Supply and demand: Handle with care
By Scott Sumner
I recently did a post that discussed a “shortage” of skilled labor in Spain, despite 20% unemployment. Companies were having trouble filling positions such as nurses, computer programmers, etc. Several commenters suggested this made no sense; if there was a shortage then firms could simply raise wages until equilibrium was restored. I don’t think it’s quite that simple.
If the supply and demand model applies to individual labor markets, then my critics are certainly correct. But does it? See if these claims sound reasonable:
1. Companies don’t do job interviews, as workers are identical. They simply hire workers as needed.
2. Companies can just as easily hire 1 worker or 1000 workers, all at the exact same wage rate.
That’s because the S&D model assumes there is an infinitely elastic supply of identical workers facing any given firm.
Obviously, that’s not how labor markets work. Instead, firms are monopsonists who face an upward sloping supply of labor. That’s not to say that the S&D model might not be a useful approximation for many markets where it does not apply exactly. I am a Chicago economist, and one definition of Chicago economics is a belief that the S&D model is a useful approximation in most settings. I accept that. But it’s not an exact fit, and the Spanish labor market is one example.
Let’s consider a simple example of the problem faced by monopsonists. A firm has 100 computer programmers, all making $20/hour. They want to hire an additional programmer, but can’t find anyone at that wage rate. The supply of workers facing an individual firm is upward sloping. Thus they must raise the wage to $21 dollars to get that additional worker. So how much would it actually cost to employ one extra worker?
It depends. In the standard monopsony model, the extra worker costs the firm $120/hour. That’s because the standard model assumes all workers are paid the same. Everyone else’s wage also has to be bumped up by $1/hour. One weakness of this model is that the firm might be able to hire a new worker at $21/hour, but continue to pay the existing workers $20/hour. Or there might be a third possibility. Hire the new worker at $20/hour, plus a $1000 signing bonus, to avoid disrupting the existing wage structure.
If we rule out the signing bonus, here are some reasons why it may be difficult to pay new workers more than existing workers:
1. Other companies hiring computer programmers would face the same dilemma, and hence existing programmers earning $20/hour would “jump ship” and go to competitors paying $21/hour to new hires.
2. Worker morale might suffer if new hires make more than existing workers.
3. There might be union rules that assure equal pay for a given job category.
The bottom line is that when a monopsonist faces an upward sloping supply of labor, the actual marginal cost of hiring one more worker may be far higher than the hourly wage rate. That still doesn’t mean there is literally a “shortage”, as the term is used in S&D analysis, but there is a situation that feels very much like a skilled worker shortage, from the perspective of the employer.
Employers observe different types of labor markets. They only assign the term ‘shortage’ to a subset of labor market conditions. The most reasonable response is not to scold them for misusing the term ‘shortage’, but rather to understand that they are now facing an unusually steeply sloping supply of skilled workers, perhaps because very few are still unemployed. And yes, it is quite possible for there to be relatively few unemployed nurses and computer programmers in an economy with 20% unemployment, if that economy has large numbers of unskilled workers (which seems to be the case in Spain.) And keep in mind that a college education does not mean that you are skilled enough for the actual jobs available in Spain