Monopsony and the Low Wage Puzzle By: Gabriel PotterMBA, AIFA® 2018.09.21

The problem with wages

We’re into the tenth year of recovery since the Great Recession. From an investor’s point of view, things couldn’t be much better. We’ve experienced years of record earnings, profits, and market advances while forecasts are encouraging for the near future. On the other hand, some economists have noted disparities in this recovery, relative to previous recoveries, for average Americans.

To wit, only half of Americans (52% according to Gallup) own stock and ownership is highly concentrated in the top 10% of stock owners. For the average American, the vital proof of household financial health and stability is not a rising stock market, but the rise of real wage growth. In contrast to the booming stock market, wages have been sticky and low; that fact both puzzles and concerns many economists. To understand the cause of frustratingly slow wage growth, analysts have posited a new explanation which requires a review of three economic concepts.

First, supply and demand

Our readers have assuredly heard of “supply and demand” as economic principles. We won’t rewrite the first chapter of an economic textbook, so let us remind readers of one basic truism. If a good or service is commonly available (i.e. high supply), the price should be relatively low. If a good or service is rare (i.e. low supply), the price should be relatively high.

Second, monopoly

Many of our readers are familiar with the term “monopoly”. Even if they couldn’t define the term academically, many readers have played enough of the ubiquitous board game to understand the implication – economic dominance. More accurately, a monopoly refers to exclusive, singular production or control of a good or service. For instance, your local water utility company is a monopoly because they are the only providers of water service for a local home owner. You, as a consumer, can’t simply go to a competing water company; there aren’t any. You can’t get a substitute for water; there isn’t any. Municipalities often establish utility companies – like water – as monopolies, therefore there also tends to be higher regulatory burdens and pricing oversight for these companies. In the real world, there tend to be fewer pure monopolies and generally they exhibit less control. Many lawsuits have seen debates on complicating factors including competitive advantages, superior branding, legal impediments, unfair business practices, availability of substitutions, and so on to determine if a business is operating in an anti-competitive or monopolistic way.

There are hundreds of textbooks which delve into this topic and its variants (e.g. oligopolies, natural monopolies, perfect monopolies), but let’s focus on the top-level concern: why do you care if an industry is a monopoly? Monopolies – being the only provider – can set the price to a good or service wherever they’d like. In classic economic theory, the price set by a monopolist provider is the one that maximizes their profit. This monopoly price is markedly higher than a perfectly competitive market price, which is determined by the marginal production cost of that good or service. In effect, monopolies tend to produce less and charge higher prices, reducing the beneficial utility for consumers.

Third, monopsony

Most of us have heard of a monopoly. In contrast, here’s a term so rare modern spell-checkers don’t recognize it: monopsony. Monopoly refers to great economic power when there is only one producer of a good or service. Monopsony is great economic power when there is only one consumer of a good or service.

As an example, let’s imagine a company-sponsored, work-camp in the old west. In this camp, gold prospectors travel many miles to a remote location to live at camp and work on a river bed, panning for gold. Laborers find gold and may then sell it to the local company representative for $5 an ounce. It doesn’t matter if there are a dozen gold workers or a thousand – the company sets the price on what they will pay. Because they have a semi-captive audience, the price the company sets for gold purchases may be far below the competitive price for gold elsewhere in the world. In other words, the company is a monopsony, being the only consumer (i.e. buyer) of prospectors’ gold.

To make matters worse, this company supplies the work camp store with the only available supplies for the laborers, thus they may act as a monopoly as well. Clearly, this is a situation rife with potential manipulation.

Let’s make this situation more complicated and therefore more realistic. For example, if the gold price set by the company was painfully low, some enterprising prospector is bound to collect their gold, transport it to a bigger city, and find substitute buyers to get competitive prices, thus reducing the company’s power as a monopsony. While in town, if that same prospector decides to load up on supplies to sell back at the work camp; this actions would reduce the company’s power as a monopoly as well.

It doesn’t take too many competitors to soften the impact of a monopoly or a monopsony, so long as there is no collusion between the sellers or buyers. Still, the company has substantial, if imperfect, monopsony power. The company can still offer uncompetitive prices for gold because prospectors have to incur high additional costs to find an alternate buyer. At best, the illiquidity of this market lacks pressure which would keep gold prices competitive with the outside world.

The price of labor

In short, an uncompetitive market place – one with too few consumers or producers – can create lopsided positions of economic power and pricing oddities. So how does this apply to labor and slow wage growth? Well, labor itself can be thought of a good or service, just like buying a water or gold. In this case, the supply of labor can be estimated by the number of unemployed individuals. If unemployment is high, the supply of available labor is plentiful and vice versa. The price for labor is represented by wages and wage growth.

