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Why Monopsony Power May Be Irrelevant to the Effects of A Minimum Wage Increase

Posted by on | May 11, 2017 | Comments Off

Most of us who took Econ 101 would expect that an increase in the minimum wage would increase unemployment, at least among low-skilled and younger workers.  After all, demand curves slope downards so that an increase in price of labor should result in a decrease in demand for that labor.

Supporters of the minimum wage, however, argue that employers have monopsony power when hiring low-skill workers. What they mean by this is that due to a bargaining power imbalance, employers can hire workers for less than they would be willing to pay in a truly competitive market.  As the theory goes, this in turn creates an additional consumer surplus for employers, which manifests itself as higher profits.  A minimum wage increase would thus reduce this surplus but not effect employment because companies before the new minimum wage were paying less than they were willing to pay.  Thus minimum wage supporters argue that higher wages mandated by minimum wage laws will be paid out of these excess profits, and not result in higher prices or less employment.

My understanding (and I am not an economist) is that the evidence for monopsony power in hiring low-skill workers is weak or at best limited to niche circumstances.  However, I am going to argue that it does not matter. Even if companies are able to pay workers less than they might via such monopsony power, whatever gains they reap from workers ends up in consumer hands.  As a result, minimum wage increases still must result either in employment reductions or consumer price increases or more likely both.

Why Monopsony Power May Not Matter

Why? Well, we need to back up and do a bit of business theory.  Just as macroeconomics (all the way back to Adam Smith) spends a lot of time thinking about why some countries are rich and some are poor, business theory spends a lot of time trying to figure out why some firms are profitable and some are not.  One of the seminal works in this area was Michael Porter’s Five Forces model, where he outlines five characteristics of markets and firms that tend to drive profitability.  We won’t go into them all, but the most important for us (and likely for Porter) is the threat of new entrants — how easy or hard is it for new firms to enter the marketplace and begin competing against an incumbent firm.  If new companies can enter into competition easily, a profitable firm will simply attract new competitors, and keep attracting them until the returns in that market are competed down.

So let’s consider a company paying minimum wage to most of its employees.  At least at current minimum wage levels, minimum wage employees will likely be in low-skill positions, ones that require little beyond a high school education.  Almost by definition, firms that depend on low-skill workers to deliver their product or service have difficulty establishing barriers to competition. One can’t be doing anything particularly tricky or hard to copy relying on workers with limited skills. As soon as one firm demonstrates there is money to be made using low-skill workers in a certain way, it is far too easy to copy that model.  As a result, most businesses that hire low-skill workers will have had their margins competed down to the lowest tolerable level.  Firms that rely mainly on low-skill workers almost all have single digit profit margins (net income divided by revenues) — for comparison, last year Microsoft had a pre-tax net income margin of over 23%.

As a result, the least likely response to increasing labor costs due to regulation is that such costs will be offset out of profits, because for most of these firms profits have already been competed down to the minimum necessary to cover capital investment and the minimum returns to keep owners invested in the business. The much more likely responses will be

  1. Raising prices to cover the increased costs. This approach may be viable competitively, as most competitors will be facing the same legislated cost pressures, but may not be acceptable to consumers
  2. Reducing employment. This may take the form of stealth price increases (e.g. reduction in service levels for the same price) or be due to a reduction in volumes caused by price increases. It may also be due to targeted technology investments, as increases in labor costs also increase the returns to capital equipment that substitutes for labor
  3. Exiting one or more businesses and laying everyone off. This may take the form of targeted exits from low-margin lines of business, or liquidation of the entire company if the business Is no longer viable with the higher labor costs.

An Example

When I discuss this with folks, they will say that the increase could still come out of profitability — a 5% margin could be reduced to 3% say.  When I get comments like this, it makes me realize that people don’t understand the basic economics of a service firm, so a concrete example should help. Imagine a service business that relies mainly on minimum wage employees in which wages and other labor related costs (payroll taxes, workers compensation, etc) constitute about 50% of the company’s revenues. Imagine another 45% of company revenues going towards covering fixed costs, leaving 5% of revenues as profit.  This is a very typical cost breakdown, and in fact is close to that of my own business.  The 5% profit margin is likely the minimum required to support capital spending and to keep the owners of the company interested in retaining their investment in this business.

