Monopoly Power in Input Markets Chapter 17

Introduction As a result of their monopoly power in input market (called monopsony power) Factor markets diverge from perfectly competitive assumption developed in Chapter 16 In an input market, monopsony, a single buyer for an input, is the polar case of perfect competition An example is a mining firm in a company town If you will be employed in this town, you will work for the mine Other examples are Southern plantation prior to Civil War In agricultural regions, a single food processing plant dominating employment for many miles around A firm that is a major but not the sole employer is called an oligopsony Examples are a number of textile companies in a small town or a university in a college town Also possible for a supplier of input to possess monopoly power For example, in some labor markets a labor union may have monopoly power

Introduction Our aim in this chapter is to determine efficiency loss associated with monopoly and monopsony power in a factor market Must first determine firms’ input pricing and employment decisions under various assumptions Focus of this investigation is on labor market We derive a monopsony’s profit-maximizing wage rate and level of employment General condition that a firm equates its marginal revenue to marginal cost for profit maximization still holds However, in this case marginal revenue and marginal cost are measured as Additional worker hired rather than additional output produced

Introduction Illustrate inefficiency of monopsony pricing by deadweight loss in total surplus A monopoly in the supply of inputs is the same as a monopoly in the supply of output We investigate a monopoly facing a monopsony Called a bilateral monopoly We discuss labor unions as cartels With potential of exerting monopoly power, in terms of their objectives and effectiveness Similar to output-price discrimination, a monopsony may wage discriminate Rise of monopsony power directed toward labor in 19th century and emergence of labor unions to counter this power is an ongoing topic of research Applied economists working for monopsonies are constantly devising new approaches to determine factor supplier’s reservation price (wage) Economists for factor suppliers are always devising methods for determining demanders’ reservation price

Monopsony Wage and Employment Determination In 1998 Georgia’s construction industry employed over 346,000 workers and had revenues in excess of $26 billion However, there was a continual shortage of qualified labor State’s construction industry could have used an additional 6000 to 8000 workers each year Given this shortage, existing workers were benefiting from higher wages A skilled tradesperson earned between $15 to $16 per hour Construction companies were facing double-digit annual wage increases Such conditions are characteristic of firms with monopsony power in a labor market facing an upward-sloping supply curve for labor For a firm to hire an additional worker under such conditions, wage rate has to increase Not just for this additional worker but for all workers Marginal input cost, MIC, curve is upward sloping and lies above supply curve

Monopsony Wage and Employment Determination For example, given a linear inverse labor supply curve, firm’s average input cost, AIC, is AICL = w = a + bL, with b > 0 w/L = b > 0 For the firm to hire an additional worker, wages for all workers must increase by b If total input cost, TIC, is TICL = (AICL)L = aL + bL2 Marginal input cost is MICL = TICL/L = a + 2bL MICL/L = 2b > 0 For a linear supply curve, MIC curve is twice as steep as AIC curve Bisects this AIC curve and vertical axis Illustrated in Figure 17.1

Monopsony Wage and Employment Determination A monopsony who hires a relatively large share of available employees faces an upward-sloping average input cost curve (supply curve) for labor, the AICL curve AICL (wages) is a function of number of workers hired, w(L) Increasing number of workers requires increasing all wages, w(L)/ L > 0 Corresponds to moving to a higher point on AICL curve Monopsony will not only pay a higher wage to additional worker but also to those workers already employed Specifically, TICL = w(L)L

Monopsony Wage and Employment Determination Using product rule to take derivative with respect to L yields MICL = [w(L)L]/L = w + L(w/L) = AICL + L(w/L) Marginal input cost for labor (MICL) is equal to AICL plus an adjustment factor L(w/L) Adjustment factor accounts for having to pay a higher wage to those workers already employed Under perfect competition in factor market, adjustment factor is zero Marginal cost of hiring one more worker is market wage Firm takes wage rate as given For a firm with monopsony power, adjustment factor is positive Marginal input cost of hiring an additional worker (MICL) is greater than wage rate (AICL )

Monopsony Wage and Employment Determination If marginal unit (in this case MICL), is greater than average unit (AICL), average is rising Relationship between MICL and AICL is illustrated in Figure 17.1 AICL is rising, so adjustment is positive Results in MICL > AICL In terms of elasticity of supply, S = (LS/w)(w/LS), we represent MICL as MICL = wL/L = w + L(w/L) = w[1 + (1/S) = AICL[1 + (1/S)] When supply is perfectly elastic, supply curve is horizontal MICL = AICL (firm is a perfectly competitive employer of labor) In contrast, when a firm is facing an upward-sloping supply curve Potential for monopsony power exists with MICL > AICL

