What happens when firms can choose wages?

In an introductory economics course, students are shown models of the labor market that assume the market is perfectly competitive. Wages are set by supply and demand, the well-known mechanisms of the market, and firms take these wages as given. Supply and demand are very important, but there’s increasing evidence that individual firms do have the ability to set wages as they balance other factors that also affect profits. Whether this observation is true has important implications for how we think about the labor market and economic inequality.

How exactly might perfectly competitive models of the labor market not hold up to scrutiny? What other models might do better at explaining the world around us? There are two telling models of imperfect labor market competition. First is the efficiency wage model, in which higher wages can boost the productivity of workers by boosting morale. In these cases, employers have a reason to raise wages because it can help the bottom line.

The second model is what’s known as a monopsony, in which employers have some degree of power in the marketplace because they have enough purchasing power over labor. In these cases, the level of employment in the overall economy is affected by the wages offered by employers rather than the other way around. So offering a higher wage might actually increase the pool of available labor.

So what are the implications of these two models? As two posts by Nobel Laureate Paul Krugman and one by the University of Massachusetts-Amherst’s Arindrajit Dube show, employers with some control over pay can actually raise wages a bit without seeing much of a decline in profits. As Krugman depicts in one of his posts, the trade-off between higher wages and higher profits is small and might even be zero. This result, if it actually holds up in the real world, would mean that firms can somewhat control wages and thus could raise them without seeing a major dent in profits. Krugman points to the recent experience of Walmart as an example reflecting the efficacy of these models.

But the implications of the models don’t stop here. Economics commentator Robert Waldmann points out that they might resolve a riddle in economics research posited by Harvard University economist George Borjas, who notes findings that indicate minimum wage increases don’t raise unemployment and that more immigration has a small effect on wages. Yet, as Waldmann points out, there’s only a contradiction between the two results Borjas point to if one believes the labor market is perfectly competitive. If one believes competition in the market is imperfect, then Krugman and Dube may be onto something.

Of course, we shouldn’t take these models too far. Employers may have some control over wages, but perfectly competitive models may also be good tools for explaining other trends in the labor market. Still, many of the labor market policies that are used to reduce inequality in the market, such as raising the minimum wage or increasing unionization, don’t seem to have the negative effects on the efficiency of firms and economic growth that the perfectly competitive models would have us believe. The implications could be significant.