Monopsonistic Markets

Monopsony

A monopsony is a market where only one firm buys a factor of production. This means that if the firm decides not to buy that factor of production, there will be no buyers. This gives the firm, the monopsonist, a high level of control over the price of that factor of production.

Now that you know the definition of a monopsony, let's explain what factors of production are and why the firm buys it in the first place. Factors of production are the resources used by firms in production. They are the inputs required to make goods and services.

The factors of production are:

• land
• capital
• labor
• entrepreneurship

From the above, we can see why firms need the factors of production. Note that firms are the buyers in factor markets. To get these factors of production, firms need to buy them from the households who own them. Households are the suppliers in factor markets, which are markets for the factors of production.

Figure 1 shows the relationship between firms and households in the circular flow diagram.

Fig 1. - Circular flow diagram

Monopsonistic Competition

While a monopsony is a factor market where only one firm buys a factor of production, monopsonistic competition is characterized by several small firms that buy similar but unidentical factors.

Monopsony Characteristics

You should be able to identify a monopsony by looking out for certain key conditions. Let's help you do this.

A monopsony has three main characteristics:

1. There is a firm that is a buyer for this factor of production.
2. There are no alternative buyers for that factor of production in the market.
3. The entry of other firms into the market is restricted.

Let's explain this some more using the following example.

From the above example, let's check each characteristic to determine whether it is a monopsony.

1. This firm employs people who can process coffee.
2. There are no other companies employing people who can process coffee.
3. The firm owns large farmlands and plants its own coffee. A new company will have to start from scratch while competing with the already established company, making this a restriction to the entry of a new company.

As we can see, the example satisfies all the three characteristics of a monopsony.

Characteristics of Monopsonistic Competition Market Structure

Now, let's help you identify monopsonistic competition. There are four main characteristics you should take note of:

1. There are several small firms.
2. The small firms buy similar but not identical factors.
3. The firms know a lot about prices and technology, but they do not know all about them.
4. The firms can leave and enter the market relatively easily. There are weaker barriers to entry.

One way to think of monopsonistic competition is a small town with two or three big employers. Thus, the workers have a few options. The firms cannot keep their wages too low or they will lose their employees to the other firms. However, the wage rate will still be lower than if there had been an unlimited supply of employment opportunities.

Graph of Monopsonistic Competition

How does a profit-maximizing firm in a monopsonistic factor market decide how much of the resource to demand at each given price? The firm's demand curve is the quantity that the firm would like to purchase for any given price. We can generally expect that the firm operates in the range where each additional unit provides a benefit--it increases the total revenue that the firm receives.

All else being equal, an increase in revenue is an increase in profit, and we will address costs later on. Just as the demand curve in a goods market reflects the marginal benefit of the next consumer, the monopsonistic firm's demand curve (D) for a resource is the marginal increase in revenue from using an additional unit of that resource. This is called the marginal revenue product (MRP).

Let's consider a local labor market with very few employers. The firm's marginal revenue from hiring additional workers is called the marginal revenue product of labor (MRPL). This is the firm's demand curve. For a given wage rate, the firm would like to hire workers as long as the marginal worker has a non-negative effect on profit.

Now, notice that the firm in this monopsonistic labor market faces an upward sloping supply curve given by the market. As the firm's wage rate increases, more people are willing to leave one of the other companies and seek jobs from this company. As the wage rate decreases, people are incentivized to quit and go work at one of the other companies.

Also, notice that the firm must offer one wage rate for all of its employees. If the firm is struggling to hire new workers and must increase its wage rate, it must do so for all employees. The wage increase for existing labor is necessary because the existing employees will want their wage rate to match that of any new employee. Otherwise, they have an incentive to quit their job and get rehired! So the firm ends up having to give everybody a raise!

This means that the marginal factor cost to the firm of hiring an additional worker is higher than the labor supply curve.

Consider the graph in Figure 2. This is a firm in a monopsonistic labor market. Labor supply is given by the market. It is the supply curve faced by this individual firm. When the firm is employing Qm workers at wage Wm, we are on the labor supply curve. This means that Qm is precisely the number of workers willing to work for Wm, and the next marginal hiree would require a higher wage rate.

Fig 2. - Monopsony labor market

The firm can hire additional workers at wage rate Wc, and we can see that there are in fact Qc workers who will be incentivized to work at that rate. However, the marginal cost to the firm is not just Wc for the new workers but also includes Wc - Wm for all of the existing workers! Thus, we see that the marginal factor cost curve (MFC) for the firm is increasingly higher than the labor supply curve (S), which reflects the marginal cost of the new labor alone.

The profit maximizing firm hires labor up to the point where MC = MB. Specifically, this is where the firm's marginal revenue product of the new labor equals the marginal cost of that new labor combined with the wage increase for all existing labor. This is the intersection of MFC and D. The profit-maximizing behavior of the firm in a monopsony is to make sure the marginal factor cost equals the firm's demand (D). It is equivalent to say that the firm makes sure the marginal factor cost (MFC) of labor equals the marginal revenue product of labor (MRPL).

In equilibrium, the firm ends up employing fewer workers (Qm instead of Qc) and paying a lower wage (Wm instead of Wc) than it normally would have done if the factor market had been perfectly competitive. The firm ends up at point Y instead of point X. This is an inefficient outcome relative to perfect competition.

Advantages and Disadvantages of Monopsonistic Competition

While monopsonistic competition mostly benefits the firms in such a market, the suppliers (households) in the same market bear some unwanted conditions. Let's look at the advantages and disadvantages of monopsonistic competition.

First, the social advantages of monopsonistic competition:

• The firms exercise higher control over factor prices and factor demand
• The firms are able to drive down factor prices to reduce their production costs
• The firms gain larger profits due to the ability to drive down factor prices
• Weaker barriers to entry

Economists refer to the second bullet point above as monopsonistic discrimination.

Now, the social disadvantages of monopsonistic competition:

• Households have no choice but to sell to the only firm willing and able to buy their factors of production
• Workers face significantly lower wages in a monopsonistic market

Monopsonistic Markets and Monopsony Examples

One example of a monopsony market is the coal mining towns that used to exist in the U.S. when the coal mining industry was flourishing. A coal town was created around each coal plant, and the coal plant was the only employer around. These towns were known for also having a company store where the employees could buy goods and services. However, because the company was a monopsonist in the labor market and a monopolist in the goods and services market, it could keep wages down and goods prices high, and these situations were disastrous for the employees caught up in them.

Another more modern example of monopsony is a small town with an Amazon warehouse. If Amazon is the only employer in the town, it is a monopsonist in the labor market.

Let's end this article with a scenario involving companies you may already know. Google and Apple! Consider the following example of monopsonistic competition.

Well done! You made it to the end of this article and you now know how companies can have an unfair advantage over workers in a monopsony. Read our article on the Imperfectly Competitive Labor Market to understand what really goes in in a monopsony. We have some interesting graphs over there!