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What if the firm is perfectly competitive in the OUTPUT market, such that it is one
of a very large number of producers who all sell the identical product, but is a MONOPSONY
in the resource market -- i.e., the sole buyer of the resource? If you are the monopsonistic
hirer of, for example, labor, then you are the only employer in this market (this could
occur if there was just a single employer in a small, isolated town). You are no longer
a competitive hirer of labor, subject to the price determined by the overall supply of
and demand for Labor in the market -- that is, you are no longer a price taker when it
comes to the wage that you pay the workers. You are no longer facing the perfectly elastic
supply of labor seen in the competitive resource market; no, as the only buyer of labor (i.e.,
the only employer), anyone who wants to work will work for you -- the firm sees the entire
supply of labor available in this market.
What does it mean, that the supply of labor is now upward-sloping, rather than horizontal?
Before, in the competitive labor market, wage was constant, and the employer could hire
as many workers as he/she wanted at the "going wage." Now, each time the employer wants to
attract more workers, that employer will need to offer a better price -- i.e., a higher
wage. Let's look at an example: let's say that you are the employer. If you pay nothing,
no one is willing to work for you, so suppose that you offer to pay two dollars an hour.
At a wage of two dollars, only one person is willing to work for you. How do you attract
more employees? Offer a better wage! When you offer four dollars an hour, two people
are willing to work for you; at a salary of six dollars an hour, 3 people are willing
to work for you, and so on. The upward-sloping supply shows that, at higher wages, more labor
will be supplied (there is a concept of a "backward-bending" supply of labor, but I'm
not going to get into that in this episode).
OK, so where was I? We wanted to know, if a firm is competitive in the output market,
and has monopsony power in the labor market, how many workers will that firm hire, and
at what wage? Before I get into that, let me do a quick re-cap of the firm that is perfectly
competitive in BOTH input and output, so that we can make some comparisons later. If you
remember, we started out with just the workers and the output. From there, because we know
that marginal product is the change in the output when the resource (labor, in this case)
changes, we can look at the change in output in the table, each time we hire another worker.
Once we knew MP, we were able to establish the market value of that Marginal Product
by taking Marginal Product times Price. If the market-determined price of output is constant
(this is a competitive product market, remember) at, say, two dollars, then we can easily calculate
the Value of the Marginal Product by taking Price times Marginal Product. And because
the output market is competitive, remember also that Price equals Marginal Revenue. This
means, of course, that Price times Marginal Product is the same as Marginal Revenue times
Marginal Product, or the Value of the Marginal Product equals Marginal Revenue Product, so
we can enter the VMP figures into the MRP column. In the perfectly competitive output
and factor market scenario, we also found that the wage is constant (determined by labor
market forces), let's say, at eight dollars. A constant wage also meant that the added
cost of bringing in another worker (the "Marginal Factor Cost") would be constant at that wage,
since each worker is hired in at that same wage. So in the end, with perfect competition
in both the output and factor markets, the profit-maximizing rule (Marginal Revenue Product
equals Marginal Factor Cost) is satisfied at four workers, who each get paid a wage
of eight dollars.
But we aren't dealing with perfect competition in both the factor and output markets, are
we? When I started this episode, I said that we want to think about a perfectly competitive
output market, but a monopsony resource market. That means we'll have to back up a bit -- if
we go back to the original data, the labor, total product, and marginal product will be
unchanged by this shift in market structures (the product figures are unrelated to the
structure of the market). And because we were looking at perfectly competitive output previously,
and we are STILL looking at perfectly competitive output, the output price (constant at two
dollars, in this case), Value of the Marginal Product, and Marginal Revenue Product are
the same as they were before.
The difference comes in when we shift from a perfectly competitive factor market to a
monopsonistic factor market -- we change from having a small firm facing a perfectly elastic
supply of labor, and therefore a constant wage, to having a single large firm facing
the entire industry supply of labor, where wage will rise as the firm tries to attract
more labor. In the data table, this means that rather than having a wage that is constant
at eight dollars, the wage now rises, the more labor is hired (remember, to get more
employees to work for you, you will need to offer a higher wage). Because the wage rises
as more labor is hired, the total cost of hiring the labor (wage, w, times L, the number
of workers) rises much more quickly than in a competitive market, where wage was constant.
This, in turn, alters Marginal Factor Cost (defined as the change in cost over the change
in the resource, labor) substantially -- the Marginal Factor Cost values end up being higher
than the wages. Why is this? Well, in this model the firm must pay all of its employees
the same wage. Why does this matter? Think about it: the employer cannot simply lure
in a new employee with a higher wage; all of the other employees' wages must be raised
to match. Take the data in our table, for example: the firm can hire a single employee
at a wage rate of two dollars, for a total cost of two dollars. If the firm wants to
attract more workers, it will need to offer better wages. The firm can hire two workers
by offering a wage of for dollars, but because it must pay BOTH employees the four dollar
wage, the total cost is now eight dollars. So the added cost of the second worker, or
the Marginal Factor Cost, is six dollars -- the four dollar added salary, plus a two dollar
raise for the existing employee. To get three workers, the firm will have to offer a wage
of six dollars, raising the total cost of labor to eighteen dollars. The third worker,
therefore, added ten dollars to the cost. As each new worker is added, you can see that
the Marginal Factor Cost of that worker is greater than the wage paid; the added cost
is not only the new employee's salary, but also the raises that must be given to all
of the existing employees. Ultimately, the profit-maximizing hiring decision for the
monopsonist occurs where Marginal Revenue Product equals Marginal Factor Cost, somewhere
between three and four workers.
To re-cap, because of the perfectly competitive output market, Value of the Marginal Product
equals Marginal Revenue Product; because of monopsony in the factor market (there is a
single buyer of the resources), the firm faces the industry supply of labor, and Marginal
Factor Cost of labor will lie above supply. Choosing to hire where Marginal Revenue Product
equals Marginal Factor Cost, "L*" workers will be hired (less than with perfect competition),
and the employer will drop down to the supply curve of labor to see what wage the sellers
of labor (i.e., the employees) are willing to accept. Because w* is LESS that the market
value of the output added by this last worker hired, there is MONOPSONISTIC EXPLOITATION
of labor.
In the end, the monopsonistic employer hires fewer workers, and at a lower wage, than a
perfectly competitive hirer.
NEXT TIME: Monopsony factor market, Monopoly output market.