Why Monopsony Power May Be Irrelevant to the Effects of A Minimum Wage Increase

Most of us who took Econ 101 would expect that an increase in the minimum wage would increase unemployment, at least among low-skilled and younger workers.  After all, demand curves slope downards so that an increase in price of labor should result in a decrease in demand for that labor.

Supporters of the minimum wage, however, argue that employers have monopsony power when hiring low-skill workers. What they mean by this is that due to a bargaining power imbalance, employers can hire workers for less than they would be willing to pay in a truly competitive market.  As the theory goes, this in turn creates an additional consumer surplus for employers, which manifests itself as higher profits.  A minimum wage increase would thus reduce this surplus but not effect employment because companies before the new minimum wage were paying less than they were willing to pay.  Thus minimum wage supporters argue that higher wages mandated by minimum wage laws will be paid out of these excess profits, and not result in higher prices or less employment.

My understanding (and I am not an economist) is that the evidence for monopsony power in hiring low-skill workers is weak or at best limited to niche circumstances.  However, I am going to argue that it does not matter. Even if companies are able to pay workers less than they might via such monopsony power, whatever gains they reap from workers ends up in consumer hands.  As a result, minimum wage increases still must result either in employment reductions or consumer price increases or more likely both.

Why Monopsony Power May Not Matter

Why? Well, we need to back up and do a bit of business theory.  Just as macroeconomics (all the way back to Adam Smith) spends a lot of time thinking about why some countries are rich and some are poor, business theory spends a lot of time trying to figure out why some firms are profitable and some are not.  One of the seminal works in this area was Michael Porter's Five Forces model, where he outlines five characteristics of markets and firms that tend to drive profitability.  We won't go into them all, but the most important for us (and likely for Porter) is the threat of new entrants -- how easy or hard is it for new firms to enter the marketplace and begin competing against an incumbent firm.  If new companies can enter into competition easily, a profitable firm will simply attract new competitors, and keep attracting them until the returns in that market are competed down.

So let's consider a company paying minimum wage to most of its employees.  At least at current minimum wage levels, minimum wage employees will likely be in low-skill positions, ones that require little beyond a high school education.  Almost by definition, firms that depend on low-skill workers to deliver their product or service have difficulty establishing barriers to competition. One can’t be doing anything particularly tricky or hard to copy relying on workers with limited skills. As soon as one firm demonstrates there is money to be made using low-skill workers in a certain way, it is far too easy to copy that model.  As a result, most businesses that hire low-skill workers will have had their margins competed down to the lowest tolerable level.  Firms that rely mainly on low-skill workers almost all have single digit profit margins (net income divided by revenues) -- for comparison, last year Microsoft had a pre-tax net income margin of over 23%.

As a result, the least likely response to increasing labor costs due to regulation is that such costs will be offset out of profits, because for most of these firms profits have already been competed down to the minimum necessary to cover capital investment and the minimum returns to keep owners invested in the business. The much more likely responses will be

  1. Raising prices to cover the increased costs. This approach may be viable competitively, as most competitors will be facing the same legislated cost pressures, but may not be acceptable to consumers
  2. Reducing employment. This may take the form of stealth price increases (e.g. reduction in service levels for the same price) or be due to a reduction in volumes caused by price increases. It may also be due to targeted technology investments, as increases in labor costs also increase the returns to capital equipment that substitutes for labor
  3. Exiting one or more businesses and laying everyone off. This may take the form of targeted exits from low-margin lines of business, or liquidation of the entire company if the business Is no longer viable with the higher labor costs.

An Example

When I discuss this with folks, they will say that the increase could still come out of profitability -- a 5% margin could be reduced to 3% say.  When I get comments like this, it makes me realize that people don't understand the basic economics of a service firm, so a concrete example should help. Imagine a service business that relies mainly on minimum wage employees in which wages and other labor related costs (payroll taxes, workers compensation, etc) constitute about 50% of the company’s revenues. Imagine another 45% of company revenues going towards covering fixed costs, leaving 5% of revenues as profit.  This is a very typical cost breakdown, and in fact is close to that of my own business.  The 5% profit margin is likely the minimum required to support capital spending and to keep the owners of the company interested in retaining their investment in this business.

