The not so-simple interaction between labour and product markets: Applications to competition policy

Authorities are increasingly interested in enforcing competition in labour markets.[1] However, since a specific conduct, such as a merger, can influence outcomes simultaneously in the labour and product markets, the overall effect is often ambiguous and difficult to unpack – what benefits the firm’s consumers can harm its employees, and vice versa. In this article, Joe Perkins and Benoît Voudon [2] explain how economic theory helps navigate that complexity and provides insight.

Introduction

Recently, policymakers and academics have discussed practices that affect the competitiveness of labour markets. Such practices raise concerns as they can give dominant firms sufficient purchasing power – or “monopsony” power – to set lower wages than they would if labour market competition was unaffected.

These discussions have prompted competition authorities to consider whether they should intervene to protect the competitiveness of labour markets, and how they might do so. There are two main areas where competition authorities could intervene.

• Preventing anti-competitive agreements between rival employers, including: (a) no-poaching agreements, which prohibit competitors from hiring each other’s employees; (b) non-compete agreements, which restrict employees from competing with the firm after their employment period ends; and (c) wage-fixing agreements.
• Incorporating labour market effects in merger reviews. On 26 February, the US Federal Trade Commission sued to block a proposed supermarket merger – Kroger Company’s acquisition of Albertsons Companies, Inc. Its allegations included concerns about the impact the merger may have on competition for workers.

Analysing the likely impact of these practices is complicated, as they potentially affect outcomes in both the labour market and the product market – sometimes in counterintuitive ways. In this article, we present a conceptual framework that helps disentangle those complexities, called the Oligopoly-Oligopsony Model.[3] In particular, it captures the interaction between competition in labour markets and outcomes in both the labour and the product markets.

The model is particularly useful for explaining opposing effects when looking at labour and product markets together: a practice that reduces wages for workers can benefit consumers; and one that increases prices for consumers can benefit workers. Here, we show how the framework serves as a conceptual toolbox, improving our understanding of the relationship between labour and product markets. Then, to illustrate, we apply it to two hypothetical cases: a no-poach agreement and a merger between firms that compete in both product and labour markets.

Applying the framework helps unpack otherwise counterintuitive insights that:

• A no-poach agreement consistently reduces end-customer prices and increases output. It can increase wages, if it improves productivity.
• A horizontal merger does not necessarily increase product prices. Nor does it necessarily reduce wages. But, unless there are synergies, it cannot benefit both consumers and workers.

The link between labour markets and product markets: why the Oligopoly-Oligopsony Model is helpful

The Oligopoly-Oligopsony Model is a framework that allows us to study simultaneously competition between firms when they compete with each other in both the product market (as sellers) and the labour market (as buyers). Such an integrated framework allows us to identify how competition in one of the markets affects outcomes in both of them.

Competition in one market affects outcomes in both markets…

On one hand, competitiveness in the labour market affects outcomes for both workers and consumers. Labour is an input cost that, like other costs, affects the quality, quantity, and price of the goods and services companies produce. It is also a market in its own right, and therefore the intensity of competition for jobs affects the skills, opportunities, and wages available.
On the other hand, the same is true for competitiveness in the product markets: competition between rival producers determines the quality, quantity, and prices for consumers; and that also affects workers to the extent it determines producers’ demand for labour.

…which makes analysis complicated

As a result, the interaction between labour markets and product markets makes it challenging to predict the impact of practices that potentially change the intensity of competition in both markets; the intensity of competition in each market is linked and their effects overlap. For example, a horizontal merger reduces both the number of sellers in the product market and the number of buyers in the labour market, and these two changes can have different effects on both markets. Therefore, establishing how such a merger affects the welfare of both consumers and workers becomes increasingly complex and difficult to answer without a clear conceptual framework.

A theoretical framework helps to break down the problem into clear steps

Competition economists and industrial organisation researchers often use theoretical models as conceptual frameworks to support their analyses. By breaking down complex interactions into their simple constituent parts, one can analyse each of them in turn, and then consider how they all add up to form the outcomes that are observed in the market. But until recently, only a few studies have investigated the link between product market power and labour market power and their effect on outcomes in both labour and product markets using economic theory.[4]

The Oligopoly-Oligopsony Model provides such a framework, and helps navigate the impact of various practices that affect both the product and the labour markets, and explain some of the more counterintuitive outcomes that occur due to the links between the two markets.[5]

To illustrate, consider the following example.

