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14.3: Price Setters on the Supply Side

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  • Learning Objectives

    1. Explain and illustrate how a monopoly supplier of some factor of production maximizes profit.
    2. Discuss some of the ways that labor unions try to exercise market power.
    3. Define bilateral monopoly and explain and illustrate why prices in the model are indeterminate.
    4. Explain how professional associations and producers’ cooperatives affect supply.

    Buyers are not the only agents capable of exercising market power in factor-pricing choices. Suppliers of factor services can exercise market power and act as price setters themselves in two ways. First, a supplier may be a monopoly or have a degree of monopoly power in the supply of a factor. In that case, economists analyze the firm’s choices as they would analyze those of any other imperfectly competitive firm. Second, individual suppliers of a factor of production may band together in an association to gain clout in the marketplace. Farmers, for example, often join forces to offset what they perceive as unfair market power on the part of buyers of their products. Workers may join together in a union in order to enhance their bargaining power with their employers. Each case is discussed below.

    Monopoly Suppliers

    A firm with monopoly power over a particular factor can be expected to behave like any other monopoly. It will choose its output where the marginal revenue and marginal cost curves intersect and charge a price taken from its demand curve.

    Figure 14.11 Monopoly Factor Supply


    A monopoly supplier of a factor of production acts just as any other monopoly firm. Here, the monopoly faces the demand curve D and the marginal revenue curve MR. Given the marginal cost curve MC, it maximizes profit by supplying Qm and charging a price Pm.

    A monopoly supplier of a factor faces a demand curve that represents the MRP of the factor. This situation is illustrated in Figure 14.11 “Monopoly Factor Supply”. The firm will charge a price Pm equal to the MRP of the factor and sell Qm units of the factor.


    Workers in a competitive market receive a wage equal to their MRP. If they face monopsony power, they get less. Regardless of the market structure, workers are likely to seek higher wages and better working conditions. One way they can try to improve their economic status is to organize into a labor union, an association of workers that seeks to raise wages and to improve working conditions. Unions represent their members in collective bargaining, a process of negotiation of worker contracts between unions and employers. To strengthen its position, a union may threaten a strike—a refusal by union members to work—unless its demands are met.

    A Brief History of Unions

    Workers have united to try to better their lot at least since the Middle Ages, when the first professional guilds were formed in Europe. In the United States, “workingmen’s societies” sprang up in the late eighteenth century. These organizations were craft unions uniting skilled workers in the same trade in an attempt to increase wages, shorten working hours, and regulate working conditions for their members.

    One goal unions consistently sought was a closed shop, where only union members can be hired—an arrangement that gives unions monopoly power in the supply of labor. A second objective was to gain greater political and economic strength by joining together associations of different crafts. Union goals went largely unfulfilled until the twentieth century, when the courts began to favor collective bargaining between workers and employers in disputes over wages and working conditions. Closed-shop arrangements are illegal in the United States today, but many states permit union shop arrangements, in which a firm is allowed to hire nonunion workers who are required to join the union within a specified period. About 20 states have right-to-work laws which prohibit union shop rules.

    The development of the industrial union, a form of union that represents the employees of a particular industry, regardless of their craft, also aided the growth of the labor movement. The largest industrial union in the United States, the AFL-CIO, was formed in 1955, when unions accounted for just over 35% of the labor force. The AFL-CIO remains an important economic and political force, but union strength has fallen since its peak in the 1950s; today, less than 10% of workers in the private sector belong to unions. Quite dramatically, in 2005, three unions, representing about a third of the total membership, withdrew from the AFL-CIO. The break-away unions argued that they would be more successful working on their own to recruit new members. The impact of this break-up will not be known for several years.

    Part of the reason for the failure of unions to represent a larger share of workers lies in the market forces that govern wages. As the marginal revenue product of workers has risen throughout the economy, their wages have increased as well—whether they belonged to a union or not. Impressive economy-wide wage gains over the last two centuries may be one reason why the attraction of unions has remained weak.

    Higher Wages and Other Union Goals

    Higher wages once dominated the list of union objectives, but more recent agreements have also focused on nonwage issues involving job security, health insurance, provision of child care, and job safety. Unions such as the United Auto Workers have negotiated contracts under which members who are laid off will continue to receive payments nearly equal to the wages they earned while on the job. They have also pushed hard for retirement pensions and for greater worker involvement in management decisions.

    Union efforts to obtain higher wages have different effects on workers depending on the nature of the labor market. When unions confront an employer with monopsony power, their task is clear: they seek a wage closer to MRP than the employer is paying. If the labor market is a competitive one in which wages are determined by demand and supply, the union’s task is more difficult. Increasing the wage requires either increasing the demand for labor or reducing the supply. If the union merely achieves a higher wage in the absence of an increase in demand or a reduction in supply, then the higher wage will create a surplus of labor, or unemployment.

