Microeconomics for MBAs 51

Chapter 15 Competitive and Monopsonistic Labor Markets The farmers who employ migrant workers are caught in a competitive bind. Consumers want to buy their food at the lowest possible price. As producers, farmers must be able to sell their produce at a competitive price. That means minimizing the cost of production, including the full wage rate paid to employees. If farmers are forced to provide better housing for their laborers, they must reduce costs in other ways, including the substitution of machinery for labor. This is precisely what happened in many farm areas since the imposition of stricter housing standards. A federal law establishing migrant housing standards was passed in the late 1960s. In 1969 the farm labor service of the Michigan Employment Security Commission arranged jobs and housing for 27,163 migrants, but in the summer of 1970 it estimated that it would be able to place only 7,000 to 8,000 workers. State and local officials forecast that on balance, the new housing standards would eliminate 6,000 to 10,000 jobs. Meanwhile many growers, stung by the bad publicity surrounding migrant housing, closed their camps and switched to mechanical harvesting. As one grower put it, “It might be cheaper for me to continue using migrant help for a few more years, but mechanization is the trend of the future. And no matter what kind of housing I provide I’m going to be criticized for mistreating migrants. So I might as well switch now.” 3 Monopsonistic Labor Markets Competition is bad for those who have to compete. Not only as producers but as employers, firms would rather control competitive forces than be controlled by them. They would like to pay employees less than the market wage—but competition does not give them that choice Similarly, workers find that competition for jobs prevents them from earning more than the market wage. Thus doctors, truck drivers, and barbers have an interest in restricting competition in their labor markets. Acting as a group, they can acquire some control over their employment opportunities and wages. Such power is difficult to maintain without the support of the law or the threat of violence, whether real or imagined. It comes at the expense of the consumer, who will have fewer goods and services to choose from at higher prices. As always, the exercise of power by one group leads not only to market inefficiencies but also to attempts by other groups to counteract it. The end result can be reduction in the general welfare of the community. This section examines both employer and employee power in the labor market; the conditions that allow it to persist; its influence on the allocation of resources; and its effects on the real incomes of workers, consumers, and entrepreneurs. 3 “Housing Dispute Spurs Migrant Farmers to Switch to Machines from Migrant Help,” Wall Street Journal, June 29, 1970, p. 18 Chapter 15 Competitive and Monopsonistic Labor Markets 13 The Monopsonistic Employer Power is never complete. It is always circumscribed by limitations of knowledge and the forces of law, custom, and the market. Within limits, employers can hire and fire, and can decide what products to produce and what type of labor to employ. Laws restrict the conditions of employment (working hours, working environment) they may offer, however, as well as their ability to discriminate among employees on the basis of sex, race, age, or religious affiliation. Competition imposes additional constraints. In a highly competitive labor market, an employer who offers very low wages will be outbid by others who want to hire workers. Competition for labor pushes wages up to a certain level, forcing some employers to withdraw from the market but permitting others to hire at the going wage rate. 4 For the individual employer, then, the freedom of the competitive market is a highly constrained freedom. Not so, however, for those lucky employers who enjoy the power of a monopsony. A pure monopsony is the sole buyer of a good, service, or resource. (Monopsony should not be confused with monopoly, the single seller of a good and service.) The term is most frequently used to indicate the sole or dominant employer of labor in a given market. A good example of a monopsony would be a large coal-mining company in a small town with no other industry. A firm that is not a sole employer but that dominates the market for a certain type of labor is said to have monopsony power. Monopsony power is the ability of a producer to alter the price of a resource by changing the quantity employed. By reducing competition for workers’ services, monopsony power allows employers to suppress the wage rate. _________________________________________ FIGURE 15.7 The Competitive Labor Market In a competitive market, the equilibrium wage rate will be