Step 1: Understanding the impact of product market power on both product and labour markets

Product market power is the result of a reduction in the intensity of competition between rival sellers in a product market. In the absence of any synergies, the primary effect of reducing product market competition is that it increases prices and/or reduces the quantity and quality of products, which is detrimental to end consumers. This is illustrated in Figure 1 below.

In an oligopolistic set-up – as we can see on the left of Figure 1 – quantity is set at a level that makes marginal costs equal to marginal revenues. That is the point where a firm maximises its profit, because any further increase in price would be more than offset by a reduction in sales (reducing revenue) and increase in costs.

An increase in product market power makes the marginal revenue curve steeper – which we can see in the left-hand chart. That has the following effects:

• In the product market, the firms set a higher price and reduce quantity. This is due to reduced product market competition, which increases product market power. As usual, this represents an upward shift along the demand curve, which increases price and reduces the quantity sold – as we can see on the right-hand side of Figure 1.
• In the labour market, the firms can reduce wages. This is purely due to the linkage with the product market, meaning that the reduction in competition in the product market has a secondary effect on outcomes in the labour market. We can see this on the left-hand side of Figure 1, where the change in the marginal revenue curve means that it intersects the marginal cost curve at a lower point. The reduction in the quantity of products sold decreases the firms’ demand for labour, leading to lower employment and lower wages on the labour market side. Graphically – as we can see on the right-hand side – this effect is represented by a downwards move along the labour supply curve.

Figure 1: The impact of a reduction in product market competition

Step 2: Understanding the impact of labour market power on both product and labour markets:

In the labour market, buyer power results from a reduction in the intensity of competition between rival employers. This labour market power can similarly distort outcomes in both the labour market and product market.

A change in labour market power shifts the marginal cost curve – as we can see on the left-hand side – but, importantly, it also brings about a downward shift of the supply curve itself: such that, whatever their demand for labour, employers can hire that number of workers at a lower wage than before – as we can see on the right-hand side of Figure 2. This has the following effects:

• In the labour market, wages fall further. Reduced competition between employers increases their labour market power. That power pushes the marginal cost of labour downward such that it intersects marginal revenue at a lower point, meaning employers will profit maximise at a greater volume – which we can see on the left-hand side of Figure 2. Although the firms need more labour, employers’ bargaining power represents a downward shift of the supply curve itself, making it shallower – as we can see on the right. The result is that wages are lower than they were on the previous supply curve, even though more workers are employed.
• In the product market, prices fall: the link between the two markets means that an increase in labour market power has a secondary effect in the product market. It has lowered the costs of production in the product market – represented on the right-hand side of Figure 2 by a reduction in the supply curve. That leads to lower prices and higher quantities, passing on a proportion of the reduction in labour costs to consumers.

Figure 2: The impact of a reduction in labour market competition

Step 3: Understanding the interaction between the two effects

It is crucial to understand how labour and product markets interact in order to analyse how specific practices affect the welfare of consumers and workers, both in isolation and jointly – practices that affect competition in both labour and product markets can have ambiguous effects as a whole: a practice that may benefit workers can harm consumers, and vice versa.

The net effect depends on how competition in each market changes. Once we work through the primary and secondary effects that a change in product market power has in each market, and then the primary and secondary effects that a change in labour market power has in each market, it is straightforward to assess the combined effects of moving from the pre-conduct state to the post-conduct market. Figure 3 shows the move from pre-conduct outcomes stated above (p1, q1, and w1) to post-conduct outcomes (p3, q3, and w3) without the intermediate step. In this example, reduced competition leads to lower prices for consumers and lower wages for workers – the increase in monopsony power in the labour market outweighs the increase in monopoly power in the product market, meaning that consumers benefit overall.

Figure 3: The combined impact of reduction in competition in both the product and labour markets

No-poach application: the effect of coordinated practices on the labour supply curve

A key concern of competition authorities is related to practices that restrict the mobility of workers across firms. No-poach agreements aim to block or limit transfers of employees between firms. This will tend to increase the employers’ labour market power. Typically, that would lead to reduced wages or worse working conditions, unless efficiency benefits directly result from the agreement.