Let’s consider some numbers. In the 2003-2008 post tech-crash expansion, unemployment fell from 6.3% to about 4.2% while wage growth bounced around 3%-to-4% per year. This wage growth didn’t represent a huge advantage for US workers, but wages grew faster than inflation and represented modest gains. During the Great Recession, unemployment ultimately spiked at 10% in October 2009. Given a high supply of available workers, economists were not surprised to see extended periods of low wage growth, bottoming out in 2012 below 2%. Naturally, the supply of labor was high, so prices were low. Here’s the puzzle. The unemployment rate today is about 4.0%, about where it was the year 1970 or 2000. Wage growth is currently 2.7%. In 1970 or 2000, wage growth was closer to 4% to 6%, so why aren’t wages growing that much today? The labor market has tightened up and there aren’t many unemployed workers left. Jobless claims are at a 49 year low. The supply of labor is low, so why is the price of labor relatively cheap?

Is the labor market uncompetitive?

Reader, if you’ve been following the logic thus far, you may have guessed one of the proposed solutions to this economic puzzle: wages aren’t going up because the demand for labor is controlled by too few purchasers of labor. In other words, some economists posit the existence of a labor monopsony. The argument suggests a divergence between upper class salaries, which still bear hallmarks of a competitive marketplace, and middle & lower class salaries, which have stagnated during the post-recession recovery. The large employers of low skill laborers – Amazon warehouse stockers, Wal-Mart cashiers and other menial positions at “superstar” firms – can set their own price for labor. These mega-firms control too many laborers themselves or, it has been suggested, an unspoken, uncompetitive collusion between large employers keeping labor prices low.

Alternative theories

Naysayers to this theory point out just how numerically challenged this argument is. There are millions and millions of individuals and employers in the United States. We live in a globally connected marketplace, with a constant influx of new suppliers and purchasers, in an environment more competitive than ever before. How can this ultra competitive environment, with so many uncoordinated players, represent a monopsony? Surely, the labor puzzle must have another solution.

One alternative theory suggests that US wage growth has been suppressed because unskilled middle-class wages have been historically overpriced relative to global peers. Wage stagnation is a local phenomenon; wages are still improving elsewhere in the developing world. No matter how good US employee productivity numbers are, unskilled US workers are now competing on a global scale with an ever more sophisticated workforce in China, Eastern Europe, and Latin America which can produce goods at a fraction of our cost.

Another theory suggests automation has put a ceiling on wage growth, particularly for unskilled workers. With the expanded capability of robotic or automated systems – driving long-haul trucks, ordering food at chain restaurants, delivering flashy online retail environments – employers have found an effective substitute for human labor, thus lowering unskilled worker bargaining power.

How to test the theory

Unlike some economic theories which may never get vetted, there are already real-world proposals to test if the labor monopsony theory is correct. Most directly, there is a minimum wage test. Consider, in a theoretically perfect economic environment, the establishment of a minimum wage – a legal artificial floor on the price of labor – should create unemployment. The higher the minimum wage, the greater the unemployment. Imagine the minimum wage is set to a high value - say $40 per hour which translates to $80k per year for a prototypical worker. For those wages many new potential employees would enter the job market. Young students would drop leisure and extracurricular activities for a chance at a high-paying job. The core workforce would be more aggressive in their job search for any position at all. Older workers would defer or rescind retirement. However, many employers (particularly those who relied on cheap low skilled workers) would be unable to extract enough value out of their workers to afford these wages. The available supply of labor at a given price would far exceed the combined demand of employers. The net result is a higher unemployment level.

Alternatively, imagine a world where there is, in fact, a labor monopsony. Workers may be generating more value for their employer than employers are unconditionally willing to pay for. In a world with an active monopsony, an increase in the minimum wage might not increase unemployment, depending upon where the minimum wage is set and the marginal benefits per worker. Instead, labor stays relatively constant but some utility gets shifted from employers to employees.

Thought and policy experiments such as these are high in the mind of economists, and policy advocates. Analyzing changes to unemployment statistics in the face of minimum wage and similar policy initiatives (i.e. living wage legislation) should keep them busy.

Gabriel Potter

Gabriel is a Senior Investment Research Associate at Westminster Consulting, where he is responsible for designing strategic asset allocations and conducts proprietary market research.

An avid writer, Gabriel manages the firm’s blog and has been published in the Journal of Compensation and Benefits,...

More about Gabriel Potter
Sign up for our Newsletter
Sign up for our Newsletter