W 2 . Lower wage rates, such as W 1 , would create a shortage of labor, and employers would compete for the available laborers by offering a higher wage. In pushing up the wage rate to the equilibrium level, employers impose costs on one another. They must pay higher wages not only to new employees, but also to all current employees, in order to keep them. 4 Competitors who do not hire influence the wage rate just as much as those who do; their presence on the sidelines keeps the price from falling. If firm lowers its wages, other employers may move into the market and hire away part of the work force. Chapter 15 Competitive and Monopsonistic Labor Markets 14 The Cost of Labor Monopsony power reduces the costs of competitive hiring. Assume that the downward- sloping demand curve D in Figure 15.7 shows the market demand for workers, and the upward-sloping supply curve S shows the number of workers willing to work at various wage rates. If all firms act independently—that is, if they compete with one another—the market wage rate will settle at W 2 , and the number of workers hired will be Q 2 . At lower wage rates, such as W 1 , shortages will develop. As indicated by the market demand curve, employers will be willing to pay more than W 1 . If a shortage exists, the market wage will be bid up to W 2 . An increase in the wage rate will encourage more workers to seek jobs. As long as there is a shortage, however, the competitive bidding imposes costs on employers. The firm that offers a wage higher than W 1 forces other firms to offer a comparable wage to retain their current employees. If those firms want to acquire additional workers, they may have to offer an even higher wage. As they bid the wage up, firms impose reciprocal costs on one another, as at an auction. Because any increase in wages paid to one worker must be extended to all, the total cost to all employers of hiring even one worker at a higher wage can be staggering. If the wage rises from W 1 to W 2 in Figure 15.7, the total wage bill for the first Q 1 workers rises by the wage increase W 2 – W 1 times Q 1 workers. Table 15.2 shows how the effect of a wage increase is multiplied when it must be extended to other workers. The first two columns reflect the assumption that as the wage rate rises, more workers will accept jobs. If only one worker is demanded, he can be hired for $20,000. The firm’s total wage bill will also be $20,000 (column 3). If two workers are demanded, and the second worker will not work for less than $22,000, the salary of the first worker must also be raised to $22,000. The cost of the second worker is therefore $24,000 (column 4): $22,000 for his services plus the $2,000 raise that must be given to the first worker. TABLE 15.2 Market Demand for Tomatoes Number of Workers Willing to Work (1) Annual Wage of Each Worker (2) Total Wage Bill [(1) times (2)] (3) Marginal Cost of Additional Worker [Change in (3)] (4) 1 2 3 4 5 6 $20,000 22,000 24,000 26,000 28,000 30,000 $ 20,000 44,000 72,000 104,000 140,000 180,000 $20,000 24,000 28,000 32,000 36,000 40,000 Chapter 15 Competitive and Monopsonistic Labor Markets 15 The cost of additional workers can be similarly derived. When the sixth worker is added, she must be offered $30,000 and the other five workers must each be given a $2,000 raise. The cost of adding this new worker, called the marginal cost of labor, has risen to $40,000. The marginal cost of labor is the additional cost to the firm of expanding employment by one additional worker. Note that as the number of workers hired increases, the gap between the marginal cost of labor and the going wage rate expands. When two workers are hired, the gap is $2,000 ($24,000-$22,000). When six are employed, it is $10,000 ($40,000-$30,000). Figure 15.8, based on columns 1 and 4 of Table 15.2, shows the marginal cost of labor graphically. The marginal cost curve lies above the supply curve, for the cost of each new worker hired (beyond the first worker) is greater than the worker’s salary. _________________________________________ FIGURE 15.8 The Marginal Cost of Labor The marginal cost of hiring additional workers is greater than the wages that must be paid to the new workers. Therefore the marginal cost of labor curve lies above the labor supply curve The Monopsonistic Hiring Decision The monopsonistic employer does not get caught in the competitive bind. By definition it is the only or dominant employer. Like a monopolist, the monopsonist can search through the various wage-quantity combinations on the labor supply curve for the one that maximizes profits. The monopsonist will keep hiring more workers as long as their contribution to revenues is greater than their additional cost, as shown by the marginal cost of labor curve MC in Figure 15.9. To maximize profits, in other