Why Monopsony Employer Power Is Virtually Irrelevant to the Impact of a Higher Minimum Wage on Employment

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 most affected by the minimum wage.  After all, demand curves slope downwards so that an increase in price of labor should result in a decrease in demand for that labor.

There is a great body of work on employment effects of minimum wage, and surveying this corpus is beyond the scope of this paper, but a good starting point might be the recent detailed and careful study by Jardim et. al. of the University of Washington, which analyzed the employment effects of the increase in minimum wages in Seattle from $11 to $13.  They found that while average hourly wages for lower-paid workers went up by 3%, the total hours worked went down by 9%, resulting in a net reduction in total wages for lower-paid, lower-skill workers at the same time that other sectors of the Seattle economy were booming.

Monopsony Power & The Labor Market

Supporters of the minimum wage, however, argue that these employment effects are exaggerated, because employers have something called monopsony power when hiring low-skill workers.  What a monopoly is to customers – it limits choices – a monopsony does to suppliers, in this case the suppliers of labor.  The argument 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, gaining the company added savings that increase its profits.  Under this theory, minimum wage laws help to offset this power imbalance and force companies to disgorge some of their excess profits in favor of higher wages.  If this assumption is true, then demand for labor would not be reduced due to a minimum wage increase because, prior to the wage increase, companies were paying less than they were willing to pay and thus are still willing to continue to pay the wages at the new higher rates.

While economists argue about this monopsony theory, my intuition as an employer makes me skeptical.  However, rather than argue about whether my little company that scrambles to staff itself every year somehow wields excess power in the labor markets, I am going to argue that the existence of monopsony power is irrelevant to the employment effects of a minimum wage increase: Even if companies are able to pay workers less than they might via such bargaining power imbalances, whatever gains they reap from workers will end 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? 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 of the forces 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 to some minimum level.

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 probably averaging around 5% of revenues (for comparison, last year Microsoft had a pre-tax net income margin of over 23%).

If there were some margin windfall to be obtained from labor market power that allowed a company to hire people for far less than their labor was worth to it, and thus earn well above this lowest tolerable margin,  new companies would try to enter the market, probably by lowering prices to consumers using some of that labor premium.  Eventually, even if the monopsony premium exists, it is given away to consumers in the form of lower prices.  If the wholesale price of gasoline suddenly falls sharply, gasoline retailers don't get to earn a much higher margin, at least not for very long.  Competition quickly causes the retailer's lowered costs to be passed on to consumers in the form of lower retail prices.  The same goes for any lowering of labor costs due to monopsony power  -- if such a windfall exists, it is quickly passed on to consumers.

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 interested in the business. The much more likely responses will be:

  • Raising prices to cover the increased costs. While competitors that are subject to the same laws will likely have similar increases, the increase may not be acceptable to consumers and almost certainly will result in some loss in unit sales.
  • Reducing employment. There are a variety of ways in which a minimum wage increase could result in employment losses.  A company might raise its prices to compensate for higher costs, only to find its unit volumes falling, necessitating a layoff in staff.  Or the staff reductions may also be due to targeted technology investments, as increases in labor costs also increase the returns to investments in capital equipment that substitutes for labor
  • Exiting one or more businesses and laying everyone off. This may take the form of exiting a few selected low-margin lines of business, or liquidation of the entire company if the business is no longer viable with the higher labor costs.

A Real-World Minimum Wage Increase Example

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 places like Seattle and 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 supposedly 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 given both the minimum wage increase and the 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.

  • jon49

    A restaurant I frequent here in Prescott had to close during lunch time in the winter in order to have enough revenue flow. Not sure if they are doing it again this year. The waitress said she would prefer lower wages and not have to work evenings rather than have a higher wage. Obviously the government doesn't care about her preferences, neither do AZ voters apparently.

  • Dan Wendlick

    I'm waiting for the return of the Automat. If anything, card validation technology should make them more convenient than the previous incarnations. Just expect your food in a paper wrapper instead of on a plate.

  • morganovich

    the other key issue here is the rate of marginal substitution of capital for labor. if the price of labor rises 50%, you add capital at the margin. a productivity enhancing tool or burger cooking machine that did not make sense at $10 is not the cheaper option at $15. so you fire 4 employees, hire one new one to use and maintain the machine, and a new equilibrium is reached. that employee likely has more skills and education. the 4 who got laid off are now unemployable. or, even if one employee gets kept on at higher wages, 3 others don't.

    there are some jobs (like cleaning bathrooms) where this is hard, but many others (like doing check in, order taking, reservations, and making things) where it's REALLY easy. any current market state is an equilibrium between capital costs and labor costs. jack up labor costs, and it ALWAYS becomes more efficient to use more capital and less labor at the margin.

