Microeconomics for MBAs 51

Competition for labor pushes wages up to a certain level, forcing some employers to withdraw from the market but permitting others to hire at the going wage rate.4 For the individual emp

The farmers who employ migrant workers are caught in a competitive bind Consumers want to buy their food at the lowest possible price As producers, farmers must be able to sell their produce at a competitive price That means minimizing the cost

of production, including the full wage rate paid to employees If farmers are forced to provide better housing for their laborers, they must reduce costs in other ways, including the substitution of machinery for labor This is precisely what happened in many farm areas since the imposition of stricter housing standards A federal law establishing

migrant housing standards was passed in the late 1960s In 1969 the farm labor service

of the Michigan Employment Security Commission arranged jobs and housing for 27,163 migrants, but in the summer of 1970 it estimated that it would be able to place only 7,000

to 8,000 workers State and local officials forecast that on balance, the new housing standards would eliminate 6,000 to 10,000 jobs Meanwhile many growers, stung by the bad publicity surrounding migrant housing, closed their camps and switched to

mechanical harvesting As one grower put it, “It might be cheaper for me to continue using migrant help for a few more years, but mechanization is the trend of the future And no matter what kind of housing I provide I’m going to be criticized for mistreating migrants So I might as well switch now.”3

Monopsonistic Labor Markets

Competition is bad for those who have to compete Not only as producers but as employers, firms would rather control competitive forces than be controlled by them They would like to pay employees less than the market wage—but competition does not give them that choice

Similarly, workers find that competition for jobs prevents them from earning more than the market wage Thus doctors, truck drivers, and barbers have an interest in restricting competition in their labor markets Acting as a group, they can acquire some control over their employment opportunities and wages

Such power is difficult to maintain without the support of the law or the threat of violence, whether real or imagined It comes at the expense of the consumer, who will have fewer goods and services to choose from at higher prices As always, the exercise

of power by one group leads not only to market inefficiencies but also to attempts by other groups to counteract it The end result can be reduction in the general welfare of the community

This section examines both employer and employee power in the labor market; the conditions that allow it to persist; its influence on the allocation of resources; and its effects on the real incomes of workers, consumers, and entrepreneurs

3

“Housing Dispute Spurs Migrant Farmers to Switch to Machines from Migrant Help,” Wall Street Journal, June 29, 1970, p 18

The Monopsonistic Employer

Power is never complete It is always circumscribed by limitations of knowledge and the forces of law, custom, and the market Within limits, employers can hire and fire, and

can decide what products to produce and what type of labor to employ Laws restrict the conditions of employment (working hours, working environment) they may offer,

however, as well as their ability to discriminate among employees on the basis of sex,

race, age, or religious affiliation Competition imposes additional constraints In a

highly competitive labor market, an employer who offers very low wages will be outbid

by others who want to hire workers Competition for labor pushes wages up to a certain level, forcing some employers to withdraw from the market but permitting others to hire

at the going wage rate.4

For the individual employer, then, the freedom of the competitive market is a highly constrained freedom Not so, however, for those lucky employers who enjoy the power

of a monopsony A pure monopsony is the sole buyer of a good, service, or resource

(Monopsony should not be confused with monopoly, the single seller of a good and

service.) The term is most frequently used to indicate the sole or dominant employer of

labor in a given market A good example of a monopsony would be a large coal-mining

company in a small town with no other industry A firm that is not a sole employer but

that dominates the market for a certain type of labor is said to have monopsony power

Monopsony power is the ability of a producer to alter the price of a resource by

changing the quantity employed By reducing competition for workers’ services,

monopsony power allows employers to suppress the wage rate

_

FIGURE 15.7 The Competitive Labor Market

In a competitive market, the equilibrium wage rate

will be W2 Lower wage rates, such as W1 , would

create a shortage of labor, and employers would

compete for the available laborers by offering a

higher wage In pushing up the wage rate to the

equilibrium level, employers impose costs on one

another They must pay higher wages not only to

new employees, but also to all current employees,

in order to keep them

4

Competitors who do not hire influence the wage rate just as much as those who do; their presence on the sidelines keeps the price from falling If firm lowers its wages, other employers may move into the market and hire away part of the work force

