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.
Read the full report here