Now, imagine that the required minimum wage rises from $10 to $15 (exactly the increase we are in the middle of in California).  This will, all things equal, increase our example company's total wage bill by 50%. With the higher minimum wage, the company will be paying not 50% but 75% of its revenues to wages. Fixed costs will still be 45% of revenues, so now profits have shifted from 5% of revenues to a loss of 20% of revenues. This is why I tell folks the math of absorbing the wage increase in profits is often not even close.  Even if the company were to choose to become a non-profit charity outfit and work for no profit, barely a fifth of this minimum wage increase in this case could be absorbed.  Something else has to give -- it is simply math.

The absolute best case scenario for the business is that it can raise its prices 25% without any loss in volume. With this price increase, it will return to the same, minimum acceptable profit it was making before the regulation changed (profit in this case in absolute dollars -- the actual profit margin will be lowered to 4%). But note that this is a huge price increase. It is likely that some customers will stop buying, or buy less, at the new higher prices. If we assume the company loses 1% of unit volume for every 2% price increase, we find that the company now will have to raise prices 36% to stay even both of the minimum wage increase and lost volume. Under this scenario, the company would lose 18% of its unit sales and is assumed to reduce employee hours by the same amount.  In the short term, just for the company to survive, this minimum wage increase leads to a substantial price increase and a layoff of nearly 20% of the workers.   Of course, in real life there are other choices.  For example, rather than raise prices this much, companies may execute stealth price increases by laying off workers and reducing service levels for the same price (e.g. cleaning the bathroom less frequently in a restaurant).  In the long-term, a 50% increase in wage rates will suddenly make a lot of labor-saving capital investments more viable, and companies will likely substitute capital for labor, reducing employment even further but keeping prices more stable for consumers.

As you can see, in our example we don’t need to know anything about bargaining power and the fairness of wages. Simple math tells us that the typical low-margin service business that employs low-skill workers is going to have to respond with a combination of price increases and job reductions.

How My Company Has Responded

Just to put a bit more flesh on this, I will give a real example from my own company.  My company operates public recreation facilities, mainly campgrounds, under bid contracts.  To understand our response to rising minimum wage, you need to understand some background:

  • In bidding these, we bid both the camping fee we will charge to customers as well as the rent we will pay to the government for the concession.  Given the weights the government uses in the bid process, keeping customer price low is more important than the rent we pay, so in most cases the prices we charge customers are well below the private market rate for similar campgrounds.
  • We have limited ability to further increase productivity, in part because our ability to invest in these campgrounds in limited.
  • Because we have many contracts across the country, our reputation is important and so we seldom will entertain reductions in service, such as cleaning frequency
  • Labor and labor-related costs are about 50% of revenues, and most employees are paid minimum wage.  Profit margins hover around 5% of revenues

One of the states we operate in is California.  We are in the midst of a minimum wage increase there from $8 an hour several years ago to $15 several years hence, or an increase of 87.5%.  Basically we have had two responses:

  • In places where we are under the market price, we have been able to raise prices without a lot of drop in volume.  But this means that our camping rates in some locations have risen from $18 to a future $26 a night, an enormous increase in just a few years.
  • In places where we did not think the market would bear such a rate increase, or where our contract did not allow such a rate increase, we closed our operation.  In fact, we have exited about half our business in California (while simultaneously growing it aggressively in states like Tennessee).  In all cases this has resulted in a loss of employment -- either the location was never reopened by anyone else, or else it was reopened by a competitor with different reputational concerns who staffed the location with far fewer employees.
  • J_W_W

    A fantastic and realistic analysis.

    I believe Bernie Sanders and all of his followers are completely incapable of following this logic. In fact I doubt a Bernie supporter would be able to even read it all the way through without throwing up their hands screaming about "evil corporations".