    Increasing Demand

    The demand for labor in a competitive market is found by summing the MRP curves of individual firms. Increasing demand thus requires increasing the marginal product of labor or raising the price of the good produced by labor.

    One way that unions can increase the marginal product of their members is by encouraging investment in their human capital. Consequently, unions may pressure firms to implement training programs. Some unions conduct training efforts themselves.

    Another way to increase the MRP of a factor is to reduce the use by firms of substitute factors. Unions generally represent skilled workers, and they are vigorous proponents of minimum wage laws that make unskilled workers more expensive. A higher minimum wage induces firms to substitute skilled for unskilled labor and thus increases the demand for the skilled workers unions represent.

    Still another way to increase the MRP of labor is to increase the demand for the products labor produces. The form this union activity generally takes is in the promotion of “Made in the U.S.A.” goods. Unions have also promoted restrictive trade legislation aimed at reducing the supply of foreign goods and thus increasing the demand for domestic ones.

    Reducing Labor Supply

    Unions can restrict the supply of labor in two ways. First, they can seek to slow the growth of the labor force; unions from the earliest times have aggressively opposed immigration. Union support for Social Security also cut the labor supply by encouraging workers to retire early. Second, unions can promote policies that make it difficult for workers to enter a particular craft. Unions representing plumbers and electrical workers, for example, have restricted the number of people who can enter these crafts in some areas by requiring that workers belong to a union and then limiting the union’s membership.

    Bilateral Monopoly

    Suppose a union has negotiated a closed-shop arrangement (in a country where such arrangements are legal) with an employer that possesses monopsony power in its labor market. The union has a kind of monopoly in the supply of labor. A situation in which a monopsony buyer faces a monopoly seller is called bilateral monopoly. Wages in this model are indeterminate, with the actual wage falling somewhere between the pure monopoly and pure monopsony outcomes.

    Figure 14.12 Bilateral Monopoly


    If the union has monopoly power over the supply of labor and faces a monopsony purchaser of the labor the union represents, the wage negotiated between the two will be indeterminate. The employer will hire Lm units of the labor per period. The employer wants a wage Wm on the supply curve S. The union will seek a wage close to the maximum the employer would be willing to pay for this quantity, Wu, at the intersection of the marginal revenue product (MRP) and the marginal factor cost (MFC) curves. The actual wage will be somewhere between these two amounts.

    Figure 14.12 “Bilateral Monopoly” shows the same monopsony situation in a labor market that was shown in Figure 14.3 “Monopsony Equilibrium” The employer will seek to pay a wage Wm for a quantity of labor Lm. The union will seek Wu, the highest wage the employer would be willing to pay for that quantity of labor. This wage is found on the MRP curve. The model of bilateral monopoly does not tell us the wage that will emerge. Whether the final wage will be closer to what the union seeks or closer to what the employer seeks will depend on the bargaining strength of the union and of the employer.

    Unions and the Economy: An Assessment

    Where unions operate effectively in otherwise competitive markets, they may reduce economic efficiency. Efforts to increase demand for American workers through restricting imports or to increase demand for skilled workers by restricting opportunities for unskilled workers almost certainly reduce economic efficiency. Artificial restrictions on the supply of labor reduce efficiency as well. In each case, the wage gain will increase the cost of producing a good or service and thus shift its supply curve to the left. Such efforts, if successful, increase the earnings of union members by creating higher prices and smaller quantities for consumers. They may also reduce the profitability of their employers.

    Other attempts by unions to raise wages by increasing the demand for their members are not likely to create inefficiency. For example, union efforts to increase worker productivity or to encourage consumers to buy products made by union members do not reduce economic efficiency.

    In the case of bilateral monopoly, the amount of labor employed is restricted by the monopsony firm to a quantity that falls short of the efficient level. In effect, the efficiency damage has already been done. The labor union seeks merely to offset the monopsony firm’s ability to restrict the wage.

    Are unions successful in their primary goal of increasing wages? An examination of the impact on wages paid by firms that faced organizing drives by unions between 1984 and 1999 found virtually no change in wages attributable to union organizing efforts. The study examined firms in which unions had either barely won or had barely lost the election. It found that unions that had eked out victories had gone on to organize workers but had had no significant impact on wages or on productivity (Dinardo, J., and David S. Lee, 2004). Other evidence, however, suggests that unions do tend to raise wages for their members. Controlling for other factors that affect wages, over the period 1973 to 2002, unions appear to have increased wages by about 17% on average (Blanchflower, D. G., and Alex Bryson, 2004). Part of the explanation of this finding is that unions have had the most success in organizing in the public sector, where union pressure for higher wages is most likely to be successful.