Why do Real-World Markets Not Tend to Operate at the 'Full Employment' Level?

INTRODUCTION 

This post follows from my previous two posts:

1) Market Structure: Classical Vs. Keynesian Assumption where I talk about the difference in the Classical and Keynesian assumption regarding Market Structure. Classicals assume that markets (both output and factor markets) are Perfectly Competitive, which is a necessary condition for markets to operate at/move towards 'Full Employment'. Keynesians on the other hand, reject this assumption and assert that real-world markets are comprised of powerful monopolies and oligopolies, and that in such market structures there are no natural forces pushing the system towards Full Employment. 

and

2) Why do Perfectly Competitive Markets Tend to Operate at the 'Full Employment' Level? where I continue from my post on market structure, and go on to demonstrate using a fair amount of Microeconomics, how Perfectly Competitive markets tend to operate at the Full Employment level. 

In this current post, I will explain (using microeconomic concepts again) why real-world markets where monopolies and oligopolies (buyers exerting market power) as well as monopsonies (single seller) or a few sellers are common, do not tend to operate at the Full Employment level. With that preamble, let's move on to the business at hand. 

CURRENT POST

Keynesian theory asserts that the assumption of Perfect Competition is unrealistic. There are strong Monopolies and Oligopolies in the real world. Under such market structures, the labour market does NOT function at Full Employment levels. Let us explain how. 

How Price and Output are Determined in a Monopoly Output Market

Just like in perfect competition, a profit maximizing monopoly will produce upto the point where MR = MC. However, unlike a firm operating in a perfectly competitive market (faces a flat, perfectly elastic demand curve), the monopolist faces a downward sloping demand curve. This is because a monopolist has market power and can exert influence on the price of output by changing the quantity it produces. See chart 2 below.

Chart 2: Output and Price determination in a Monopoly vs. Perfect Competition

A monopolist will produce a quantity of output (QM) where MR = MC (see in chart above that the MR and MC curves interest at this level of output). He will then sell this quantity QM at a price PM that he gets off his demand curve.

Notice that at price PM, demand for output (i.e. QM) is not = supply. The monopolist chooses to sell at price PM because this maximizes his profit.

In perfect competition on the other hand, equilibrium price would be Pc and equilibrium quantity would be Qc, and demand for output would be = supply for output at this equilibrium level. 

Conclusion: Lower output is produced (at a higher price) in a monopoly vs. in a perfectly competitive market. As a result, employment of labour would be lower in a monopoly too. Since we know now, that a perfectly competitive output market functions at the “full employment” level, we can conclude that a monopoly output market operates below the full employment level of the economy. 

How Price and Output are Determined in a Monopsonist Labour Market 

1. How do we get the Labour Demand curve for a Monopsonist?

Let’s assume that the firm that we’ve talked about above, which a Monopolist (single seller) in its output market, is a Monopsonist (single buyer) in the labour market. I've done this to introduce another dimension of market power, even though we've shown above that  a firm being a monopolist in its output market is enough to ensure that the labour it employs is less than the 'full employment" level of labour employed by a perfectly competitive output market.

That said, let’s see how the wage rate and labour employed by a monopsony is determined in the labour market and compare it with the wage rate and labour employed by a perfectly competitive labour market. 

At any wage rate (w), the monopsonist will demand labour upto the point where the MR from an additional unit of labour - this is called the Marginal Revenue Product of labour (MRPL) - is equal to “w”. 

MRPL = MR * MPL 

Consequently, the MRPL curve of the monopsonist (MRPL at different levels of labour employment plotted against the wage rate) is the demand curve for labour in this market (since the monopsonist is the only buyer). See chart 3 below. 

Chart 3: Determination of Labour employed and Wage rate in a Monopsony vs. Perfect Competition

2. The Labour Supply curve in a Monopsony

The labour supply curve for a monopsony is upward sloping (see curve labeled “supply” in chart above). Since the monopsonist is the only buyer, he can hire more labour when he pays a higher wage, unlike a perfectly competitive firm that can hire any amount of labour at the prevailing wage rate. 

3. How much Labour does the Monopsonist employ and at what Wage?

The monopsonist will employ labour upto the point where the MRPL of the last unit of labour = the MC of this unit of labour. Note: the MC of an incremental unit of labour will be different from the existing wage because of the upward slope of the labour supply curve. This is why I’ve plotted the MC curve for labour separately in chart 3. 

So, the monopsonist will employ LM amount of labour because when labour = LM, MRPL = MC.

To determine the wage the monopsonist will pay, we look at the labour supply curve and read off the wage rate (wM) corresponding to LM amount of labour. The monopsonist will employ LM amount of labour at a wage = wM. 

4. How does this compare with Labour employed and Wage rate in a Perfectly competitive Labour market?

The labour demand curve in a perfectly competitive labour market = the summation of the MRPL curves of all the firms comprising the market. We assume that these individual firms sell output in a perfect competitive market as well. Therefore, the MRPL for each of these firm is = P0 * MPL (as we discussed in the Classical section) where P0 is the price of their output. 

In chart 3, we’ve denoted the labour market demand curve for a perfectly competitive labour market as P0 * MPL, even though technically it should be denoted as Σ P0 * MPL.

You’ll see that this curve lies above the demand curve for the monopsonist. The reason is simple. For the sake of comparison, if we assume that the price (P0) and the total quantity of output sold in the output market is the same for the monopsonist as well as the perfectly competitive firms, and that the MPL is also the same for both the monopsonist and the perfectly competitive firms in the labour market, then the P0 * MPL curve will always lie above the MR * MPL curve. This is because the market demand curve in the output market is usually always downward sloping, which means that P0 is always > MR. 

The labour market supply curve is the same in perfect competition as it is for the monopsonist. 

Now, the equilibrium wage in the perfectly competitive labour market will be wPC where the labour demand curve (P0 * MPL) intersects the labour supply curve. See chart 3 above. 

So, in a perfectly competitive labour market, LPC units of labour will be employed (higher than the LM units employed in a monopsony) at wage wPC (higher than wM - the wage paid out by the monopsonist). 

Conclusion: The amount of labour employed and the wage paid out in a monopsony are always LOWER than those in a perfectly competitive labour market. 

While in a perfectly competitive labour market, at the equilibrium wage (wPC), demand for labour = the supply of labour i.e. the labour market is at “full employment”, a monopsony (labour market) functions below the full employment level of the economy.

Finally, in both the scenarios examined above, we've shown that in real-world markets which are far from perfectly competitive and where individual firms can exert tremendous power on wage and output determination, the labour market tends to function below the full employment level of the economy.