Fictions About Frictions

by Don Boudreaux on August 14, 2015

in Curious Task, Data, Hubris and humility, Myths and Fallacies, Scientism, Seen and Unseen, Work

Nothing that Daniel Kuehn says in his comments on this post and this later post reveals that he understands the point of being asked to put his money where his mouth is when he asserts the existence of monopsony power in the market for low-skilled workers.  With apologies to some commenters who have pointed to important aspects of his misunderstanding, I here summarize my take on that misunderstanding.

Mr. Kuehn too readily assumes that the empirical data he relies upon is evidence of monopsony power.  Yet instead this evidence might be (1) flawed – that is, the numbers give a distorted picture of reality, or (2) evidence of mutually advantageous bargains struck between workers and their employers.  Because entry into the industries that employ disproportionately large numbers of low-skilled workers is quite easy, it is a relevant and probing test of the economic understanding of those who allege the existence of monopsony power as a justification for minimum-wage legislation to ask such analysts “Why does not entry occur to dissipate the implied excess profits?”  Asking such a question reveals that the empirical data that these analysts take to be evidence of monopsony power might well be, again, either simply flawed or evidence of something else entirely.

Of course it’s true, as Mr. Kuehn notes, that real monopsony power in the labor market implies that incumbent employers are protected from having to compete against each other to hire workers.  But Mr. Kuehn himself cannot deny that entry into the industries that employ disproportionately large numbers of low-skilled workers is easy and unrestricted.  So there is no classic monopsony power.  Therefore, Mr. Kuehn must assert the existence of some source of monopsony power (“dynamic”) other than entry restrictions or other legal prohibitions on competing for workers.  That source is summarized by the word “frictions.”

But what might these frictions be?  One answer, especially in markets with unrestricted entry, is “profit opportunities.”  All profit in markets is earned by discovering and overcoming frictions.  (Read, for example, Schumpeter.  Read Hayek.  Read Coase.  Read Kirzner.)  Without frictions, there are never any opportunities for entrepreneurs to profit from doing in the market something better than that something was done before.  Far from being obstacles to profitably exploiting existing profit opportunities, frictions are the chief source of such profit opportunities in a market economy.  It is not inaccurate to describe market entrepreneurship as the act of overcoming market frictions.

Because entry into industries that employ large numbers of low-skilled workers is open and easy, academic claims that those workers are consistently and generally underpaid must overcome a heavy burden of persuasion in order to be taken seriously.  This burden doesn’t begin to be met by pointing out that some econometric studies, published in well-respected journals, offer data that can be interpreted by academics as evidence of underpayment caused by monopsony power.  The reason, again, is the relevance of the question: why are not profit-hungry entrepreneurs rushing in to profit from the implied profit opportunities?  Are these entrepreneurs consistently less informed and cagy about the existing details of economic reality than are the academics?  Of course, the answer to this question is ‘highly unlikely.’

So we’re left with the following competition: On one hand, abstract claims from some academics that real-world markets with easy and open entry are chockfull of unexploited profit opportunities, against, on the other hand, observed reality in which entrepreneurs consistently refuse to act as they would act if the academics’ claims about worker underpayment are correct.  No one of good sense would side in such a contest with the academics.  The sensible conclusion is that those academics have either produced flawed empirical data or their interpretation of their data is wildly off-base.  No one is obliged here to continue with the assumption that the data reveal evidence of real-world monopsony power.  A more sensible conclusion is that the workers are in fact not generally underpaid at all – that the data on pay are simply erroneous or that they fail to reveal the full panoply of benefits transferred by employers to workers.

Mr. Kuehn – insisting that the data do in fact show, or imply, evidence of underpayment of low-skilled workers – will respond by claiming that “frictions” prevent entrepreneurs from entering these markets in sufficient number to adequately exploit the implied profit opportunities.  To this response it is fair to ask “How so?  Give us a plausible account of just how, in reality, businesses and entrepreneurs either fail to see or fail to exploit the profit opportunities that you and your like-minded fellow academics insist are real.  What ‘frictions’ prevent, say, a newly established lawn-care company from offering slightly higher wages to currently underpaid employees of established lawn-care services?  Ditto for new owners of new restaurants seeking to hire workers.  Is it plausible that, hearing that the new maid-service located three miles away is paying higher wages to its workers, underpaid workers for an existing maid-service are prevented by ‘frictions’ from offering their services to the new, higher-paying firm?  What are the ‘frictions’ that prevent at least some other of these workers from telling their current employer that they will quit in order to take a higher paying job unless their current employer gives them a raise?”

Such questions can be greatly multiplied.  The point is that saying “frictions” is not a magic incantation to protect econometric findings that appear to show that workers are underpaid from being interpreted in ways that reach some conclusion other than that those findings reveal the existence of monopsony power.  Do the data in question accurately measure all dimensions of pay – including job security, on-the-job leisure, informal job training, formal fringe benefits, and unusually pleasant or safe work conditions?  Many of these aspects, which are valuable to workers, of employment contracts are difficult to observe and even more difficult to quantify.  They’re very easy to miss.  Yet Mr. Kuehn implicitly asks us simply to assume that the studies that he favors do in fact capture and accurately measure all of these aspects of the employment arrangements or contracts of low-skilled workers.

But, in reality, there is good reason to reject Mr. Kuehn’s implicit claim.  The reason for our rejection is not only, or even mainly, that econometric data are too seldom as reliable and as detailed as they need to be in order to give us a decently good impression of reality.  The main reason for our rejection is found in the question we ask at the start: If entry into those industries is easy and open, why do not entrepreneurs enter these industries in ways that compete away these profit opportunities?  This question – for anyone who thinks remotely like an economist – is sufficient to shift the burden onto Mr. Kuehn (and those who share his perspective) to supply plausible explanations for why, with easy and open entry, entry and competition do not dissipate the available profits.  Shouting “frictions” is insufficient given that a sensible economist asks in response questions (as above) such as “What frictions prevent a new employer from offering higher wages to currently underpaid workers.?”  Unless and until Mr. Kuehn and his comrades identify specific and plausibly existing frictions in reality, we should ignore any policy advice they offer that is based upon their assertion of “frictions.”


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