In the standard model of the labor market, taught in introductory economics classes around the world, there is nothing special about the relationship between employer and employee. Instead, the model simply relabels the canonical supply-and-demand diagram, magically transforming price floors into minimum wages and unions into monopolists. The labor market is governed by the same forces of supply and demand as are refrigerators or carrots, according to the model. Because labor market institutions and norms impede these forces, the model considers them merely obstacles to efficiency.
This perfectly competitive view of the labor market is not entirely wrong. But it is incomplete—and has pushed economic-policy thinking to focus on demand and supply as the only things that matter for labor market outcomes. It presumes that the law of one price—which postulates that identical commodities have the same price everywhere—includes workers and their wages. As a result, the model considers the supply of human capital and technology-induced demand as the sole levers that move labor markets, with little role for firms, norms, or interventionist institutions, such as labor unions and governments. The perfect competition model generally portrays efforts to shape the terms of voluntary contracts between workers and firms (like union negotiations or minimum wages) as either of secondary importance at best or counterproductive at worst. As the late Milton Friedman wrote, “The employee is protected from being coerced by his employer by the existence of other employers for whom he can work.”
But the empirical implications of the theory do not much match up with the real world. For example, in the hypothetical case of a company reducing wages by 10 percent, the perfect competition model predicts that all workers eventually will quit and go to competitors. Firms have no scope for wage setting, and the market determines a worker’s value at every firm.
A dose of reality
But experimental and quasi-experimental estimates in relatively unregulated scenarios all suggest that is not what happens. The number of workers who leave in response to a wage cut is much smaller, perhaps 20 to 30 percent—and in developing economies, lower still. This suggests that employers have wide latitude to set wages. A higher wage does help recruit and retain workers, but the market does not seriously constrain companies’ wage decisions, and different employers can make different choices. That is, employers exercise monopsony power—the labor market analog of demand-side monopoly power that gives sellers a degree of control over pricing.
Dissatisfaction with the traditional depiction of the labor market is not new. The oldest criticisms of this model—for example, that it does not predict involuntary unemployment—remain true. And new ones have emerged—such as the importance of firms, market power, and cultural norms.
Nevertheless, despite a large collection of theories and evidence from the 1980s that poked holes in the model, the traditional framework remains the default model for pedagogy and economic policymaking. Prior to CORE Econ (Curriculum Open-access Resources in Economics)—an open-source economics textbook project I am involved in—the model of the labor market in introductory textbooks was some version of supply and demand. Various other economic forces are acknowledged as possible deviations from the basic model, but the model has not changed. As a result, for example, there is pervasive bias in US employment law that both firms and workers can readily terminate an employment relationship at low cost.
Cracks in the edifice
Much of the current criticism of the traditional labor market model stems from increasingly wide empirical cracks in the economic paradigm:
- Although the basic model postulates that firms do not matter much because all workers doing the same kind of job should get the same market wage, it is clear that employer behavior is responsible for a significant share of wages. Early 20th century labor economists had marshaled some evidence on this point, but the advent of high-quality matched employer-employee data, combined with transparent quasi-experiments, has moved the research frontier considerably.
- There is a large body of evidence showing some firm-specific wages that reflect in part the productivity and profitability of their employers, which conflicts with the law of one price.
- It is remarkably difficult to find negative effects of a minimum wage on employment, although the perfectly competitive model predicts that a minimum wage increase would make the least productive workers expendable, with no countervailing effects on turnover or effort.
- There is robust evidence to suggest that labor market concentration is negatively correlated with wages and that mergers of large employers lower wages. Moreover, there is more recent evidence that unions and minimum wages mitigate the negative effect of concentration on wages.
- Most directly, quasi-experimental changes in wages across workers, all else equal, lead to only moderate changes in quits and recruits.
All this evidence points toward pervasive monopsony as a force in the labor market, where firms set wages for groups of workers, losing those who have better outside options but making profits off those who do not.
While monopsony is but one thread in a web of forces that make the labor market messier than the supply-and-demand model, it is readily seized on to explain aberrations in the labor market because it is both empirically quantifiable from readily available data and conceptually not too far away from the safe space of Economics 101. Simply relaxing the assumption that firms take market wages as given already yields a much more plausible view of the labor market.
Job searches are difficult
Large firms set wages for a whole set of jobs without having to compete with themselves, which creates a bubble of noncompetitive behavior within a workplace. Employees find searching for jobs costly, and many vacancies and possible matches are communicated only informally through social networks. Evidence shows that workers have relatively little credible information on jobs outside their firms (Jäger and others 2022).
A major reason that labor market monopsony exists is that jobs are more than sources of income and employees factor in more than compensation when making job choices. Among other things, jobs also offer social experiences and status and sometimes confer identity. Many aspects of a job matter—including relationships with coworkers and supervisors, commute times, tastes and abilities for particular tasks, scheduling, and hours. People value work they think others think is valuable. Subjective experiences of work—such as meaning and sense of purpose, managerial respect, and the experience of dignity—are important to workers.
The taste for the same job and knowledge about outside jobs vary among workers, which gives employers some scope to reduce wages, losing some workers who would rather work elsewhere but keeping those for whom the job is the best they could hope to find.
