Neoclassical Models of Imperfectly Competitive Labor Markets

The scenario of perfect competition, as augmented by human capital theory, yields a large body of testable hypotheses concerning labor market outcomes. These hypotheses, overviewed in the first chapter of this volume, might all be understood as applications of three more fundamental implications of perfectly competitive equilibrium conditions: no unemployment or vacancies, the law of one wage, and compensating wage differentials. The hypothesis of no equilibrium unemployment or job vacancies (NUV) follows immediately from the assumption that wage rates flexibly adjust to clear markets, so that the only reason for actors not to be engaged as employees or employers is because they choose not to participate in labor markets at going wage rates. The law of one wage (LOW) asserts that employees with equal (marginal) productivities facing identical working conditions receive the same wage rates, and follows from the assumption of frictionless exchange. Complementarily, the hypothesis of compensating wage differentials (CWD) asserts, broadly speaking, that variations in wage rates across workers are explained by either variations in labor productivity arising from costly investments by workers or variations in working conditions that are costly for employers to modify. These fundamental implications of competitive theory are challenged by both casual observation and careful empirical analysis. The NUV hypothesis conflicts with the appearance of persistently positive unemployment and vacancy rates. The LOW hypothesis is tested by manifestations of labor market " duality " or segmentation (Dickens and Lang 1993), persistent inter-and intraindustry wage differentials (Krueger and Summers 1988, Groshen 1991b) discrimination by ethnicity, gender, or race (Cain 1986; Jacobsen 2007, Chapter 9), and other indications that workers who are seemingly identical from the standpoint of competitive theory 2 nonetheless receive unequal wages. Indeed, such indications motivated the initial emergence of labor economics as a distinct field (Kerr 1988). Finally, consistent evidence of CWD has been notoriously hard to establish (Dorman 1996, Chapter 4). Such inconsistencies help motivate the study of models of imperfect competition in labor markets. Consistently with the observation that employers typically set wage levels, the chapter's primary focus will be on two cases of imperfect competition in which equilibrium wage levels are set by firms, monopsony and efficiency wages. In one sense, these cases reflect contrary views of employers' wage-setting power, in that the former scenario is generally associated with equilibria in which wages are below their corresponding perfectly competitive levels, while the latter are generally associated with supra-competitive wage …