Is it time to rebalance competition policy for workers?

Firms’ labor market power is large and costly

Economic theory suggests that in a competitive labor market, the wage paid to the worker should be equal to their marginal product. However, the evidence shows that firms can and often do pay wages well below the marginal product, resulting in a markdown on the wage . This markdown is prevalent not only in high-income countries as the United States, where the average manufacturing worker earns only 65 cents on the marginal dollar generated but also in large developing countries as China and India, where workers receive wages respectively 16 and 18 percent lower than the competitive level.

Such large markdowns reflect excessive employer labor market power, which is beneficial to firms but detrimental to workers and the economy as a whole. By artificially lowering wages, employer labor market power reduces the economy’s employment and output. That is because labor supply is typically upward sloping, hence a lower wage is associated to a lower equilibrium employment. In this context, the additional employment induced by a wage increase would generate an increase in output still above the wage, thus enhancing overall welfare. The impacts are sizable, with evidence from the US suggesting welfare losses from labor market power of around 8 percent of GDP and output losses equivalent to a fifth of GDP. Moreover, these figures do not account for dynamic effects on growth, such as reduced human capital investments due to lower wages. In addition, by depressing employment and wages, labor market power also reduces the labor share of national output, a key measure of inequality that has been declining in most of the world, including developing countries.

Product market regulation is a key driver of labor market power

To reduce the negative impact of employer labor market power, it is crucial to understand its causes. Previous research has identified employer concentration as the key contributor. In concentrated labor markets workers have fewer employment options, which increases the relative bargaining power of employers. Empirical evidence supports this hypothesis, showing lower wages in more concentrated labor markets in the US and Peru. As a result, some experts have suggested using antitrust approaches to regulate labor markets. However, the evidence of a causal relation between market concentration and labor market power remains unclear. In fact, the correlation between concentration and markdowns at the aggregate market level has also been questioned in the US.

To help fill this evidence gap, a recent paper focused on assessing the impacts of changes in barriers to entry in product markets on labor market power in  Indonesian manufacturing.  Our estimates suggest that Indonesian plants exert on average some degree of labor market power. The study leveraged Indonesia’s Negative Investment List (NIL)—or Daftar Negatif Investasi—to measure changes in investment conditions across narrowly defined product markets. The granular data collected for successive iterations of the NIL in the late 2000s-early 2010s allowed us to show that when at least one investment restriction is introduced in a product market, firm entry in that market drops by around a quarter. As a result of the lower entry, the wage markdown increases by the same proportion.  At the same time wages go down and price markups go up—a sign of declining competition. The main findings are statistically significant at conventional levels and are robust to a wide array of tests addressing various estimation concerns, including the endogeneity of investment restrictions and the definition of labor markets.

Extending competition policy to labor markets would yield great returns

The evidence suggests that product market regulation has a significant impact on labor market power through its impact on firm entry and hence on labor market competition . The existence of this negative labor market externality of product market regulation supports the calls to evaluate any change in industry concentration, due for instance to mergers or investment restrictions, not only against its impact on product markets but also on labor markets. This has two key policy implications.

First, it calls on competition authorities to extend antitrust approaches from product to labor market assessments, something they have been largely neglecting so far. This should not require significant technical efforts. Naidu, Posner and Weyl propose relatively straightforward adaptations to labor markets of three standard approaches to product market merger analysis. For example, adapting standard approaches to product market merger analysis, such as the hypothetical monopsonist test and the Herfindahl-Hirschman Index of labor market concentration, can be useful for assessing labor market power.

Second, the findings in the paper highlight the key role that governments can play in reducing firms’ market power in labor markets by regulating product markets, for instance reducing investment restrictions . Those are standard policy tools that go beyond antitrust regulation and competition authorities but that can be as effective to curb excessive labor market power.