Monopsony graph.jpg

This month, the President’s Council of Economic Advisers issued a 21-page report on labor market monopsony. It’s titled “Labor Market Monopsony: Trends, Consequences, and Policy Responses.” As with many reports issued by economists who are paid by government, it has a mix of good and bad ideas, and good and bad proposals.

Economist Adam Ozimek has a nice short analysis of the report. I’ll go through the report seriatim, making my own comments or reporting Ozimek’s where I think he is on target, which is virtually all the time.

But I’ll do so in a post tomorrow. First, for those who don’t understand monopsony, a quick recap of the economics of monopsony. Monopsony is monopoly on the buyer’s side. The monopsonist uses his monopsony power to pay less than otherwise. Economists who write about monopsony typically are writing about monopsony in labor market, and the CEA report is no exception. The problem with monopsony, from an efficiency point of view, is that instead of hiring laborers up to the point where the value of marginal product (VMP) equals the wage, the firm hires up to the point where the VMP (assuming the firm has no market power in the output market) equals the marginal factor cost (MFC). And the MFC is above the wage. So, in monopsonistic equilibrium, the firm is not hiring “enough” labor. That is, the wage rate is below the VMP.

See the graph above. Why is the MFC above the wage? Because the supply curve faced by the firm is upward-sloping. Workers further down on the supply curve have lower supply prices than workers higher on the supply curve. (The supply price is the minimum price for which a worker is willing to supply that particular hour of labor.) The firm knows that when it pays an additional dollar per hour, say, to entice that higher-supply-price employee, it will need to, assuming it pays every employee the same, pay a dollar more per hour even to the lower supply price employees. Thus the cost of an extra dollar an hour to that last employee is more than a dollar an hour to one employee. The equilibrium employment is Q* and the equilibrium wage is W*. The efficient level of employment, by contrast, is Qefficient with the corresponding Wefficient wage.

A solution to the efficiency problem would be for the monopolistic firm to price discriminate, paying more to workers with higher supply prices and less to workers with lower supply prices. That way, the firm would come closer to the efficient amount of employment.

So, for example, in the graph above, the employer could pay each employee his supply price plus a penny. Each potentially employee would accept. This is called “perfect price discrimination” and is quite rare. What would the new equilibrium be? An amount of employment equal to Qefficient.

Keep that in mind when we analyze the CEA report.

Short of perfect price discrimination, one way to come close to Qefficient is to segment the labor market, paying a lower wage to the lower supply price segment and a higher way to the higher supply-price segment. Keep that in mind also when we analyze the CEA report.

To be continued.