  • anon

    There is a literature backing this up; in the book Time on the Cross the authors cite research showing that slave labor on plantations in the antebellum South was in fact both lower cost and higher productivity than free labor, leaving free labor plantations unable to compete in the market.

    The research further showed that the economic surplus extracted from this windfall ended up going to the purchasers of clothing rather than to slaveholders.

  • Mike Powers

    The problem here is that people refuse--*REFUSE*--to believe that businesses might make only 5% profit.

    Well, or there's the one Champion Of Intellectual Tolerance who said that if a business couldn't handle a 25% increase in the cost of wages then it *deserved* to go out of business, because they had all along been "exploiting workers" by underpaying them. As in, the minimum wage should ALWAYS have been $15.

  • Not Sure

    There are a significant number of people who believe that "business owner = rich" (read: Scrooge McDuck rolling around in gold coins in his vault). Nothing you say will convince them otherwise.

  • Peabody

    It's a shame that many folks don't want to have these types of discussions and try responding with logic, reasoning, and maybe sprinkle in a few facts or data points. It's much easier to just say that business owners are racist against poor minorities.

  • Joe - the non economist

    "They found that while average hourly wages for lower-paid workers went up by 3%, the total hours worked went down by 9%, resulting in a net reduction in total wages for lower-paid,"

    This has been true in virtually every study (not withstanding the Card Krueger study).

    Progressives like to claim the effect on the unemployment rate is neglible or even positive, demonstrating that the law of supply and demand doesnt apply to the minimum wage - Paul Krugman frequently makes this claim. However, the reduction in hours when the minimum wage is increased proves the law of supply and demand is spot on.

  • Joe - the non economist

    Scrooge McD is made of the corporate stores, and the corporate organization which makes its money on the franchise fees and the rents paid by the franchisees. McD corp owns the real estate at most of the franchise locations.

    The profit margins at the Franchise stores is much closer to the 5-10% range, ie tight margins

  • cc

    Another response by the business is to reduce perks: McD's offers meals, education, flexible schedules to employees. Some companies offer uniforms. Easy to cut back on these and some companies have already.
    On of the most absurd aspects of the monopsony argument is that low income/low skill workers actually have the highest mobility. If you are a retail clerk, you can walk away and get another job the next day. Same for a secretary. A mid-level professional not so much.
    There is actually one population that is trapped and is subject to a type of monopsony power: older workers. If you are near being vested in a pension plan you don't dare leave or you lose the whole thing. You are trapped. Such pensions are perhaps even designed to encourage "employee loyalty" haha. Likewise, if you are over 50 the rampant age discrimination by business means that the difficulty of changing jobs rises rapidly with age. Again you are trapped. In this situation you do not have much of a bargaining chip against the company.

  • cc

    There exists a self-cleaning bathroom design for places like gas stations. When you turn it on it locks the door and hoses itself down. Cost is the only issue. There exists a brick paving machine that lays down brick sidewalks. Cost again. Some university libraries have created automated systems to retrieve books. You key in your request and the machine goes and gets it. No more people to restock the shelves.

  • cc

    What they often ignore is that the people who are most hurt by a minimum wage hike are black teens. Their unemployment was shown in one study to go from 10% to 25% due to a wage hike.

  • cc

    It is amusing that the same people who believe this don't go out and start their own business and make those big bucks.

  • Joe - the non economist

    Good point - numerous progressive organizations have touted studies showing no change in employment rates as proof that minimum wage increases dont have a negative effect. Surprisingly, most of those progressive studies promoting increases in minimum wage even acknowledge the negative effect on black teens - albeit in a footnote in many cases, but at least they acknowledge it.

  • irandom419

    I find they dismiss any automation as just part of a trend, but the pace is the key issue.

    "In the long-term, a 50% increase in wage rates will suddenly make a lot of labor-saving capital investments more viable."

  • irandom419

    I find him stupid for not investing that money and instead using it like a swimming pool. I mean at least in the long term, who wouldn't want to roll around gold for a little while. I'll ignore the gold bug inflation argument.