimum wage.

Note, also, why the argument, “why not a $10,000 minimum wage,” is not a good one (in this case). In our example, increasing the minimum wage to eight dollars would decrease total employment (and the total wage bill). To eliminate the welfare loss entirely, the optimal wage would be set at where the labor supply curve (the solid red line) intersects the demand curve (the solid green line). There are definitely limits to where the minimum wage should be set (of course, different models may have different optima). But, the government doesn’t necessarily have to set the minimum wage at the optimal value; there’s a range of wages where the outcome is still welfare improving compared to the market outcome, again all within the context of this limited model.


I have a related thought, although this is one of those “spur of the moment” ideas. The reason why the marginal cost curve lies above the labor supply curve in the monopsony model, is because the firm has to raise the wage of all other employees as it draws a new laborer from the market. This is where the marginal wage cost figures come from in the tables above. Say that we’re looking at the monopsonist firm (without minimum wage) in the above example, and this firm originally employs two workers at three dollars each (total wage bill of six dollars). The firm wants to employ one more person, who will join the company if and only if she’s paid four dollars. In the model, the firm not only has to pay the additional four dollars to hire the marginal employee, but it also has to pay an additional dollar per each employee already hired, for a total marginal wage cost of six dollars (the total wage bill being $12, 12 – 6 = $6).

How well does this represent real world marginal cost curves in markets where the firm is not a “wage taker” (the labor supply curve is upward sloping, or, amounting to the same thing, the labor supply curve is not perfectly elastic)? There is evidence that there is wage dispersion within firms (see, for example, Edward P. Lazear and Kathryn L. Shaw, “Wage Structure, Raises, and Mobility,” in The Structure of Wages: An International Comparison). This suggests that, to some degree, firms can price discriminate when they set wages (price discrimination means that the firm can charge different prices to different customers, or in this case different employees). If this is true, won’t the marginal cost curve exist somewhere closer to the labor supply curve (or, in the case of perfect discrimination, the marginal wage cost curve would be the labor supply curve)?

Of course, the straightforward monopsony model is not usually what minimum wage proponents have in mind. In introductory micro, monopsony is presented as the case where there is a single buyer (analogous to the basic monopoly model, where there is a single seller). Instead, they rely on theories like differentiation, where employees prefer one firm or another for some reason — if firm attractiveness varies, the reservation wage (the minimum wage a person is willing to accept in exchange for her labor) will vary by firm and the supply curve will be upward sloping. Other factors which can give employers market power include moving costs (the cost an employee has to pay to move between firms) and search considerations (imperfect information). So, these factors have to be considered alongside factors which may make monopsonistic elements less relevant. (A very good review of various theories of labor monopsony and empirical studies is William M. Boal and Michael R. Ransom, “Monopsony in the Labor Market,” Journal of Economic Literature 35, 1 [1997], pp. 86–112; although, I get the feeling that they are skeptical of the minimum wage and monopsony models in general, so the literature they review may be an incomplete picture of the evidence [selection bias, of sorts].)

2 thoughts on “Monopsony and Minimum Wage Logic

  1. Chris Pacia

    IMO to the extent that monopsonistic elements exist in the labor market, you wouldn’t want to employ price controls for the same reason you wouldn’t want to employ price controls to deal with monopolistic competition in goods markets. The market is never is a static monopsonistic equilibrium, rather it is dynamic and constantly changing. The minimum wage is bound to negatively effect some industries/firms.

    But we have to question even more the likelihood that the low end of the labor market is even monopsonisitic. It seems that would be the most competitive part of the labor market with the top end being the least.

    It seems to be more grasping for a justification for a minimum wage rather than rationally considering how markets work.

  2. Pingback: Minimum Wage:  Defeating price discrimination, not creating inflation | Politically Skewed

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