The Cost of Labor

Monopsony power reduces the costs of competitive hiring Assume that the

downward-sloping demand curve D in Figure 15.7 shows the market demand for workers, and the

upward-sloping supply curve S shows the number of workers willing to work at various

wage rates If all firms act independently—that is, if they compete with one another—the

market wage rate will settle at W2, and the number of workers hired will be Q2 At lower

wage rates, such as W1, shortages will develop As indicated by the market demand

curve, employers will be willing to pay more than W1 If a shortage exists, the market

wage will be bid up to W2

An increase in the wage rate will encourage more workers to seek jobs As long as there is a shortage, however, the competitive bidding imposes costs on employers The

firm that offers a wage higher than W1 forces other firms to offer a comparable wage to

retain their current employees If those firms want to acquire additional workers, they

may have to offer an even higher wage As they bid the wage up, firms impose

reciprocal costs on one another, as at an auction

Because any increase in wages paid to one worker must be extended to all, the total cost to all employers of hiring even one worker at a higher wage can be staggering If the

wage rises from W1 to W2 in Figure 15.7, the total wage bill for the first Q1 workers rises

by the wage increase W2 – W1 times Q1 workers Table 15.2 shows how the effect of a wage increase is multiplied when it must be extended to other workers The first two

columns reflect the assumption that as the wage rate rises, more workers will accept jobs

If only one worker is demanded, he can be hired for $20,000 The firm’s total wage bill

will also be $20,000 (column 3) If two workers are demanded, and the second worker will not work for less than $22,000, the salary of the first worker must also be raised to

$22,000 The cost of the second worker is therefore $24,000 (column 4): $22,000 for his services plus the $2,000 raise that must be given to the first worker

TABLE 15.2 Market Demand for Tomatoes

Number of

Workers Willing

to Work

(1)

Annual Wage

of Each Worker (2)

Total Wage Bill [(1) times (2)]

(3)

Marginal Cost of Additional Worker [Change in (3)]

(4)

1

2

3

4

5

6

$20,000 22,000 24,000 26,000 28,000 30,000

$ 20,000 44,000 72,000 104,000 140,000 180,000

$20,000 24,000 28,000 32,000 36,000 40,000

The cost of additional workers can be similarly derived When the sixth worker is

added, she must be offered $30,000 and the other five workers must each be given a

$2,000 raise The cost of adding this new worker, called the marginal cost of labor, has

risen to $40,000 The marginal cost of labor is the additional cost to the firm of

expanding employment by one additional worker Note that as the number of workers

hired increases, the gap between the marginal cost of labor and the going wage rate

expands When two workers are hired, the gap is $2,000 ($24,000-$22,000) When six are employed, it is $10,000 ($40,000-$30,000)

Figure 15.8, based on columns 1 and 4 of Table 15.2, shows the marginal cost of

labor graphically The marginal cost curve lies above the supply curve, for the cost of

each new worker hired (beyond the first worker) is greater than the worker’s salary

_

FIGURE 15.8 The Marginal Cost of Labor

The marginal cost of hiring additional workers is

greater than the wages that must be paid to the new

workers Therefore the marginal cost of labor

curve lies above the labor supply curve

The Monopsonistic Hiring Decision

The monopsonistic employer does not get caught in the competitive bind By definition

it is the only or dominant employer Like a monopolist, the monopsonist can search

through the various wage-quantity combinations on the labor supply curve for the one

that maximizes profits The monopsonist will keep hiring more workers as long as their

contribution to revenues is greater than their additional cost, as shown by the marginal

cost of labor curve MC in Figure 15.9 To maximize profits, in other words, the

monopsonist will hire until the marginal cost of the last worker hired (MC) equals his

marginal value, as shown by the textiles market demand curve for labor Given the

demand for labor D, the monopsonist’s optimal employment level will be Q2, where the

marginal cost and demand for labor curves intersect Note that that level is lower than

the competitive employment level, Q3

Why hire where marginal cost equals marginal value? Suppose the monopsonist

employed fewer workers—say Q1 The marginal value of worker Q1 would be quite high

(point a), while her marginal cost would be low (point b) The monopsonist would be

forgoing profits by hiring only Q1 workers Beyond Q2 workers, the reverse would be

true The marginal cost of each new worker would be greater than his marginal value

Hiring more than Q2 workers would reduce profits

Once the monopsonist has chosen the employment level Q2, it pays workers no

more than is required by the labor supply curve, S In Figure 15.9, the monopsonist must pay only W1—much less than the wage that would be paid in a competitive labor market,