  • Peabody

    Greedy Corporations!
    Income Inequality!
    Demand "Free" Stuff!
    So don't come at me with your math and logic, bro.

  • Hell_is_Sartre

    Scenario A:

    Assume I have something you want and am willing to sell to you. You will not pay more than $30 and I will not accept less than $20.

    Q: At what price will the exchange take place?
    A: Who the heck knows? All we can say is that the trade will take place somewhere between $20 and $30.

    Scenario B:

    Assume I have something you want and am willing to sell to you. You will not pay more than $20 and I will not accept less than $30.

    Q: At what price will the exchange take place?
    A: Trick Question.

    Apologists for the minimum always assume Scenario A. Scenario B to them either does not exist (as a matter of positive economics) or does not matter (as a matter of normative economics).

  • cc

    Let us say that you can hire workers for less than you would be willing to pay due to monopsony power. If the minimum wage goes up, your payroll costs still go up, so even if you "can" absorb the costs, your profitability still goes down. Less profit means less competitive on the global or national market and less able to invest in new stores/plants/equipment. This is what is idiotic about these claims of monopsony power.

  • cc

    Note that Bernie's wife drove a college into bankruptcy and is now being investigated for fraud. Perhaps Bernie is unaware of his wife's activities. More likely it is just "bad luck" that always follows socialists everywhere they go.

  • kevinsdick

    As Don Boudreaux reminds us, from a formal perspective, an employer must have _both_ monopoly and monopsony power for minimum wage not to decrease employment.

    http://cafehayek.com/2016/11/41632.html

  • cc

    Some further considerations. One of the things a company must plan for is unforseen circumstances. Let us say a big snowstorm or hurricane or labor strike or the city tears up your street or economic downturn. If your profit margin is 5% you might survive but if it is 2% you can't.
    Another thing that happens is that low wage firms often offer perks. McDonald's used to give free lunch (don't know about now). Some offer flexible schedules which are great for moms or students. If the business is under pressure, these may be dropped.
    Finally, it is good to remember WHY the minimum wage was first introduced many years ago: to price undesirable minorities out of work to protect whites (yes, by the democrats). They understood the cost curve back then!!

  • TruthisaPeskyThing

    Warren made reference to evidence . . . and I believe he meant from a scholarly point of view. There have been hundreds of studies that show decrease in employment -- especially for the poor -- that follows increases in minimum wage laws. Several years ago, one study in New Jersey on fast food establishment came to a contradictory conclusion, and that study received much interest -- and much citation by liberals. However, that study was based on telephone calls seeking data that was not verified. The same establishments were contacted by skeptics and actual payroll data was obtained. The actual payroll showed the consistent conclusion: increases in minimum wages decrease employment.

  • irandom419

    It is the perfect storm, ignorance plus 10 from public schools that discourage anyone with any ability from teaching. So that no one can comprehend the simplest math. People like Bernie Sanders who hate business, whip those feeling left out into a frenzy.

    Aside from the weird business owners who sound happy that they can offer more to employees now, the best argument I heard was the shear number of hours that the minimum wage folks work. You multiple that increase and that number gets real noticeable.

  • jon49

    A restaurant I go to in Prescott had to close for lunch for 3 months until the busier summer months. The sandwich was also smaller. The waitress said she told her employer that she prefers working in the afternoon, not in the evening even though she makes more money in the evening. Not sure if the price increased or not. I hadn't been there for a couple years (had to work in Phoenix for 1 1/2 years until I got my remote job and could move back to the Prescott area).

  • May Xu

    One of the points that is not clear in his book is this: the right to a job.

    In a free market, there is no right to a job. There is no right to work. There is no right to another person's wallet. There is no right to tell somebody else what the terms of exchange must be.

    COMPETITION

    Employers compete against employers. Employers also compete against would-be employers. Employees compete against employees. Employees also compete against would-be employees. Out of this competition come jobs.

