Labor Market Monopsony: Fundamentals and Frontiers

This chapter reviews the theory of monopsonistic wage setting, its empirical implications, and some puzzles the framework has struggled to explain. We begin by examining the fundamentals of monopsonistic wage determination. The core of the theory is a mapping from the distribution of worker outside options to wages. We study non-parametric shape restrictions that ensure this mapping is unique. Building on these results, we introduce a menu of tractable parametrizations of labor supply to the firm, some of which are shown to emerge naturally from equilibrium search models. Next, we review why wage markdowns do not necessarily signal inefficiency and discuss some criteria for assessing misallocation in a monopsony model with search frictions. Turning to the model’s empirical implications, we examine how the magnitude of productivity-wage passthrough depends on the super-elasticity of labor supply to the firm and establish that compensating differentials for firm amenities depend on the curvature of the outside option distribution. We show that firm-specific shifts in either productivity or amenities can be used as instruments to identify labor supply elasticities and review strategies for estimating non-constant elasticities. We then consider extensions of the basic model involving third-degree wage discrimination and examine their ability to rationalize patterns of worker-firm sorting. Monopsony models traditionally assume that firms commit to posted wages. Relaxing this assumption, we develop a connection between the first-order conditions of the monopsony model and models of bargaining with incomplete information. These models explain why bilateral inefficiencies may persist in the presence of negotiation, yield predictions about the response of within-firm wage dispersion to productivity shocks, and suggest reasons why some productivity shifters may not constitute excludable instruments. Next, we endogenize productivity by allowing for efficiency wages, non-constant returns to scale, and price-cost markups. Empirical monopsony estimates often suggest that firms enjoy implausibly large profit margins. We argue that allowing for non-constant labor supply elasticities and firm adjustment costs can potentially resolve this difficulty. Finally, we review why the strong passthrough of minimum wages to product prices presents a challenging puzzle for standard monopsony models and discuss potential reconciliations to this puzzle involving firm heterogeneity, quality upgrading, and lumpy price adjustment.