Figure 17.1 Monopsony power in the labor market resulting in MICL > AICL

Profit Maximizing Suppose a firm with monopsony power in both of its two variable inputs, L and K, is interested in maximizing profits Subject to a production function q = f(L, K) Forming the Lagrangian, we have

Profit Maximizing The F.O.C.s are

Profit Maximizing As developed in Chapter 12, MR = p + (p/q)q If there is perfect competition in output market, p/q = 0 and MR = p Otherwise, firm also has some monopoly power in its output market, so MR > p First F.O.C. indicates that MR = * Substituting MR = * into next two F.O.C.s yields conditions for profit maximization MICL = MRPL and MICK = MRPK As defined in Chapter 16, MR(MPL) = MRPL, marginal revenue product of labor Similarly, MR(MPK) = MRPK, marginal revenue product of capital

Profit Maximizing As indicated in Figure 17.2, F.O.C.s imply that a monopsony has restricted labor and decreased wages compared with perfectly competitive market solution Monopsony firm equates MICL to MRPL for determining profit-maximizing level of labor, LM Obtain wage rate necessary to acquire this level of labor by moving up to AICL curve and across A perfectly competitive market equilibrium corresponds to where AICL = MRPL Competitive-equilibrium input price and level of input are wC and LC, respectively Compared with a monopsony, LC > LM and wC > wM To keep profits up, a monopsony will keep wages down In case of monopsony power, MRPL curve is not labor demand curve of the firm As illustrated in Figure 17.2, if MRPL curve were the demand curve, at wM monopsony would be willing to hire L' workers, but instead it is only willing to hire LM A monopoly restricts output and increases output price A monopsony restricts input and decreases input price

Figure 17.2 Comparison of perfect competition and monopsony wage rate and labor employment

Inefficient Monopsony Market Monopsony’s profit-maximizing solution is to restrict number of workers and decrease wage rate compared with perfectly competitive market solution Results in an inefficient solution where w = AICL < MRPL MRP is additional revenue or benefit to society from hiring an additional worker w is cost of hiring this additional worker Benefits are greater than cost, so society would prefer firm to increase employment In contrast, perfectly competitive solution is w = MRPL Additional benefits just equal additional cost Can illustrate this inefficiency in a monopsony market by net loss in consumer surplus and economic rent

Inefficient Monopsony Market In a perfectly competitive input market, sum of consumer surplus and economic rent is maximized F.O.C. results in MRPL = AICL A perfectly competitive input market will result in MICL = AICL = MRPL Maximizes sum of consumer surplus and economic rent

Inefficient Monopsony Market Inefficiency is illustrated in Figure 17.2 Under perfect competition, consumer surplus is area wCAB and economic rent is area EwCB A monopsony restricts amount of input employed Results in input price falling to wM Consumer surplus increases to area wMACD, which captures some of the perfect-competition economic rent, area wMwCFD Measure of level of exploitation by monopsony Efficiency loss resulting from monopsony power is represented by deadweight loss Shaded area DCB In markets where firms are exploiting labor by exercising a great deal of monopsony power Poverty is not caused as a result of national resource scarcity but the rich exploiting the poor A firm with monopsony power in its input market reacts much the same as a firm with monopoly power in its output market In both cases, firm has control over its market By reacting to either consumer demand for a monopoly or input supply for a monopsony Both types of firms restrict market allocation compared with perfectly competitive solution

Lerner Index As with monopoly power, a Lerner Index exists for measuring degree of monopsony power Measures relative wedge between wages, w, and MRPL Specifically, given MICL = w[1 + (1/S)] At optimal level of profits MRPL = w[1 +(1/S)] Solving for 1/S yields a Lerner Index LI(MRPL – w)/w = 1/S Difference between MRPL and w provides a measure of monopsony power Specifically, it is percentage markdown due to monopsony power If there are few alternatives for employment, supply curve for a firm becomes more inelastic Wedge between MRPL and w increases, and LI increases, indicating a greater degree of monopsony power

Lerner Index Monopsony power is particularly prevalent where cost for workers to relocate or commute for alternative employment is high As these costs are reduced, monopsony power of firms declines For example, first the automobile and then the interstate highway system greatly increased mobility of workers Removing monopsony power of many company towns Regional public transit systems that allow inner-city workers to be employed outside the city decrease inner-city monopsony power of firms Internet is currently greatly reducing monopsony power of many firms By giving many people ability to work from home and thus enlarging employment opportunities