    This seemingly simple concept is not widely understood, but it is the essence of free market competition. It is not understood by Keynesians, socialists, Marxists, and welfare state advocates. It is also not understood by most free market defenders.

    http://www.garynorth.com/public/13684.cfm

    Minimum Wage Laws
    These establish price floors. Price floors create gluts -- in this case, unemployed workers.

    http://www.garynorth.com/public/13606.cfm

    The central law of economic theory is this one: "As the price increases, the quantity demanded falls." This is known as the law of demand.

    If this is not true, then all economic theory is wrong. It is not just the Austrian school that is wrong. The Chicago school is wrong. Public choice theory is wrong. Every economics textbook is wrong. If, in the face of rising prices and costs, with other things remaining equal, there is not a decrease in the quantity demanded, then economic theory is wrong.

    http://www.garynorth.com/public/12010.cfm

  • JoseM

    Higher unemployment is a bit of a red herring, isn't it? Why is it a bad thing? What happens to the newly unemployed? Do they go get some training and become more productive? Without a complete picture, your examples are misleading. Could be higher minimum wages' main result is to increase productivity of the labor force over the long run, and the temporary unemployment, while disconcerting, is a means to doing this.
    Second obvious point: Higher minimum wage costs are split between lower profit and higher consumer prices. What's the average over all firms? 50-50? By only using 0-100 examples you mislead. In a 50-50 split, lower minimum wage is a transfer of money from the wealthy (owners of businesses) to the non-wealthy (minimum wage employees). It is just one more way of doing this. It could be done by taxing the wealthy and giving negative tax to the non-wealthy. Just one more way of coping with the ever-increasing disparity of income, which is a topic in itself. Which way is better? I don't know.

  • To your second paragraph -- what does Income Inequality have to do with any of this? Seriously.

    To your first paragraph -- lower employment IS an important thing. Raising the minimum wage to $15 doesn't help those who are now making Zero. And there are indeed fewer jobs to be had, no matter how much training you give people.

    One more thing -- raising someone's wage does NOT raise their productivity. What raising a wage DOES do is attract a larger pool of potential employees, such that you have a greater chance of hiring someone with the experience and training to be more productive. That is because the incentive for them to do _______ is now great enough to satisfy their sense of value for their time.

    That does not mean that bumping Johnson from $8 to $15 is going to make Johnson that much better a worker. It means that Johnson (with no previous skill or job history) is going to be passed over in favor of Bennett, who has experience. From the standpoint of the employer, you can get a better employee by paying more -- but that doesn't mean that it fits your business model, it does NOT mean that the work being done is worth that expense, and it send a nice hearty f*** you to people like Johnson, who are now sitting on their butts at home.

    Do you know where people get their skills? On the job. No external training program is going to come close.

    And it speaks greatly to your argument that you claim to be doing things "for the working man," but in reality you are trying to justify it through the lens of the employer. You would do well to save your consoling words for the people who become permanently locked out of the job market thanks to policies for which you advocate.

  • Zachriel

    May Xu: The central law of economic theory is this one: "As the price increases,
    the quantity demanded falls." This is known as the law of demand.

    Veblen goods are one of several exceptions to the law of demand.

  • Zachriel

    Most every government regulation bends the supply-demand curve. That doesn't mean regulations should be abandoned. For instance, requiring independent inspections to make sure that electrical wires hidden in walls of new homes is probably a prudent course of action. Such regulations increase the cost of homes, and that means some people are not able to afford a home. Nevertheless, most people reasonably believe that the overall benefit to society is worth the cost. Such regulations prevent fires that could kill the inhabitants, or in crowded urban areas, fires that could result in a conflagration. Of course, this sort of policy then invites help for those made homeless by the policy.

  • CC

    Veblen goods only appear to violate the law of demand. Veblen goods like luxury cars are in fact expensive to make and market. Being a status symbol only gives so much extra boost. The success of a luxury product does in fact inspire competitors and if there are too many a glut can be created which drives down the price. Notice what happens to the sales of luxury items like fine art during a recession. Veblen goods also inspire knock-offs such as fake jewelry or fake purses, many of which can fool most people.