words, the monopsonist will hire until the marginal cost of the last worker hired (MC) equals his marginal value, as shown by the textiles market demand curve for labor. Given the demand for labor D, the monopsonist’s optimal employment level will be Q 2 , where the marginal cost and demand for labor curves intersect. Note that that level is lower than the competitive employment level, Q 3 . Chapter 15 Competitive and Monopsonistic Labor Markets 16 Why hire where marginal cost equals marginal value? Suppose the monopsonist employed fewer workers—say Q 1 . The marginal value of worker Q 1 would be quite high (point a), while her marginal cost would be low (point b). The monopsonist would be forgoing profits by hiring only Q 1 workers. Beyond Q 2 workers, the reverse would be true. The marginal cost of each new worker would be greater than his marginal value. Hiring more than Q 2 workers would reduce profits. Once the monopsonist has chosen the employment level Q 2 , it pays workers no more than is required by the labor supply curve, S. In Figure 15.9, the monopsonist must pay only W 1 —much less than the wage that would be paid in a competitive labor market, W 2 . In other words, the monopsonist hires fewer workers and pays them less than an employer in a competitive labor market. _________________________________________ FIGURE 15.9 The Monopsonist The monopsonist will hire up to the point where the marginal value of the last worker, shown by the demand curve for labor, equals his or her marginal cost. For this monopsonistic employer, the optimum number of workers is Q 2 . The monopsonist must pay only W 1 for that number of workers—less than the competitive wage level, W 2 . It is the monopsonistic firm’s power to reduce the number of workers hired that enables it to hold wages below the competitive level. In a competitive labor market, if one firm attempts to cut employment and reduce wages, it will not be able to keep its business going, for workers will depart to other employers willing to pay the going market wage. The individual firm is not large enough in relation to the entire labor market to exercise monopsony power. It therefore must reluctantly accept the market wage, W 2 , as a given. Employer Cartels: Monopsony Power through Collusion Envying the power of the monopsonist, competitive employers may attempt to organize a cartel. A employer cartel is any organization of employers that seeks to restrict the number of workers hired in order to lower wages and increase profits. Chapter 15 Competitive and Monopsonistic Labor Markets 17 The usual way of lowering employment is to establish restrictive employment rules that limit the movement of workers from one job to another. Such rules tend to reduce the demand for labor. In Figure 15.10, demand falls from D 1 to D 2 . As a result, the wage rate drops, from W 2 to W 1 , and employment falls, from Q 3 to Q 2 . Although the method of limiting employment is different from that used in monopsony, the effect is the same. Whether the monopsonistic firm equates marginal cost with marginal value (shown by curve D 1 ) or the employer cartel reduces the demand for labor (to D 2 ), employment still drops to Q 2 . In both cases workers earn a wage rate of W 1 —less than the competitive wage. One industry in which employers have tried to cartelize the labor market is professional sports. Owners of teams have developed complex rules governing the hiring of athletes. In the National Football League (NFL), for example, teams acquire rights to negotiate with promising college players through an annual draft. Once one team has drafted a player, no other team in the league can negotiate with him (unless he remains unsigned until the next year’s draft). Teams can buy and sell draft rights as well as rights to players already drafted, but within leagues they are prohibited from competing directly with one another for players’ services. Violations of these rules carry stiff penalties, including revocation of a team’s franchise. __________________________________________ FIGURE 15.10 The Employer Cartel To achieve the same results as a monopsonist, the employer cartel will devise restrictive employment rules that artificially reduce market demand to D 2 . The reduced demand allows cartel members to hire only Q 2 workers at wage W 1 —significantly less than the competitive wage, W 2 . ___________________________________ MANAGER’S CORNER I: Paying for Performance To this point in the chapter, our discussion has been focused on how labor “markets” work, and our interest has been on how the wage rate and other benefits are determined by the broad forces of supply and demand. However, markets must ultimately work with the interests of workers in mind. The problem most firms must solve is how to get Chapter 15 Competitive and