Unit 6 The firm and its employees

6.12 How employers exercise power

In Unit 5 we explain that power takes two forms in economics: first, an economic actor may have the ability to profit by setting the terms of an exchange, and second, the actor may have the ability to effectively threaten to impose heavy costs on others if they do not do as they wish. The first is called market power (Unit 7 shows that it can be exercised not only in hiring labour, but also in selling goods). We term the second ‘power over others’ because it involves the powerful actor commanding others to do things in that actor’s interest that the others would not have done in the absence of the threat.

Employers in our model of wage setting exercise both kinds of power:

  • The power to control wages: By hiring fewer workers, they can pay lower wages.
  • Power over others: They can get workers to work hard by threatening to terminate their employment if they do not.

The word ‘monopsony’ was introduced by Joan Robinson in her 1932 book, The Economics of Imperfect Competition. She asked a colleague at Cambridge University (a classics scholar) to suggest a Greek term to indicate a market with a single buyer, analogous to ‘mono-poly’ for the case of a single seller. The most direct analogy would have been ‘mono-ony’, but they decided that ‘monopsony’ sounded better—although its literal translation would be ‘a market with a single buyer of fish’.

labour market power
A firm has labour market power (sometimes called monopsony power) if it can reduce the wage it needs to pay its workers by lowering the number of workers that it employs.
monopsony power
A firm has labour market power if it can reduce the wage it needs to pay its workers by lowering the number of workers that it employs. It is sometimes called monopsony power because it applies, in particular, to a firm that is the only employer in a particular labour market.

The firm’s power to hold down wages by restricting employment is called labour market power, or sometimes monopsony power. The term ‘monopsony’ originally referred to a ‘single buyer’ of labour: a firm that was the only potential employer for workers living in its neighbourhood would have the power to control local wages by controlling employment. But our model applies more generally: we did not assume that the language school was the only employer in Paris. Its tutors would have alternative options.

In our model, labour market power comes from the search and matching process: it takes time for workers and firms to find suitable matches. At the point when a job offer is made, a worker’s only immediate alternative is to remain unemployed, so their reservation wage is lower than the average wage offered by other firms. However, labour market power is reduced when there are more employers competing for the same workers. If Paris had many schools competing for tutors, potential employees would be able to find jobs more quickly, so their reservation wages would be higher. Then each school would need to offer higher wages to attract the same number of workers, and profits would be lower.

Employers exercise power over others (the second form) by placing their employees in a position where they receive an employment rent, and then threatening to deprive them of the rent by terminating their contracts if they do not work as hard as the employer requires. Each worker receives a rent because the wage is higher than their reservation wage.

There are many other uses of the term ‘power’ in economics. For example, ‘bargaining power’, which is discussed in Unit 5.

These two aspects of the employer’s power are related. The level of the wage necessary for the worker to receive a rent sufficient to motivate them to work hard depends on their reservation wage. So, by hiring fewer workers, the firm can avoid employing workers with higher reservation wages (who would be motivated to work hard only by higher no-shirking wages).