How do labor markets work?

Like every other market. Supply and demand determine broccoli, bean, and bowling ball prices. They also determine wages. What Bryan Caplan calls The World’s Greatest Market is complicated, and the competitive model doesn’t explain everything. People don’t understand, however, how competitive labor markets work, and that’s a bigger problem than voters not subscribing to the Journal of Labor Economics. As teachers, economists have work to do.

Historians and economists have based much of their analysis on the notion that workers and employers have unequal bargaining power. W.H. Hutt traced this idea, which he called “wooly,” back to Adam Smith. Hutt argued that competitive labor markets are workers’ friends, not enemies. His view runs counter to what a lot of people think. Hutt didn’t believe employers were enlightened or benevolent. Bob might be obsessed with his bottom line, however, other employers are obsessed with their bottom lines and stand ready to hire workers whom Bob might be mistreating. Hutt isn’t thinking wishfully, either. Rising productivity in competitive labor markets improves wages and working conditions. Studies of South African apartheid show how white workers enriched themselves by stopping native competition. So how does a competitive labor market work?

First, people try to maximize their well-being. Second, they compare costs and benefits. It’s easy to object that people shouldn’t be self-interested or aren’t always rational. By rational, however, we do not mean people will always get things right, that psychological biases do not beset them, or that they never do stupid things. The economists’ assumption of “rational choice” is not a postulate about how well the mind works. Instead, we mean by “rational” that people change their behavior in response to evolving costs, benefits, and constraints. If beef prices rise and chicken prices fall, people will buy less beef and more chicken, holding everything else constant. As Ronald Coase explained, it may not be “rational” to dash across a busy street to get to a sandwich shop. Still, we can predict that people will take more such chances if traffic dies down a bit.

Economists also aren’t excusing or rationalizing the kind of self-absorption we try to teach out of our children. When we say people maximize their wellbeing, we don’t mean they are pathologically selfish sociopaths. We define “interest” and “wellbeing” broadly and subjectively: people try to fashion the world to their liking. They might be narrowly, materially focused, or pathologically selfish. They might also be altruistic. Parents define their “own interest” and their “own wellbeing” to include their kids’ welfare. People also make tradeoffs. Sometimes, they read to the kids at bedtime. Other times, they are too tired and decide to go straight to bed.

Workers’ alternatives determine how much labor people will supply in a competitive labor market. Workers’ productivity, as measured by the value of the workers’ incremental contributions to output, also known as the marginal product, determines how much labor firms demand at different wages. In competitive equilibrium, workers supply labor and firms demand it, until the point at which the value of the marginal product of labor is equal to the value of the workers’ best alternative. Once the dust settles, firms and workers in competitive markets realize all the possible gains from trade.

We have to remember some important facts. First, markets are competitive on the demand side as well as the supply side, and profit-obsessed employers are keen to snatch up labor they can employ profitably. Second, labor market brinksmanship is costly, because time is money. Refusing to hire a worker who could be employed profitably means sacrificing the difference between the worker’s contribution to output and the worker’s wage. It might be possible for a monopsonist (a single employer in the labor market) to hold out. But in a competitive labor market, profit-obsessed employers will be keen to snatch up workers they can employ profitably. Third, people act as individuals, not classes. While it might be good for capital as a class to hold down wages, combinations in pursuit of that power are notoriously difficult to maintain. For example, suppose everyone else in the cartel will offer low wages. In that case, an individual cartel member can increase profits by cheating on the cartel and offering slightly higher wages.

Labor market competition, therefore, protects market participants from “exploitation.” When there is a labor shortage, it pushes wages up. When there is a labor surplus, it pushes wages down. In equilibrium, it maximizes gains from trade. Government intervention, however, can redistribute some of these gains from trade (at a cost in terms of foregone output). On this, Marxists and public-choice economists can agree that there is a great deal of effort expended to induce the state to create economic rents, or returns to an asset over what it could earn elsewhere. A Marxist analysis would emphasize the capitalist class’s power. In South Africa especially, it would be incorrect. Generally, apartheid helped white workers, while it hurt business owners and black workers.

W.H. Hutt argued that competitive labor markets were workers’ most reliable guardians. He was never one to defer to people simply because of their “greatness.” On the contrary, he argued that even greats like Adam Smith and Alfred Marshall had “wooly” ideas about bargaining power. Workers compete with one another for jobs, but firms compete with one another for workers. When people are allowed to compete, one’s folly becomes another’s opportunity. If we want, as Hutt did, to increase incomes (particularly for the poor), we would be wise to repeal rules and laws that make labor markets less competitive.