Ever wondered why your wages aren't rising?

It’s dawning on people that when the competition between businesses isn’t strong, firms can raise their prices by more than the increase in their costs, and so fatten their profit margins. What’s yet to dawn is that weak competition also allows businesses to pay their workers less than they should.

In standard economic theory, it’s the intense competition between firms that prevents them from overcharging for their products and earning more than a “normal” profit.

Normal profit gives the owners of the firm just sufficient return on the capital they’ve invested to stop them leaving the industry and trying their luck elsewhere.

The theory assumes the industry has numerous firms, each one too small to influence the market price. In today’s world, however, many markets are dominated by just two, three or four huge firms.

These firms are big enough to influence the market price, especially when it’s so easy for them to collude tacitly with their rivals.

We see the four big banks doing this every time interest rates are raised. They have an unspoken agreement not to compete on price.

EverI say they have “pricing power”, but many economists say they have “monopoly power”. How can a handful of firms have monopoly power? Because economists don’t use that term literally. On a scale of one to 1000 firms, we’re right down the monopoly end.

Dr Andrew Leigh, the Assistant Minister for Competition, and a former economics professor, has been giving a series of speeches about recent empirical studies on how competitive our markets are.

In one, he quoted the findings of Jonathan Hambur, a researcher who pivots between Treasury and the Reserve Bank, that Australian firms’ “mark-ups” – the gap between their cost of production and their selling price – have been rising steadily.

But in a further speech this month, Leigh turned the focus from what “market concentration” (among a few massive companies) means for the industry’s customers, to what it means for its employees.

So, in econospeak, we’re moving from monopoly to “monopsony”. Huh? Taken literally, monopoly means a market in which there’s a single seller meeting the demand for the product. Monopsony means there’s a single buyer from the people supplying the inputs to production. Workers supply the firm with the labour it needs.

The term was introduced by Joan Robinson, a colleague of Keynes at Cambridge, who was among the first to question the standard theory of how markets work. She was 30 in 1933 when she published her dissenting view that truly competitive markets were rare.

She argued that monopsony was endemic in the labour market and employers were using it to keep wages low. If there are few employers competing for workers, those workers have fewer “outside options” (to move to another firm offering higher pay or better conditions).

This limits workers’ bargaining power and gives employers the power to keep wages lower.

At the time, few economists took much interest. But in recent years there’s been a growing focus on market power by academic economists.

For instance, monopsony was cited in a US Supreme Court ruling against Apple in 2019. A report by Democrats in the US House of Representatives accused Amazon of using monopsony power in its warehouses to depress wages in local markets.

Evidence from the US, Britain and Europe has demonstrated that increases in labour market concentration – fewer employers to work for – are associated with lower wages.

Leigh says economists have long known that people in cities tend to earn more than those in regional areas. His own research found that when someone moves from a rural area to a major Australian city, their annual income rises by 8 per cent.

“The economics of monopsony suggests that an important part of the urban wage premium can be explained by greater employer competition in denser labour markets,” Leigh says.

Leigh reminds us that Australia’s average full-time wage ($1808 a week last November) was only $18 a week higher than it was 10 years ago, after allowing for inflation. Many things would explain this pathetic improvement, but one factor could be employers’ monopsony.

We know that the rate at which people move between employers has fallen. But over a person’s working life, the biggest average wage gains come when people switch employers. And when some people leave, the bargaining power of those who stay is increased.

This decline in people moving could be caused by increased employer monopsony. Hambur has done a study of employment concentration between 2005 and 2016.

He found that, within industries where concentration rose, growth in real wages over the decade was significantly lower.

When a firm has a large share of the industry’s employment, the gap between the value of the work a worker does, and the wage they’re paid in return, tends to grow.

He found that employment in regions close to major cities is twice as concentrated as in the cities. In remote areas it’s three times.

Read this carefully: Hambur found that labour markets had not become more concentrated over the decade. But at every degree of concentration, its negative impact on wages had more than doubled.

So, employers’ market power could well be a factor helping to explain the virtual absence of real wage growth over a decade. Hambur finds that the greater impact of employer concentration may have caused wage growth between 2011 and 2015 to be 1 per cent lower than otherwise.

This would help explain why not all the (weak) growth in the productivity of labour during the period was passed through to real wages – as conventional economists and business people always assure us it will be. Weak competition allowed employers to keep a lot of it back for themselves.

Part of the competitive process is new firms entering the industry. New firms usually poach staff away from the existing firms. But we know the rate of new entry has declined.

