Monopsony employers and minimum wages

We've already talked about the notion of a monopsony employer in other videos, but now we're going to review it a little bit, and we're going to introduce a twist. The twist is what happens when they have to deal with a minimum wage, and as we'll see, it's kind of counter-intuitive.

So, first of all, just as a review, a monopsony is a situation where you have one buyer and you have many sellers of something. When we're talking about a monopsony employer, the buyer is the buyer of labor. We're talking about the buyer in the labor factor markets, and the sellers are the workers, the people who would sell their labor for a wage. We have already studied monopsony employer situations before, but I will redo it. It never hurts to get the practice in.

In the vertical axis, you have the wage, which is really the price of this factor of labor that we're studying right now. In the horizontal axis, you have the quantity of the factor that we care about, and this is the quantity of labor. Now, we have seen this show many times before. You're going to have, or you typically have, a downward sloping marginal revenue product curve. That describes a situation where every incremental unit of labor you bring on, the marginal revenue—the incremental revenue you get—goes lower and lower and lower because of, arguably, diminishing returns in some way.

So this is the marginal revenue product of labor. You could also have a marginal revenue product of capital or of land or other factors. Then we could think about the supply of labor. Well, actually, really what we're trying to get at is what the marginal factor cost curve is. If this employer were not a monopoly employer, if they were just operating in a perfectly competitive labor market, the marginal factor cost curve would just be the market wage. So it might look something like that.

But we are dealing with a monopsony employer, and so they don't just take the market wage; they have—you could view it as a supply curve for labor that's specific to them. Because remember, they're the only show in town. They are the big employer, maybe, in this small town. So you have this supply curve—this is the supply of labor—but this is not the marginal factor cost curve. We've explained this before, but that's because, as you bring on higher and higher quantities of labor, you need to pay more to that incremental person.

But what typically happens is if you need to pay one person more, you need to pay everyone the same wage. So as you bring on that incremental labor, not only do you have to pay more for that incremental unit, but you have to raise the wage for everyone. So the marginal factor cost goes up twice as fast as the supply of labor curve. The marginal factor cost curve might look something like this.

Then what's rational is a firm would keep bringing on that factor—in this case, labor—would keep hiring folks as long as the incremental revenue that it gets from hiring that next unit is higher than the marginal or the incremental cost. So they will keep bringing people on as long as the marginal revenue product is higher than the marginal factor cost. We would get to that point right there, and so it'd be rational for this firm to hire this quantity of labor. Let's call that q sub 1.

And then what wage are they paying? Pause this video and think about that because this is always a little bit tricky. Well, you might be tempted to draw a line here, but remember this doesn't describe the actual wage. The wage of that quantity is described by the supply of labor, so this would be the wage that the firm would pay.

So now let's introduce our twist. Let's think about what happens if a minimum wage is employed in this region. That, for whatever reason, the city council says, "Hey, that employer needs to be paying more money." Let's say they institute a minimum wage at—I will do this in a bold color—let's say they institute a minimum wage right over here. Let's call this wage sub m. Pause the video and think about what would then happen. What would the marginal factor cost curve look like, and then what would be the rational quantity for the firm to hire?

All right, so now that the town has instituted a minimum wage, and it's higher than the rational wage that the firm would have otherwise paid for labor, what it does is it—at least at a certain range of quantities of labor being employed—essentially makes this monopoly employer have to think a little bit like an employer in a competitive labor market, where you just have to accept a wage. Now, this wage isn't being set by some market; it's being set by a government.

So, as long as this wage is higher than the supply of labor—well, then, this is going to be, or higher than our old supply curve—well this is going to be, from the firm's point of view, the new supply curve. So it's going to look something like this. But then, when the supply curve, when the wages that the supply curve describes, go higher than that minimum wage—well, then it will track that.

So this is our new supply curve right over here—so new supply curve—and we're talking about the supply of labor, and it's this whole red thing. What would be our new marginal factor cost curve? Well, we said that it has twice the slope, but when the slope is just flat here—I'm going to do this in a new color—so the marginal factor cost curve, it's going to track this horizontal line right over here.

Then, all of a sudden, when the supply curve starts to go up, well then it's going to jump back to the old marginal factor cost curve. So it's going to look something like this. So M F C—I’ll call it 2—that's in blue. So it tracks the supply curve here when it's horizontal, and it is really just analogous to when we just have to accept a wage, and then it jumps. We have a bit of a discontinuity, and then you get up there.

But what's rational, as always, is for a firm to keep hiring as long as the marginal revenue product is higher than the marginal factor cost. So it's going to keep hiring; it's as long as this yellow line is above the blue line, it would keep hiring, keep hiring all the way until this point right over here.

So notice what just happened. It is now rational for the firm to hire more people. That is counter-intuitive in everyday thought. If I thought I was running some type of a business, if I was running a burger joint, and all of a sudden there's a higher minimum wage, then it feels like, "Hey, I might not have enough money to hire people; I might lower the number of people I hired."

But we just showed, at least with some very simplified economics model, that theoretically, when you're dealing with a monopsony employer, it actually might get them to hire more people. So an interesting question is why did this counterintuitive thing happen? One hand-wavy argument—but I encourage you to ponder it—is to realize that in the old world, every time they brought on an incremental person, they had to raise the salary of everyone. That's what made the marginal factor cost go up so quickly.

But now, since you have this whole flat part of your supply curve, because regardless of how many people you hire in this range right over here, you're paying the same amount, that incremental person does not increase the wage for everyone else. So that is what made it rational for the firm to go and keep hiring.

Now, the community, the government, the city council would have to be very careful about what this minimum wage is because it's very possible that they could overshoot and actually end up in a situation where the firm hires less. So, for example, if they made this the minimum wage right over here—let's call that w 3—well now, all of a sudden, you would have a marginal factor cost curve that is going like this for at least a good bit. We can think about it a little bit later as what happens as you go further and further to the right.

But then, it would only be rational for the firm to hire that much, and so then you would have a decrease in employment. But if we go back to the original situation, another thing that you might be thinking of—"Hey, this seems too good to be true!" It's now rational for the firm to hire more folks, and those folks are getting more income. Surely someone must be losing.

And it is the case that the firm is now going to lose more of, I guess you could say, the surplus that it was having in the old world, and more of that is now being given to the workers.