Monopsonistic Labor Markets 18 workers to do what they are supposed to do, which is work effectively and efficiently together for the creation of firm profits. This is no mean task, as we will see at various points in this book. There is a lot of trial and error in business, especially as it relates to how workers are paid. At the same time, thinking conceptually about the payment/incentive problem can help firms moderate the extent of errors in business. One of the most fundamental rules of economics, and the reason d’être the discussions in the “Manager’s Corners,” is that if you offer people a greater reward, then they will do more of whatever is being rewarded, everything else equal. Many people find this proposition to be objectionable, because it implies that people can, to one degree or another, be “bought.” Admittedly, incentives may not matter in all forms of behavior; some people will sacrifice their lives rather than forsake a strongly held principle. However, the proposition that incentives matter does seem to be applicable to a sufficiently wide range of behavior to be considered a “rule” that managers are well advised to keep in mind: Pay someone a higher wage -- such as time and a half -- and they will work overtime. Pay them double time, and they will even work holidays. There is some rate of pay at which a lot of people will work almost any time of the day or night on any day of the year. This rule for incentives is not applicable only to the workplace. Parents know that one of the best ways to get their children to take out the garbage is to tie their allowance to that chore. Moreover, patients in psychiatric hospitals, many of whom have literally lost virtually all capacity for rational discourse, appear to respond to incentives. According to research, if mentally ill, institutionalized patients are paid for the simple tasks they are assigned (for example, sweeping a room or picking up trash), they will perform them with greater regularity. 5 Even pigeons, well known for having the lowest form of birdbrains, respond to incentives. Granted, pigeons may never be able to grasp the concept of monetary rewards (offering them a dollar won’t enlist much of a response), but pigeons apparently know how to respond to food rewards (offer a nut in the palm of your outstretched hand and a whole flock will descend, and maybe leave their mark, on your shoulder). From research, we also know that pigeons are willing to work -- measured by how many times they peck colored levers in their cages -- to get food pellets, and they will work harder if the reward for pecking is raised. Researchers have also been able to get pigeons to loaf on the job just like humans. How? Simply lower their rate of “pay.” 6 The “Right” Pay It would appear that rules of incentives would lead managers everywhere to make sure that workers have the right incentives by always tying pay to some measure of performance. Clearly, the lone worker in a single proprietorship has the “right” incentive. His or her reward is the same as the reward for the whole firm. The full cost 5 See Richard B. McKenzie and Gordon Tullock, The New World of Economics (New York: McGraw-Hill, 1994), chap. 4. 6 Ibid. Chapter 15 Competitive and Monopsonistic Labor Markets 19 of any shirking is borne by the worker/owner. However, such a congruence between the rewards of the owners and workers is nowhere else duplicated. There are always “gaps” between the goals of the owners and the workers, and the greater the number of workers, typically, the greater the gap in incentives. In very large firms, workers have greatly impaired incentives to pursue the goals of the owners. The workers are far removed from the owners by layers of bureaucracy, communications on firm goals are often imperfect, and each worker at the bottom of the firm pyramid can reason that his or her contributions to firm revenues and goals, or the lack of them, can easily go undetected. A reoccurring theme of this book is that when monitoring is difficult, one can expect many workers to exploit opportunities at their disposal. And the opportunities taken can result in substantial losses in worker output. Management specialist Edward Lawler reported that during a strike at a manufacturing firm, a secretary was asked to take over a factory job and was paid on a piece rate basis. Despite no previous experience, within days she was turning out 375 percent more output than the normal worker who had spent 10 years on the job and was constantly complaining that the work standards were too demanding. 7 Obviously, the striking workers had been doing something other than working on the job. How can managers improve incentives, reduce shirking, and increase worker productivity? At the turn of the century, the great management guru Frederick Taylor strongly recommended piece-rate pay as a means of partially solving what he termed the “labor problem,” but he was largely ignored in his own time by both management and labor, and for the good reasons discussed in this chapter. 