Now, imagine that the required minimum wage rises from $10 to $15 (exactly the increase we are in the middle of in California).  This will, all things equal, increase our example company’s total wage bill by 50%. With the higher minimum wage, the company will be paying not 50% but 75% of its revenues to wages. Fixed costs will still be 45% of revenues, so now profits have shifted from 5% of revenues to a loss of 20% of revenues. This is why I tell folks the math of absorbing the wage increase in profits is often not even close.  Even if the company were to choose to become a non-profit charity outfit and work for no profit, barely a fifth of this minimum wage increase in this case could be absorbed.  Something else has to give — it is simply math.

The absolute best case scenario for the business is that it can raise its prices 25% without any loss in volume. With this price increase, it will return to the same, minimum acceptable profit it was making before the regulation changed (profit in this case in absolute dollars — the actual profit margin will be lowered to 4%). But note that this is a huge price increase. It is likely that some customers will stop buying, or buy less, at the new higher prices. If we assume the company loses 1% of unit volume for every 2% price increase, we find that the company now will have to raise prices 36% to stay even both of the minimum wage increase and lost volume. Under this scenario, the company would lose 18% of its unit sales and is assumed to reduce employee hours by the same amount.  In the short term, just for the company to survive, this minimum wage increase leads to a substantial price increase and a layoff of nearly 20% of the workers.   Of course, in real life there are other choices.  For example, rather than raise prices this much, companies may execute stealth price increases by laying off workers and reducing service levels for the same price (e.g. cleaning the bathroom less frequently in a restaurant).  In the long-term, a 50% increase in wage rates will suddenly make a lot of labor-saving capital investments more viable, and companies will likely substitute capital for labor, reducing employment even further but keeping prices more stable for consumers.

As you can see, in our example we don’t need to know anything about bargaining power and the fairness of wages. Simple math tells us that the typical low-margin service business that employs low-skill workers is going to have to respond with a combination of price increases and job reductions.

How My Company Has Responded

Just to put a bit more flesh on this, I will give a real example from my own company.  My company operates public recreation facilities, mainly campgrounds, under bid contracts.  To understand our response to rising minimum wage, you need to understand some background:

  • In bidding these, we bid both the camping fee we will charge to customers as well as the rent we will pay to the government for the concession.  Given the weights the government uses in the bid process, keeping customer price low is more important than the rent we pay, so in most cases the prices we charge customers are well below the private market rate for similar campgrounds.
  • We have limited ability to further increase productivity, in part because our ability to invest in these campgrounds in limited.
  • Because we have many contracts across the country, our reputation is important and so we seldom will entertain reductions in service, such as cleaning frequency
  • Labor and labor-related costs are about 50% of revenues, and most employees are paid minimum wage.  Profit margins hover around 5% of revenues

One of the states we operate in is California.  We are in the midst of a minimum wage increase there from $8 an hour several years ago to $15 several years hence, or an increase of 87.5%.  Basically we have had two responses:

  • In places where we are under the market price, we have been able to raise prices without a lot of drop in volume.  But this means that our camping rates in some locations have risen from $18 to a future $26 a night, an enormous increase in just a few years.
  • In places where we did not think the market would bear such a rate increase, or where our contract did not allow such a rate increase, we closed our operation.  In fact, we have exited about half our business in California (while simultaneously growing it aggressively in states like Tennessee).  In all cases this has resulted in a loss of employment — either the location was never reopened by anyone else, or else it was reopened by a competitor with different reputational concerns who staffed the location with far fewer employees.
 Why Monopsony Power May Be Irrelevant to the Effects of A Minimum Wage Increase  Why Monopsony Power May Be Irrelevant to the Effects of A Minimum Wage Increase  Why Monopsony Power May Be Irrelevant to the Effects of A Minimum Wage Increase

 Why Monopsony Power May Be Irrelevant to the Effects of A Minimum Wage Increase

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