Competition in the Labor Market

by Lindy Davies

It is often said that “perfect competition” doesn’t actually happen in the real world, that it is merely a theoretical ideal used to illustrate points in Econ texts. The goods commonly cited as examples of perfect competition — agricultural goods such as wheat, corn, soybeans, etc. — are often provided with public support in the form of subsidies or protective tariffs! In fact, few, if any, goods that are sold in perfectly competitive markets, and firms seek to limit the pressure of competition in any way they can.

There is one market, though, in which perfect competition reigns supreme, and has for hundreds of years. In this market, the quality of one seller’s product is essentially identical to that of any other seller, and the number of sellers is very large. Competition forces the price right down to the good’s marginal cost, every time. Not only that — this market is very important and ubiquitous; it is a fundamental building block of the economy.

What is it? The market for unskilled labor.

When I say “unskilled labor,” I mean no disparagement; I just mean workers who are selling their labor time, without any resource that would improve their bargaining power, such as union membership, governmental regulation or professional license. An economist will tell you that in a perfectly competitive market, profit is maximized when the price is equal to the seller’s marginal cost.

But what could that mean, in the case of labor? What is labor’s marginal cost?

Labor’s marginal cost is, essentially, working another day, instead of not working — the unskilled worker has no better alternative. So, while it is true that workers engage in what economists like to call “profit maximizing” behavior, we must not forget that for most of them, “profit maximization” means working, instead of starving. Any wage rate higher than mere subsistence will always be undercut by some other worker who is just a bit more desperate. The marginal cost of unskilled labor is subsistence. That is its market-clearing price.

Clearly, just selling one’s labor is no way to get ahead. Labor must find a better bargaining position. And to a large extent, it has — at least in the world’s developed economies. Wretched subsistence was the general condition of most workers during the rise of the industrial revolution in the 19th century. Over time, in the general interest of social stability, workers had to be given some relief from the crushing burden of pure competition in the labor market.

There were three basic ways in which this came about:

  • Labor unions. Workers acted collectively — often at great risk to themselves — to stop or inhibit production until wages and working conditions were improved. Over time, their solidarity and sacrifice gave unionized workers better bargaining power.
  • Education. By enhancing their skills or gaining professional credentials, workers could raise their price. (In this case, workers took themselves out of the general labor market, seeking to enter less-competitive skilled-labor markets.)
  • Welfare-state protections. Prominent among these are social security, which provides retirement benefits, workplace safety and health regulations, and minimum wage requirements. (These interventions effectively set a “floor” for wages — they were no longer allowed to fall to their market-clearing level.)

These attempts to ease the crushing burden of perfect competition in the labor market were successful — as far as they went. In the “First World,” they contributed to the creation of a large middle class, a huge group of eager consumers whose demand for goods created high levels of overall prosperity.

In a way, though, they carried the seeds of their own destruction. To see why, consider this matter from management’s point of view. There was a labor market whose equilibrium price for labor was bare subsistence. Along came the labor unions, saying the workers aren’t paid enough. Their strikes succeeded at last, and management agreed to pay the workers more of the wealth that they produced.

But: when the workers went back to the factory after the strike, had they suddenly become more productive? No: they produced the same amount of wealth per day as before. Yet management had to pay them more! In order to get back up to the same level of profit, management had to find some way to get more wealth out of the same worker/hour. They had to invest in increased productivity.

Thus we see that an economy in which large numbers of workers can command high wages will tend to be innovative and highly productive — and an economy in which most of the workers have no better opportunity than bare-subsistence wages will tend to have trouble getting out of its own way.

Nevertheless: markets do what markets do; people seek to satisfy their desires with the least exertion. If employers are able to pay workers less, they will. They will seek to replace union workers with non-union workers… or to replace full-time, health-insured workers with part-timers with no benefits… or replace domestic health- and safety regulated workers with foreign competitors who work much cheaper. Although high stimulate overall productivity and progress, wages nevertheless tend to drift downward. Labor’s gains in the marketplace get whittled away over time.

Why? Because the market for unskilled labor is perfectly competitive. That will be true as long as there are more workers than jobs for them to do — in other words, as long as there is any unemployment at all.

To reiterate: the econ-speak definition of perfect competition is “a market in which profit is maximized when price equals marginal cost.” And in the case of laborers:

Profit Maximization = working at all, instead of starving
Marginal Cost = subsistence

We also said that this would always be the sad truth, as long as there was unemployment. Now, unemployment is an acute problem right now; we’re climbing out of a Great Recession and it’s all over the news. But the fact is, we’ve had an unemployment problem all along — even when times seemed good.

To see this, it’ll help know a bit about how unemployment is defined and counted. For the US government’s counting purposes, a person is employed if he or she has worked for pay for any time at all, even just one hour, during the past week. A person is unemployed if he or she has not worked for pay during that time but has actively sought work. People who have neither been working nor seeking work are defined as “outside the labor force”. Using these definitions, the US Department of Labor puts the current unemployment rate (September, 2012) at 8.1%, and the “labor force participation rate” at 63.5%. Seems bad.

Compare these numbers, for example, with those from 2000, when the US economy was chugging along. The Federal government was even running an annual budget surplus! Yet that year we still had an unemployment rate of 3.8%. And our labor force participation rate has never been higher than the roughly 67% it reached in the late 1990s.

Even in good times, a very sizable percentage of the adult population is not working for a living. If — according to standard macroeconomic theory — we were to put very many of these people to work, inflation would shoot through the roof.

Businesses hire workers as long as it is profitable for them to do so. We wouldn’t expect them to keep hiring workers just to stand around and get in each other’s way, would we? No, we want businesses to be lean, mean profit-maximizing machines. But, some workers always get left out.

Why should labor be unemployed? There’s no shortage of desires to satisfy. Why can’t every person willing and able to work find land to work on and capital to work with? Why can’t we send our unemployment rate down to zero?

All right: so let’s move in that direction. What happens when the economy is going great guns, more people are working, producing more stuff, increasing demand? For a while, it’s pretty easy to meet the increased demand: factories just produce more, right up to their full capacity. But: what happens when demand continues to increase? Factories will have to add more assembly lines; workers will have to work overtime. That will tend to drive prices up at a faster rate than output is increasing. In other words, it’ll lead to inflation.

There appears to be a point beyond which the economy cannot hire more people to produce more stuff, because doing so would lead to an unacceptably severe rise in prices. There must be a point, then, at which we have the highest possible number of people working without creating too much inflation. Economists call that level of production the potential output of the economy at any given time. The level of employment that exists at the economy’s potential output is called the full employment point. (It is also called the Non-Accelerating Inflation Rate of Unemployment, or NAIRU.)

So, because of the problem of inflation, “full employment” does not mean that everyone who wants a job can find one! “Full employment” in the US has hovered in the range of five to six per cent unemployed for decades.

This conventional wisdom has been well-settled in economics for many decades now. But that doesn’t mean it is correct! Georgist (or Geoist) economists content that there is a structural flaw in our economy, which is entirely removable — and which keeps us from achieving full employment without drastic increases in inflation. Does that sound interesting? You can read more about it right here.


One Response to Competition in the Labor Market

  1. Pingback: Minimum Wage | ebrunnerblog

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