8 There is a multitude of ways of getting workers to perform that don’t involve money pay, and many of the ways are studied in disciplines like organizational behavior, which draws on the principles of psychology. Managers do need to think about patting workers on the back once in a while, clearly defining corporate goals, communicating goals in a clear and forceful manner, and exerting leadership. Southwest Airlines, one of the more aggressive, cost-conscious, and profitable airlines, motivates its workers by creating what one analyst called a “community . . . resembling a 17th century New England town more than a 20th century corporation.” The airline bonds its workers with such shared values as integrity, trust, and altruism. 9 But, a company with a productive corporate culture is almost surely a company with strong incentives in place to reward productivity. Without taking anything away from the corporate culture at Southwest Airlines, it should, however, be pointed out that one reason it has the lowest cost in the business is that its pilots and flight attendants are paid by the trip. This, along with a strong corporate culture, explains why Southwest's pilots and flight attendants hustle when the planes are on the ground. Indeed, Southwest has the shortest turn-around time in the industry. It pays the crews to do what they can to get 7 Edward E. Lawler, III, Strategic Pay: Aligning Organizational Strategies and Pay Systems (San Francisco: Jossey-Bass Publishers, 1990), p. 58. 8 Frederick W. Taylor, “A Piece Rate System,” American Society of Mechanical Engineers Transactions, vol. 16 (1895), pp. 856-893. 9 William G. Lee, “The New Corporate Republics,” Wall Street Journal (September 26, 1994), p. 12. Chapter 15 Competitive and Monopsonistic Labor Markets 20 their planes back in the air. 10 Motorola organizes its workers into teams and allows them to hire and fire their cohorts, determine training procedures, and set schedules. Federal Express’ corporate culture includes giving workers the right to evaluate their bosses and to appeal their own evaluations all the way to the chairman. But, still, it’s understandable why Federal Express delivery people move at least twice as fast as U.S. postal workers: FedEx workers have incentives to do so, whereas postal workers do not. 11 We don’t want to criticize the traditional, non-incentive methods for getting things done in business. Indeed, we have taken up the issue of “teams” discussed much earlier in the book, and the importance of virtues like “trust” will be raised before we conclude this chapter. At the same time, we wish to stress a fairly general and straightforward rule for organizing much production: Give workers a direct detectable stake in firm revenues or profits in order to raise revenues and profits. Pay for performance. One means of doing that is to make workers’ pay conditional on their output: the greater the output from each worker, the greater the individual worker’s pay. Ideally, we should dispense with salaries, which are paid by the week or year, and always pay by the “piece” -- or “piece rate.” Many firms -- for example, hosiery mills -- do pay piece rate; they pay by the number of socks completed (or even the number of toes closed). Piece rate can be expected to raise wages of covered workers for two reasons: First, the incentives can be expected to induce workers to work harder for more minutes of each hour and for more hours during the workday. Second, the piece-rate workers will be asked to assume some of the risk of production, which is influenced by factors beyond the workers’ control. For example, how much each worker produces will be determined by what the employer does to provide workers with a productive work environment and what other workers are willing to do. So, piece-rate workers can be expected to demand and receive a risk premium in their paychecks. One study has, in fact, shown that a significant majority of workers covered under “output-related contracts” in the nonferrous foundries industry earn between 5 percent and 12 percent, depending on the occupation, more than their counterparts who are paid strictly by their time at work. Of that pay differential, about a fifth has been attributable to risk bearing by workers, which means that a substantial share of the pay advantage for incentive workers is attributable to the greater effort expended by the covered workers. 