This analysis will focus on the long run labour market. In the long run, the demand for labour is more elastic (as labour is more replaceable with capital). In a perfectly competitive market, social welfare is maximised. However, in reality, the employers often possess some degree of market power over the labour suppliers, resulting in a different market setting known as the Monopsony.
A monopsony market is a contrast to a monopoly market, where instead of having one single firm supplying goods for the market, the monopsony is one single firm demanding or consuming labour from the labour market. As such, the monopsony has market power to control the wage and quantity of labour consumed in the market. In reality, labour markets can exhibit monopsony behaviour if the labour force encounters barriers to exit, which can be due to reasons such as locations, qualifications etc.
In a non-wage discriminating monopsony, the firm will end up hiring less labour at a lower wage than in a perfect competition setting. The following shows the labour market:
The Marginal Revenue Product of Labour (MRP) shows the marginal revenue generated by each additional unit of labour, and this is in fact the demand curve for labour in the monopsony market. In a perfectly competitive setting, the society welfare will be maximised at a wage level of W’. However, for the monopsonist, the profit maximising level of production occurs when MC = MR, and the corresponding labour consumption will be at a quantity when Marginal Cost of Labour = MRP (point A). At this point, the firm will be paying a lower wage of W to hire the required quantity of labour L. The society will incur a deadweight loss (area AMC). The market power of a monopsonist depends on the elasticity of labour supply; the more elastic the supply, the less power the monopsonist has. Intuitively, this makes sense as a labour force with more options to pursue alternate activities will be less restricted by the demands of hiring firms.
Similar to price discrimination of monopoly, a monopsony may practice wage discrimination to maximise profit and social welfare. However in reality, this is difficult to implement due to workplace norms, concerns over fairness, as well as employment laws.
Revisiting Minimum Wage
I believe in most elementary economics courses, the topic of minimum wage is usually taught using a perfect competition market setting, hence minimum wage is often misunderstood to be upsetting the market equilibrium and creating deadweight loss. This is true indeed, but only for certain market settings. For a monopsony labour market, price intervention through minimum wage is a viable policy tool for the government to maximise social welfare.
With reference to the previous diagram, if the government is able to accurately identify the optimal wage level, and set the minimum wage to be W’, this will result in the monopsonist having a horizontal MC curve that cuts through the MRP at point C. As a result, labour will be consumed at quantity L’, and social welfare will be maximised.
However, this is tricky for the government as setting the minimum wage too high might make the labour market worse off than the monopsony level. Emperically, evidences seem to have shown that adjusting minimum wage higher results in lower employment, which creates arguments against minimum wage. However, these adjustments are often made in times of poor economy, under great political pressures, hence it is inevitable that employment will decrease.
More objective experiments have shown that minimum wage truly raises employment. Intuitively, this makes sense as minimum wage usually benefits low skilled workers, who have very limited options in the job market and therefore they are highly vulnerable to the market power of monopsonists.
(Reference: MIT OCW Principles of Microeconomics)