W2 In other words, the monopsonist hires fewer workers and pays them less than an

employer in a competitive labor market

_

FIGURE 15.9 The Monopsonist

The monopsonist will hire up to the point where

the marginal value of the last worker, shown by the

demand curve for labor, equals his or her marginal

cost For this monopsonistic employer, the

optimum number of workers is Q2 The

monopsonist must pay only W1 for that number of

workers—less than the competitive wage level, W2

It is the monopsonistic firm’s power to reduce the number of workers hired that

enables it to hold wages below the competitive level In a competitive labor market, if

one firm attempts to cut employment and reduce wages, it will not be able to keep its

business going, for workers will depart to other employers willing to pay the going

market wage The individual firm is not large enough in relation to the entire labor

market to exercise monopsony power It therefore must reluctantly accept the market

wage, W2, as a given

Employer Cartels: Monopsony

Power through Collusion

Envying the power of the monopsonist, competitive employers may attempt to organize a

cartel A employer cartel is any organization of employers that seeks to restrict the

number of workers hired in order to lower wages and increase profits

The usual way of lowering employment is to establish restrictive employment rules

that limit the movement of workers from one job to another Such rules tend to reduce

the demand for labor In Figure 15.10, demand falls from D 1 to D2 As a result, the wage

rate drops, from W2 to W1, and employment falls, from Q3 to Q2 Although the method of limiting employment is different from that used in monopsony, the effect is the same

Whether the monopsonistic firm equates marginal cost with marginal value (shown by

curve D 1 ) or the employer cartel reduces the demand for labor (to D2), employment still

drops to Q2 In both cases workers earn a wage rate of W1—less than the competitive

wage

One industry in which employers have tried to cartelize the labor market is

professional sports Owners of teams have developed complex rules governing the hiring

of athletes In the National Football League (NFL), for example, teams acquire rights to negotiate with promising college players through an annual draft Once one team has

drafted a player, no other team in the league can negotiate with him (unless he remains

unsigned until the next year’s draft) Teams can buy and sell draft rights as well as rights

to players already drafted, but within leagues they are prohibited from competing directly with one another for players’ services Violations of these rules carry stiff penalties,

including revocation of a team’s franchise

FIGURE 15.10 The Employer Cartel

To achieve the same results as a monopsonist, the

employer cartel will devise restrictive employment

rules that artificially reduce market demand to D2

The reduced demand allows cartel members to hire

only Q2 workers at wage W1—significantly less than

the competitive wage, W2

_

MANAGER’S CORNER I: Paying for Performance

To this point in the chapter, our discussion has been focused on how labor “markets”

work, and our interest has been on how the wage rate and other benefits are determined

by the broad forces of supply and demand However, markets must ultimately work with the interests of workers in mind The problem most firms must solve is how to get

workers to do what they are supposed to do, which is work effectively and efficiently

together for the creation of firm profits This is no mean task, as we will see at various

points in this book There is a lot of trial and error in business, especially as it relates to

how workers are paid At the same time, thinking conceptually about the

payment/incentive problem can help firms moderate the extent of errors in business

One of the most fundamental rules of economics, and the reason d’être the

discussions in the “Manager’s Corners,” is that if you offer people a greater reward, then they will do more of whatever is being rewarded, everything else equal Many people

find this proposition to be objectionable, because it implies that people can, to one degree

or another, be “bought.” Admittedly, incentives may not matter in all forms of behavior;

some people will sacrifice their lives rather than forsake a strongly held principle

However, the proposition that incentives matter does seem to be applicable to a

sufficiently wide range of behavior to be considered a “rule” that managers are well

advised to keep in mind: Pay someone a higher wage such as time and a half and

they will work overtime Pay them double time, and they will even work holidays

There is some rate of pay at which a lot of people will work almost any time of the day or night on any day of the year

This rule for incentives is not applicable only to the workplace Parents know that one of the best ways to get their children to take out the garbage is to tie their allowance

to that chore Moreover, patients in psychiatric hospitals, many of whom have literally

lost virtually all capacity for rational discourse, appear to respond to incentives

According to research, if mentally ill, institutionalized patients are paid for the simple

tasks they are assigned (for example, sweeping a room or picking up trash), they will

perform them with greater regularity.5

Even pigeons, well known for having the lowest form of birdbrains, respond to

incentives Granted, pigeons may never be able to grasp the concept of monetary rewards (offering them a dollar won’t enlist much of a response), but pigeons apparently know

how to respond to food rewards (offer a nut in the palm of your outstretched hand and a whole flock will descend, and maybe leave their mark, on your shoulder) From research,

we also know that pigeons are willing to work measured by how many times they peck colored levers in their cages to get food pellets, and they will work harder if the reward for pecking is raised Researchers have also been able to get pigeons to loaf on the job

just like humans How? Simply lower their rate of “pay.”6

The “Right” Pay

It would appear that rules of incentives would lead managers everywhere to make sure

that workers have the right incentives by always tying pay to some measure of

performance Clearly, the lone worker in a single proprietorship has the “right”

incentive His or her reward is the same as the reward for the whole firm The full cost