Table 17.1 Marginal Revenue Product, Salaries, and Lerner Index for …

Monopoly in the Supply of Inputs Suppliers of an input may form a cartel and exercise some degree of monopoly power Objective of this type of cartel will vary, depending on nature of input For example, labor unions may be more interested in Maximizing wages of current union membership or Increasing size of union Rather than maximizing union’s economic rent (equating marginal cost to marginal revenue) Generally assumed that a sole supplier of an input (other than labor) will attempt to maximize economic rent (profit) Supplier’s output is an input used by another firm Monopoly models for output and price determination discussed in Chapters 12 and 13 are applicable

Monopoly in the Supply of Inputs A monopoly will generally restrict output below and increase price above perfectly competitive equilibrium This same monopoly solution for a firm with monopoly power in the input market is illustrated in Figure 17.3 Input monopoly is facing market demand for its output Horizontal summation of all firms’ derived demand for output supplied by this monopoly For a given SMC curve, input monopoly will equate SMC to MR associated with this market demand and determine its profit-maximizing output, X* Firm will then determine price, v*, at which it can sell all of this output from market demand curve Input monopoly can practice price discrimination and any other (legal?) practices in an effort to enhance profit Similarly, if there are a number of suppliers of an input, various game-theory models may describe their strategic interactions

Figure 17.3 Monopoly in the input market

Bilateral Monopoly and Bargaining In 1981, after Professional Air Traffic Controllers Organization (PATCO) went on strike, President Reagan fired 11,000 controllers It was not until August 1993 that President Clinton signed an executive order lifting ban on rehiring of those controllers By 2002 only 800 of those controllers had been rehired Scenario is an example of a bilateral monopoly A monopoly supplier of an input (traffic controllers) sells its input (labor) to a monopsony buyer (FAA) A bilateral oligopoly, where a set of oligopoly firms supply to oligopsony firms can also exist Other examples of bilateral monopoly power are NFL players and owners U.S. Postal Service and National Postal Handlers Union A textile firm and Union of Needletrades, Industrial, and Textile Employees (UNITE)

Bilateral Monopoly and Bargaining A bureau and its government review group may be considered a bilateral monopoly A bureau is defined as A nonprofit organization that is financed by a periodic appropriation Employees do not appropriate any part of the difference between revenues and costs as personal income Bureau sells its service only to government Government buys this service only from bureau

Bilateral Monopoly and Bargaining Case of a bilateral monopoly for an input, X, is illustrated in Figure 17.4 Curve labeled XD is either VMPX or MRPX curve According to whether final output produced by this input is sold under conditions of perfect competition or monopoly MRPX curve represents how much monopsony is willing to pay per unit for a given level of input Directly corresponds to AR curve for monopoly Monopsony’s MRPX curve is monopoly’s AR curve Although a monopoly has no supply curve, if a monopoly were constrained to sell at competitive prices Upward-sloping portion of monopoly’s SMC curve above its SAVC would indicate amounts that would be supplied SMC curve then represents how much monopoly is willing to supply at a given wage Directly corresponds to AICX curve for monopsony

Figure 17.4 Bilateral monopoly

Bilateral Monopoly and Bargaining Monopsony solution is XM and vM Monopsony equates MRPX to MICX Ignoring monopsony power of buyer and considering only monopoly power of seller Monopoly’s profit-maximizing output and price are XU and vU Monopoly equates MR to SMC Buyer and seller are in general close to agreement on amount of input to hire Objective of both is to restrict output from perfectly competitive solution Equilibrium level of input is often the same or close Indicated in Figure 17.4 For example, professional football players are in general agreement with team owners on number of players for each team However, there is an inherent conflict on wage rate Input price offered by monopoly, vU, is considerably higher than price offered by monopsony, vM Given only one buyer and one seller of input, they will reach some agreement Impossible to determine actual price that will be established without knowing bargaining strengths and skills of each firm We could only make assumptions and incorporate them into a game-theory model to determine optimal strategies for agents

Bilateral Monopoly and Bargaining Recent bargaining situations between labor and management have produced mixed results For example, bargaining in 1990s between Caterpillar and United Auto Workers Union, along with 6- and 17-month strikes, resulted in very limited gains by union Now-famous bargaining phase between President Reagan and PATCO resulted in controllers losing not only all their demands but also their jobs In contrast, United Parcel Service (UPS) and Teamsters Union negotiations (strike in 1996) resulted in more full-time employees Numerous negotiations between baseball players’ union and team owners (8 strikes in 12 years) have diminished popularity of sport Potentially long-term damage to both players and owners In general, monopsony buying power may be partially or entirely negated by countervailing monopoly selling power