  • CC

    One of the clearest types of evidence for the pernicious effects of raising the minimum wage is the effect on minority youth. One can also look at unemployment rates in Europe for evidence.
    One of the reasons that small increases in the minimum wage don't appear to have a negative effect is that there is always a slow general rise in wages due to prosperity and inflation. If the minimum wage rise is not faster than this background change it will appear to not be a problem.

  • joe

    You are probably refering to the Card Krueger Study from the 1992 increase in NJ minimum wage. The study showed approx 7% increase in employment. That result being quite illogical based on every concept of economic theory. The authors, instead of cross checking the data and analysis for possible errors, simply concluded that the change in minimum wage had no effect on employment. (the study did show that hours worked does decrease relatively proprotionately with increase in minimum wage - basically proving the basic law of supply and demand)

    This is the study that Krugman repetitively cites as proof that changes in minimum wage have little or no effect on employment.
    Every person with minimum level of knowledge in this arena knows the Card Krueger study is deeply flawed.

    Krugman demonstrates his deep intellectual dishonesty by repetitively citing a study he knows if deeply flawed.

  • Joe - the economist

    Having the marinally employed and the unemployed pay tuition into the government educational complex (schools ) to acquire job skills is GOOD

    Private businesses paying the marginally employed and formerly umemployed insufficient amounts to acquire actual job skills is BAD

  • An Inquirer

    "lower minimum wage is a transfer of money from the wealthy (owners of businesses) to the non-wealthy (minimum wage employees)."
    it is well recognized that those who keep their jobs after increases in minimum wages are better off. However, we also know that these people (who keep their jobs) are mostly teens from affluent suburban families. Yes, you should consider that reality -- the primary beneficiaries of increases in minimum wages are affluent suburban families.
    The poor are hurt by increases in minimum wage by a number of ways. First is the increase in their unemployment. Second is another barrier that stands in the way of getting their first job. Third is increased incentive to drop of out school which increases the probability of low-term poverty. Fourth is encouragement to illegal immigration. And the list goes on.
    The very people who we want to help -- the working poor trying to support a family are the very ones who are hurt by minimum wage laws. THERE IS A BETTER WAY. The better way comes from Nixon and Reagan. That way is the Earned Income Credit. If you are a parent with children and not making much money at your job, the Earned Income Credit gives you money for your efforts. It is a great way to target those whom we want to help.

  • Zachriel

    CC: The success of a luxury product does in fact inspire competitors and if there are too many a glut can be created which drives down the price.

    There are those who wear a Rolex®. And there are pretenders who buy cheap knock-offs. A Rolex is a veblen good. It denotes status, not the time of day.

  • Heresiarch

    Fifth is the fact that people working minimum wage overwhelmingly serve other poor and almost-poor people, so that when prices go up it hurts them-- and they're much more likely to go without the service rather than to pay the increased price.

  • Heresiarch

    Oh, good-- no one has quoted Henry Ford yet, so I get to.

    “It is not the employer who pays the wages. Employers only handle the money. It is the customers who pay the wages.”

  • TruthisaPeskyThing

    Heresiarch
    That is a fair point. It is doubtful that the life of Bill Gates is going to be disrupted by increase in minimum wage. But the life of many poor will be because of increased cost of their purchases -- and/or diminished quality / service as businesses adjust their costs and business models to provide low-cost goods and services.
    I have a brother who is an employer -- he provides jobs! He has told me that the financial status of his employees will not be an issue to them: he will take care of them if they prove that they provide value to the organization. But the issue is whether somebody can get hired by him in the first place, because if a person does not get hired, then that person cannot prove he or she is adding value to the organization. At $8/hour, he will take a chance with someone who does not have a proven track record, but at $15/hour, he will hire only those with a proven track record. He will leave a position unfilled if no person with a proven track record is available.

  • Heresiarch

    Yes, it seems like part of the problem for the poor is that they've lost faith in the idea of a reputation and track record, so they don't bother having a resume. The same kind of dynamic appears with credit scores.