The myth of the perfectly competitive labour market

The myth of the perfectly competitive labour market

As new evidence has arisen, the case for a high minimum wage has become stronger and stronger, casting doubt on traditional models of the labour market

David Lawrence Once upon a time, if you the neoclassical model makes- that

asked academic economists their of perfect competition. opinion on the minimum wage the To explain why a high level of consensus would be pretty clear; competition is an important asthey lead to higher unemployment, sumption in the labour market, one higher prices and -perhaps worst of first has to explain why firms pay for all- lower economic growth. Indeed, labour. The answer is simple- firms this opinion still holds sway, with are willing to pay wages to workers 74% of economists opposing a $15 so they give up leisure time to proper hour minimum wage in the US. The above depicts a typical duce goods. In general, a firm will However, new evidence seems to supply and demand diagram to rep- never pay a worker a cent more contradict claims minimum wages resent the market for low skilled than the worker is worth to them on decrease employment. labour. W1 and E1 are the equilibri- the long run, and a worker’s worth The foremost two economists um values for wage rate and em- to a firm is called the marginal physiwho began to find evidence re- ployment levels, respectively, mean- cal product of labour (the increase in butting traditional claims about ing the quantity demanded and output occurred from hiring another wage floors were Alan Kreuger and quantity supplied of labour are unit of labour). However, if a firm David Card. In 1992, New Jersey equal at W1 and there is no excess pays a worker less than their marraised its minimum wage to $5.05 unemployment. Superficially, the ginal physical product of labour per hour, whereas neighbouring implementation of a minimum wage then, assuming some competition, Pennsylvania raised it marginally to raises wages from W1. However, the another firm can come and offer this $4.25. Card and Kreuger decided to graph shows that at the new wage worker slightly more, confident the exploit the opportunity for a natural rate, more people are willing and arrangement is profitable as long as experiment and measured changes able to work, raising the quantity of the higher wage is lower than the in employment levels along the bor- labour supplied to ES; and at the marginal physical product of labour. der. What they found surprised new rate, it costs more for firms to In conditions of perfect competition, them- employment actually fell in employ workers so they lay off mar- eventually the worker’s wage is bid Pennsylvania compared to New Jer- ginally productive workers, decreas- up until it is equal to the marginal sey, casting doubt on traditional ing the quantity of labour demanded physical product of labour. models of the labour market. to ED. The difference between ED and ES represents unemployment And this explains why miniSince then, there has been an caused by the minimum wage. mum wages are bad under a neoabundance of academic debate on classical framework. The invisible the issue. However, one thing seems Yet the findings of Card and hand of the market has found an clear- it cannot be guaranteed that Kreuger, as well as many economists optimum wage. If well-meaning poliminimum wages will always cause since, seem to dispute this conclu- ticians try to increase the wage diunemployment. And this points to- sion. And when economic models rectly instead of worker productiviwards the fact that the neoclassical are wrong, its usually because one ty, then firms have to fire marginally model of the labour market may not of the assumptions they are predi- productive workers. Because there be wholly accurate. cated on do not hold true. In this are diminishing returns to labour, case, economists are especially in- the firm does not fire every worker, terested in one critical assumption but many have to be made

Labour is unlike the other factors of production as it is sentient.

redundant. Yet here we see why competition is such an important part of the model. If there were no other competing firms, then the firm would not have to pay the marginal physical product of labour- they would just have to pay enough that a potential employee would rather work than be unemployed. Such a scenario is called monopsony- when there is only one buyer of a good (in this case labour). It is obvious that the claim there is no competition for lowskilled labour is absurd. The geographic monopsonies of the 19th century- small towns where the only employer was the local mine, for instance- where killed by the advent of the car, and the ability to travel longer distances for work it gave people. But certain realities of what it means to be an employee perhaps rebut claims that there is enough competition that workers are paid wages reasonably close to their marginal product. In general, labour is not like the other factors of production for one simple reason; it is sentient. Unlike machines or buildings, workers have preferences about where they work. This means that, even if another firm offers a higher wage, they may not opt for the new job as they prefer their current workplace. In more technical terms, workplaces are “imperfectly substitutable” and hence the effects of competition in raising wages are diluted. Also, if workers feel they are underpaid, in

many cases they cannot just leave. It takes time to search for a job, and in the interim the effects of unemployment can be stressful and depressing. Also, even though labour mobility has been improved, there are still notable “travel costs” when workplaces are far away, both explicitly monetary (the cost of fuel or train tickets) or in terms of the opportunity cost of time spent travelling, meaning that workers may not ac-

cept higher wages from firms farther away. These factors- called “search frictions” - inhibit competition and create a scenario that resembles monopsony in the form of an imper-

fectly competitive labour market. It is important to recognise that this hypothesis is not close to being universally accepted. However, if true, it brings up more corollaries than just a higher minimum wage not decreasing employment. If com-

petition cannot ensure that workers are paid the value of their labour, then it might be that trade unions and collective bargaining are an effective response rather than a general nuisance. Indeed, the proportion of GDP going to labour in the UK fell by 6% of the total from 1970 to 2014, with the decline of unionisation cited as a leading cause. Nonetheless, whether monopsony is an extensive factor or not, it is important that policy makers ensure that they do not take a perfectly competitive labour market as an axiom when analysing ways to ensure workers are paid their fair share.