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Weakening competition is adding to our inflation woes

We’ve worried a lot about inflation and its causes this year, but in one important respect the economy’s managers have yet to join the dots. The most basic economics tells us that what stops prices rising more than they should is strong competition between firms. If competition has weakened, that will be part of our inflation problem.

But is there evidence that competition is less intense than it was? Yes, lots. It was outlined by Assistant Treasurer Dr Andrew Leigh in a recent speech.

The basic model of how markets work – the one lodged in the head of almost every economist – assumes “perfect competition”.

Markets are supposed to consist of a huge number of consumers and many producers, each of them too small to have any ability to influence the price of the products they’re selling. So the price is determined purely by the interaction of producers’ supply and consumers’ demand.

Competition between these small firms is so intense that, should any one of them be so foolish as to raise their price above what all the other firms are charging, consumers would immediately cease buying their product, and they’d go out backwards.

I doubt if that was ever an accurate description of any real-world market. But even if it approximated the truth at the time economists got it so firmly fixed in their minds – the late 19th century – all the years since then have seen firms getting bigger and bigger.

So much so that many key industries today have just a handful of firms – often no more than four – accounting for well over half the industry’s sales.

This has happened thanks to a century or two of firms using improvements in technology to pursue “economies of scale”. Up to a point, the more widgets you can produce from the same factory, the lower their average cost of production.

Firms do this in the hope of increasing their profits. But the magic of markets – when they’re working properly – is that your competitors also use the new technology to cut their production costs, then undercut your price to pinch some of your share of the market.

This is the competitive process by which the benefits of scale-economies end up mainly in the hands of consumers, in the form of lower prices. This is a big part of the reason we’re all so much richer than our great-grandparents were.

The digital revolution has moved scale-economies to a new stratosphere. It costs a lot to develop a new GPS navigation program, for instance, but once you’ve done it, you can produce a million or two million copies at negligible extra cost.

So, fundamentally, the move to fewer but much bigger firms is a good thing. Except for this: the bigger a firm’s share of the market, the greater its ability to influence the prices it charges. This is a key motivation for big firms to keep taking over smaller firms.

And when markets are dominated by three or four big firms, it’s easy for them to reach an unspoken agreement to use advertising, marketing and superficial product differentiation to compete with their rivals, while avoiding undermining existing prices and profit margins by starting a price war.

Similarly, when all the big firms in an industry are hit by similar big increases the costs of their imported inputs – caused, say, by pandemic or war-related shortages of supply – it’s easy for them to reach an unspoken understanding that they will use this opportunity to fatten their profit margins by raising their prices by more than the rise in input costs justifies.

Which is just what seems to have been contributing to the huge rise in consumer prices this year – though it’s far too soon for economic researchers to have hard evidence this is happening.

What we do have, according to Leigh, is a “growing body of evidence that suggests excessive market concentration can lead to economic problems”.

“Dominant firms in a market may have less incentive to carry out research and development. They may have less incentive to produce new products. And in some cases, they may have less incentive to pay their employees fairly.

“As you can imagine, the drag on the economy only becomes stronger and deeper with each and every concentrated market,” Leigh says.

In the past decade, there has been a huge increase in the number of studies – covering the US and many other countries – confirming that markets have become more concentrated. That is, a higher share of the market held by a few big firms.

But, Leigh says, “mark-ups” – the gap between firms’ costs of production and their selling prices – are one of the most reliable indicators of “market power”. That is, power to raise their prices by more than is justified by their increased costs of production.

Australian research led by Treasury’s Jonathan Hambur finds that industry average mark-ups increased by about 6 percentage points between 2003 and 2016. This fits with figures for the advanced economies estimated in a study by the International Monetary Fund over the same period.

Hambur finds that mark-ups for the most digitally intensive firms increased by 12 percentage points, compared with 4 percentage points for all other firms.

And also that industries experiencing greater annual increase in concentration had greater annual increases in their mark-ups.

Of course, none of this should come as a great surprise to those few economists who specialise in the study of IO – industrial organisation – the way the real-world behaviour of monopolies and oligopolies differs from the way simple textbook models of perfect competition would lead us to expect.

Institutionally, the responsibility for seeking to ensure “effective competition” in our highly oligopolised economy rests with the Australian Competition and Consumer Commission. But its efforts to tighten scrutiny of company takeovers and other ways of increasing a firm’s market power have met stiff resistance from the big business lobby.

This new evidence of increasing mark-ups suggests the econocrats responsible for limiting inflation should be giving the ACCC more support.

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