Labor Unions A labor union is a cartel of workers with objective of promoting interests of the union membership Objective of a union varies a great deal depending on desires of the membership or union bosses Some unions are solely interested in improving working conditions and benefits of their members Others may have social goals or a political agenda In the past, unions have advocated establishment of a communist or socialist state However, most unions within U.S. are mainly interested in improving members’ benefits

Unions’ Influence Over Wages A labor union does not try to maximize wages Then only a few workers would be hired It also does not encourage firms to hire as many workers as possible Because wage rate would be very low or zero Instead, a general objective of a labor union may be to increase wages of union members Wages are determined by forces of supply and demand Thus, for a union to modify wages it must in some way modify or change market for labor Three general methods by which this can be done Increase demand for labor Probably most desirable method because it results in more workers being hired at an increased wage However, most difficult method because in general unions have little influence over demand for labor One way unions attempt to increase labor demand is to increase demand for final product For example, union advertising encourages consumers to buy union-made products In recent years, unions have supported laws for protective tariffs or quotas on imports and have lobbied against free trade agreements However, limiting imports has effect of limiting exports, which can curtail labor employment

Unions’ Influence Over Wages Increasing productivity of labor will also increase demand for labor To increase labor productivity, unions promote Improved working conditions Shortened work weeks Employee education Negotiating over job descriptions may also increase or at least maintain demand for labor May lead to featherbedding Attempt by unions to create or maintain jobs that employers claim are not really necessary Such make-work schemes are not very successful because they result in unnecessary production costs High costs may in long-run result in higher output prices Lead to consumers finding substitute commodities Result in a decline in demand for union labor

Unions’ Influence Over Wages A second method for increasing wages is to reduce supply of labor Unions are generally more successful with this method Particularly true among craft unions representing skilled trades Skilled unions can control supply by controlling entry into training or apprenticeship program Requiring that employees have a certificate or license bearing witness of successful completion of program Power to license is generally in hands of union Giving them power to restrict labor supply Reducing supply of labor has effect of shifting supply curve for labor to the left of what it would be with free entry Increases union wages and reduces number of workers employed Trade unions and professional associations have utilized this technique with a high degree of success Because reduced number of workers does not, at least in short-run, harm established members However, individuals who could obtain higher incomes if they were allowed to enter union are harmed Consumers are harmed by paying more for services rendered

Unions’ Influence Over Wages Third method is bargaining for higher wages Generally utilized by unskilled or semiskilled workers Including teamsters, steel workers, and auto workers Goal is to bring all workers in industry into union membership Semiskilled and unskilled unions are unable to restrict supply of workers by licensing Differs from way skilled unions use licensing Instead, semiskilled and unskilled unions will attempt to establish a closed shop Where all workers in a firm or even industry must belong to union Union then represents all workers and negotiates with management It is important for union to require that all workers join union Otherwise a worker could be an interloper Not join, save any union dues, and still reap any benefits from union negotiation

Unions’ Objectives Consider a monopsony buyer of labor services confronting a large number of independent sellers of these services In Figure 17.5, this results in equilibrium level of labor, LM, and wage, wM Now, let a union organize and become sole supplier of labor services to monopsonist (the Wobblies) If union is powerful enough to enforce any wage rate it establishes and if objective of the union is to maximize its economic rent Will seek a wage rate of w1 at an employment level of L1 However, union may have other objectives For example, union may prefer to obtain highest possible wage rate consistent with initial level of employment LM, w2 Alternatively, union may seek largest wage bill (total revenue for union) Maximizing wage bill corresponds to where MR = 0, so union would offer L3 workers at a wage rate of w3 However, at these wages (w2, w1, w3) an excess supply of labor exists More workers are willing to supply their labor than the available demand Thus, for union to obtain these higher wages it must restrict supply of labor In contrast, this excess supply of workers vanishes if union’s interests are to employ highest level of laborers at a wage above wM Results in perfectly competitive solution of Le workers at a wage rate of we