5

See Richard B McKenzie and Gordon Tullock, The New World of Economics (New York: McGraw-Hill, 1994), chap 4

6

Ibid

of any shirking is borne by the worker/owner However, such a congruence between the rewards of the owners and workers is nowhere else duplicated There are always “gaps” between the goals of the owners and the workers, and the greater the number of workers, typically, the greater the gap in incentives In very large firms, workers have greatly

impaired incentives to pursue the goals of the owners The workers are far removed from the owners by layers of bureaucracy, communications on firm goals are often imperfect,

and each worker at the bottom of the firm pyramid can reason that his or her

contributions to firm revenues and goals, or the lack of them, can easily go undetected A reoccurring theme of this book is that when monitoring is difficult, one can expect many

workers to exploit opportunities at their disposal

And the opportunities taken can result in substantial losses in worker output

Management specialist Edward Lawler reported that during a strike at a manufacturing

firm, a secretary was asked to take over a factory job and was paid on a piece rate basis Despite no previous experience, within days she was turning out 375 percent more output than the normal worker who had spent 10 years on the job and was constantly

complaining that the work standards were too demanding.7 Obviously, the striking

workers had been doing something other than working on the job

How can managers improve incentives, reduce shirking, and increase worker

productivity? At the turn of the century, the great management guru Frederick Taylor

strongly recommended piece-rate pay as a means of partially solving what he termed the

“labor problem,” but he was largely ignored in his own time by both management and

labor, and for the good reasons discussed in this chapter.8

There is a multitude of ways of getting workers to perform that don’t involve

money pay, and many of the ways are studied in disciplines like organizational behavior,

which draws on the principles of psychology Managers do need to think about patting

workers on the back once in a while, clearly defining corporate goals, communicating

goals in a clear and forceful manner, and exerting leadership

Southwest Airlines, one of the more aggressive, cost-conscious, and profitable

airlines, motivates its workers by creating what one analyst called a “community

resembling a 17th century New England town more than a 20th century corporation.” The

airline bonds its workers with such shared values as integrity, trust, and altruism.9 But, a

company with a productive corporate culture is almost surely a company with strong

incentives in place to reward productivity Without taking anything away from the

corporate culture at Southwest Airlines, it should, however, be pointed out that one

reason it has the lowest cost in the business is that its pilots and flight attendants are paid

by the trip This, along with a strong corporate culture, explains why Southwest's pilots

and flight attendants hustle when the planes are on the ground Indeed, Southwest has the shortest turn-around time in the industry It pays the crews to do what they can to get

7

Edward E Lawler, III, Strategic Pay: Aligning Organizational Strategies and Pay Systems (San Francisco: Jossey-Bass Publishers, 1990), p 58

8

Frederick W Taylor, “A Piece Rate System,” American Society of Mechanical Engineers Transactions, vol 16 (1895), pp 856-893

9

William G Lee, “The New Corporate Republics,” Wall Street Journal (September 26, 1994), p 12

their planes back in the air.10 Motorola organizes its workers into teams and allows them

to hire and fire their cohorts, determine training procedures, and set schedules Federal

Express’ corporate culture includes giving workers the right to evaluate their bosses and

to appeal their own evaluations all the way to the chairman But, still, it’s understandable

why Federal Express delivery people move at least twice as fast as U.S postal workers: FedEx workers have incentives to do so, whereas postal workers do not.11

We don’t want to criticize the traditional, non-incentive methods for getting

things done in business Indeed, we have taken up the issue of “teams” discussed much

earlier in the book, and the importance of virtues like “trust” will be raised before we

conclude this chapter At the same time, we wish to stress a fairly general and

straightforward rule for organizing much production: Give workers a direct detectable

stake in firm revenues or profits in order to raise revenues and profits Pay for

performance One means of doing that is to make workers’ pay conditional on their

output: the greater the output from each worker, the greater the individual worker’s pay