12 However, such a rule – paying by the piece -- is hardly universally adopted. Indeed, piece-rate workers probably make up a minor portion of the total work force (we have not been able to precisely determine how prevalent piece-pay systems are). Many automobile salespeople, of course, are paid by the number of cars sold. Many lawyers are paid by the number of hours billed (and presumably services provided). Musicians are often paid by the number of concerts played. 10 Howard Banks, "A Sixties Industry in a Nineties Economy," Forbes, May 9, 1994: pp. 107-112. 11 FedEx actually tracks its delivery people on their routes, and the workers understand that their pay is tied to how cost-effective they are in their deliveries. Postal workers understand that they are not being so carefully monitored, mainly because there are no stockholders who can claim the profits from a speed-up in their work. 12 Tron Petersen, “Reward Systems and the Distribution of Wages,” Journal of Law, Economics, and Organizations, vol. 7 (special issue), 1991, pp. 130-158. Chapter 15 Competitive and Monopsonistic Labor Markets 21 But there are relatively few workers in manufacturing and service industries whose pay is directly tied to each item or service produced. Professors are not paid by the number of students they teach. Office workers are not paid by the number of forms processed or memos sent. Fast food workers are not paid by the number of burgers flipped. Most people’s pay is, for the most part, directly and explicitly tied to time on the job. They are generally paid by the hour or month or even year. Admittedly, the pay of most workers has some indirect and implicit connection to production. Many workers know that if they don’t eventually add more to the revenues of their companies than they take in pay, their jobs will be in considerable jeopardy. The question we find interesting is why “piece rate” -- or “pay for performance” -- is not a more widely employed pay system, given the positive incentives it potentially provides. Many explanations for the absence of a piece-rate pay system are obvious and widely recognized. 13 The output of many workers cannot be reduced to “pieces.” In such cases, no one should expect pay to be tied to that which cannot be measured with tolerable objectivity. Our work as university professors is hard to define and measure. In fact, observers might find it hard to determine when we are working, given that while at work, we may be doing nothing more than staring at a computer screen or talking with students in the hallways. Measuring the “pieces” of what secretaries and executives do is equally, if not more, difficult. If a measure of “output” is defined when the assigned tasks are complex, the measure will not likely be all-inclusive. Some dimensions of the assigned tasks will not be measured, which means that workers’ incentives may be grossly distorted. They may work only to do those things that are defined and measured -- and related to pay -- at the expense of other parts of their assignments. If workers are paid by the number of parts produced, with the quality of individual parts not considered, some workers could be expected to sacrifice quality in order to increase their production count. If professors were paid by the number of students in their classes, you can bet they would spend less time at research and in committee meetings (which would not be all bad). If middle managers were paid solely by units produced, they would produce a lot of units with little attention to costs. There is an old story from the days before the fall of communism in the former Soviet Union. According to the story, the managers of a shoe factory were given production quotas for the number of shoes they had to make, and they were paid according to how much they exceeded their quota. What did they do? They produced lots of shoes, but only left ones! Much work is the product of “teams,” or groups of workers, extending, at times, to the entire plant or office. Pay is often not related to output because it may be difficult to determine which individuals are responsible for the “pieces” that are produced. 13 For a review of arguments offered by psychologists against incentive pay plans, see Alfie Kohn, “Why Incentive Plans Cannot Work,” Harvard Business Review September-October 1993, pp. 54-63. Kohn sums up his argument, “Do rewards motivate people? Absolutely. They motivate people to get rewards” (p. 62), suggesting that the goals of the firm might not be achieved in the process, given the complexity of the production process and the margins workers can exploit. Kohn’s criticisms are reviewed and critiqued in the last chapter of this book. . (for example, sweeping a room or picking up trash), they will perform them with greater regularity. 5 Even pigeons, well known for having the lowest form. is therefore $24,000 (column 4): $22,000 for his services plus the $2,000 raise that must be given to the first worker. TABLE 15.2 Market Demand for Tomatoes