Figure 17.5 Labor union’s objectives

Unions’ Objectives As illustrated in Figure 17.5, introduction of a labor union into a previously monopsonized labor market May possibly result in a higher level of employment as well as in a higher wage rate For example, if a union is successful at increasing wage above monopsony wage of wM, say wU in Figure 17.6 Firm can hire all the labor it wants at this wage up to LU AICL is horizontal along this level of labor, so MICL is equal to it At LU, AICL is kinked and MICL curve shifts up to its previous level Thus, in short-run, firm will hire LU workers Which is greater than LM And offer a wage wU Which is higher than monopsony wage, wM Short-run result is a win/win situation for union It got firm to not only offer a higher wage but also be willing to hire more workers

Figure 17.6 Labor union’s wage and employment

Long-Run Consequences Eighty movies were shot in Boston, Massachusetts, from 1995 to 2000 But in following two years only 15 films were made there In spring of 2000, following complaints from studios that union had forced them to hire more crew members than needed in exchange for labor peace during filming Federal investigation found that union movie contracts from Boston Teamsters Local 25 had guaranteed union members 25 hours of overtime each week Thus in recent years, location managers have shifted a significant amount of production away from Boston area To less expensive countries such as Canada, Australia, and New Zealand, and to Pittsburgh, Toronto, etc. Example illustrates that in long-run unions may not be able to maintain higher wages and higher levels of employment Firm’s cost curves will shift upward If upward pressure on costs results in increased prices, consumers might substitute other commodities for firm’s output Shifts firm’s demand curve for its output and inputs downward Result will be downward pressure on wages and labor layoffs

Long-Run Consequences An example is long-run adjustment of U.S. auto industry in 1970s Large wage hikes in 1970s, not generally associated with increased productivity Pushed up prices of U.S. automobiles to a point where they were no longer competitive with foreign manufacturers Resulted in households substituting foreign cars for American cars Caused high levels of unemployment among U.S. auto workers Firms may attempt to mitigate this higher cost by seeking other regions for their manufacturing operations with lower, nonunion labor costs Results in a loss of union employment and a reduction in wages A current trend is for U.S. manufacturers to relocate just across Mexican border Labor costs and environmental restrictions are relatively low Long-run consequences indicate that having a union card is no guarantee of long-run relatively high wages If you are among early members of a union that was successful in raising wages, you may benefit; however, encourage your children to go to college These relatively high-paying union jobs may not last into next generation of workers

Labor Strikes A major tool unions have in labor negotiations is threat of striking Labor strikes can take a number of forms From actual walking out and picketing to a worker slowdown, lasting for years or only a few minutes In all cases, a major objective of strikes is to show management how union can and will cause a significant loss in a firm’s revenue However, it is not in the general interest of union to bankrupt a firm A union must have ability to severely curtail output to have the power to inflict damaging losses upon management and shareholders Generally, in oligopolistic industries with a few large factories producing a large share of a firm’s output By picketing limited entry and exit locations, strikers can shut down a factory And prevent nonstriking workers from crossing picket lines Thus, a strike or its threat can be a very effective tool in labor negotiations

Labor Strikes However, in a perfectly competitive industry, such as agriculture Where a relatively large number of firms produce in a large number of open fields Effectiveness of strikes as a tool for labor negotiation is severely limited A union would probably not have resources to prevent production in all the fields Could possibly only restrict industry output rather than shut it down Specifically, in agricultural sector, migrant farm workers have organized into a union Have attempted to use strikes as a tool for increasing wages Demand for migrant farm workers only exists during harvest So migrant farm workers have attempted to increase wages by striking at harvest

Labor Strikes Goal of a strike is to significantly reduce production to point where firms are operating at a loss However, as previously stated, it is difficult to prevent all farms from harvesting their output with substitute labor Generally not possible for strikers to accomplish this goal In fact, a situation may result where union’s actions reduce supply of output to point that market price, along with profits for firms, increases In this case, union has forced firms into a cartel situation where they earn pure profits Thus, instead of forcing firms to increase wages so workers will come back to work Union has provided incentives for firms to not agree with union demands

Labor Strikes This occurred when United Farm Workers in California went on strike in 1979 against California lettuce growers Studies indicate that lettuce growers, in general, did actually benefit from strike As a result of limited success of their strikes, United Farm Workers instead attempted to increase wages by shifting demand curve for lettuce outward For example, they created a union label and encouraged restaurants and households to only purchase union-labeled lettuce A union often does have other objectives besides increasing wages in short run For example, a strike can provide a great deal of public exposure to problems facing workers Could result in government policies addressing these problems For example, National Association for Advancement of Colored People supported Montgomery Bus Boycott lead by Martin Luther King, Jr. , from 1955 to 1956 along with various subsequent marches Resulted in landmark 1964 Civil Rights Act and 1965 Voting Rights Act