Ideally, we should dispense with salaries, which are paid by the week or year, and always pay by the “piece” or “piece rate.” Many firms for example, hosiery mills

do pay piece rate; they pay by the number of socks completed (or even the number of

toes closed) Piece rate can be expected to raise wages of covered workers for two

reasons: First, the incentives can be expected to induce workers to work harder for more minutes of each hour and for more hours during the workday Second, the piece-rate

workers will be asked to assume some of the risk of production, which is influenced by

factors beyond the workers’ control For example, how much each worker produces will

be determined by what the employer does to provide workers with a productive work

environment and what other workers are willing to do So, piece-rate workers can be

expected to demand and receive a risk premium in their paychecks One study has, in

fact, shown that a significant majority of workers covered under “output-related

contracts” in the nonferrous foundries industry earn between 5 percent and 12 percent,

depending on the occupation, more than their counterparts who are paid strictly by their

time at work Of that pay differential, about a fifth has been attributable to risk bearing

by workers, which means that a substantial share of the pay advantage for incentive

workers is attributable to the greater effort expended by the covered workers.12

However, such a rule – paying by the piece is hardly universally adopted

Indeed, piece-rate workers probably make up a minor portion of the total work force (we have not been able to precisely determine how prevalent piece-pay systems are) Many

automobile salespeople, of course, are paid by the number of cars sold Many lawyers

are paid by the number of hours billed (and presumably services provided) Musicians

are often paid by the number of concerts played

10

Howard Banks, "A Sixties Industry in a Nineties Economy," Forbes, May 9, 1994: pp 107-112

11

FedEx actually tracks its delivery people on their routes, and the workers understand that their pay is tied

to how cost-effective they are in their deliveries Postal workers understand that they are not being so carefully monitored, mainly because there are no stockholders who can claim the profits from a speed-up in their work

12

Tron Petersen, “Reward Systems and the Distribution of Wages,” Journal of Law, Economics, and Organizations, vol 7 (special issue), 1991, pp 130-158

But there are relatively few workers in manufacturing and service industries

whose pay is directly tied to each item or service produced Professors are not paid by

the number of students they teach Office workers are not paid by the number of forms

processed or memos sent Fast food workers are not paid by the number of burgers

flipped Most people’s pay is, for the most part, directly and explicitly tied to time on the job They are generally paid by the hour or month or even year

Admittedly, the pay of most workers has some indirect and implicit connection to production Many workers know that if they don’t eventually add more to the revenues

of their companies than they take in pay, their jobs will be in considerable jeopardy The question we find interesting is why “piece rate” or “pay for performance” is not a

more widely employed pay system, given the positive incentives it potentially provides

Many explanations for the absence of a piece-rate pay system are obvious and

widely recognized.13 The output of many workers cannot be reduced to “pieces.” In

such cases, no one should expect pay to be tied to that which cannot be measured with

tolerable objectivity Our work as university professors is hard to define and measure In fact, observers might find it hard to determine when we are working, given that while at

work, we may be doing nothing more than staring at a computer screen or talking with

students in the hallways Measuring the “pieces” of what secretaries and executives do is equally, if not more, difficult

If a measure of “output” is defined when the assigned tasks are complex, the

measure will not likely be all-inclusive Some dimensions of the assigned tasks will not

be measured, which means that workers’ incentives may be grossly distorted They may work only to do those things that are defined and measured and related to pay at the expense of other parts of their assignments If workers are paid by the number of parts

produced, with the quality of individual parts not considered, some workers could be

expected to sacrifice quality in order to increase their production count If professors

were paid by the number of students in their classes, you can bet they would spend less

time at research and in committee meetings (which would not be all bad) If middle

managers were paid solely by units produced, they would produce a lot of units with little attention to costs There is an old story from the days before the fall of communism in

the former Soviet Union According to the story, the managers of a shoe factory were

given production quotas for the number of shoes they had to make, and they were paid

according to how much they exceeded their quota What did they do? They produced

lots of shoes, but only left ones!

Much work is the product of “teams,” or groups of workers, extending, at times,

to the entire plant or office Pay is often not related to output because it may be difficult

to determine which individuals are responsible for the “pieces” that are produced

13

For a review of arguments offered by psychologists against incentive pay plans, see Alfie Kohn, “Why Incentive Plans Cannot Work,” Harvard Business Review September-October 1993, pp 54-63 Kohn sums

up his argument, “Do rewards motivate people? Absolutely They motivate people to get rewards” (p 62), suggesting that the goals of the firm might not be achieved in the process, given the complexi ty of the production process and the margins workers can exploit Kohn’s criticisms are reviewed and critiqued in the last chapter of this book