We can use the Oligopoly-Oligopsony framework to analyse the impact of such agreements on outcomes in both labour and product markets; first, in the case where there are no efficiency benefits, and second, where the agreement provides efficiency benefits by increasing productivity.

The effect of no-poach agreements

A no-poach agreement reinforces labour market power and increases employers’ bargaining power. While there is no reduction in the number of firms that compete for employees, the no-poach agreement limits a worker’s ability to play firms off against each other: they are less able to “shop around” for jobs, and so they have fewer outside options during their contract negotiations. This increases the employers’ bargaining power, enabling them to set lower wages than would otherwise be possible or deteriorate terms and conditions by, for example, expecting longer working hours for the same pay.

Insight 1: a no-poach agreement consistently reduces end-customer prices and increases output in the product market

Effectively, by increasing buyer power, a no-poach agreement allows a firm to employ the same amount of labour at a lower wage. Graphically – as we can see on the right-hand side of Figure 4 – this can be represented as a downward shift of the labour supply curve, and not a movement along the curve. In isolation, the first order effect is that wages drop (shown as w1 to wi on the right-hand side of Figure 4), but the quantity of goods and services produced for consumers (q1) and the prices they pay (p1) remain the same.

Furthermore, as the no-poach agreement allows the firms to produce their goods at a lower cost, and it has no effect on competition between the firms in the product market side, there is a secondary effect: the firms produce more, because their bargaining power reduces the slope of the marginal cost curve – as we can see on the left-hand side of Figure 4. The increase in production affects outcomes in both markets:

• In the product market, prices fall [6] from p1 to p2, as we can see on the right-hand side of Figure 4; and
• In the labour market, wages increase from wi to w2, as the firm must hire more workers.

Figure 4: Impact of no-poach agreement on marginal costs and supply curves

However, note that the new wage level, w2, is less than it was before the no-poach agreement. Consumer demand has not changed, nor has competition between firms in the product market. As such, consumers will not bear higher marginal costs after the no-poach agreement than they did before it. If neither competition in the product market, nor workers’ productivity change, then both wages and prices can decrease but the difference between the two cannot reduce.

The results highlight a fundamental mechanism related to no-poach agreements: by shifting the supply curve downwards, a no-poach agreement introduces a tension between the interests of workers and consumers – the latter group will benefit from such an agreement at the expense of the former group.

Insight 2: a no-poach agreement that increases productivity can both increase wages and reduce prices

Now we consider the impact that a no-poach agreement can have on outcomes in the product and labour markets when it directly increases productivity.

No-poach agreements may be signed for pro-competitive purposes, which include investing in improving workers’ productivity. This investment is relationship-specific from the firm’s point of view, as the additional human capital it creates is tied to a particular worker. However, it creates a risk for the investing firm. Once it pays for the increase in productivity, its investment is sunk and unrecoverable if its workers leave for a competitor. It would incur the cost of upskilling the labour force, but rivals could receive the benefit.

This threat of “free-riding” is a manifestation of the “hold-up” problem – a classical issue in economics: a firm’s incentive to invest in their employees’ human capital is reduced by its fear that competitors will poach their employees once its investment is sunk. The problem is not that the investing firm helps its rivals; it is that the threat of helping its rivals deters the firm from investing in the first place, which means neither the firm nor its workers benefit from investment.

In this case, a no-poach agreement can restore the incentive for a firm to invest in their employees’ human capital.[7] Using the Oligopoly-Oligopsony Model, we can investigate this mechanism further. In particular, it allows us to identify the conditions under which a no-poach agreement that improves workers’ productivity will also improve their welfare.

In this set-up, firms sign a no-poach agreement. This affects the employer in two ways:

• The employer gains bargaining power. As before, this reduces the slope of the marginal cost curve and represents a downward shift of the supply curve.
• The employer invests in productivity, which pushes the marginal cost curve down and is a further downward shift of the supply curve. This shift in the supply curve happens for two reasons: first, the firm needs fewer workers to produce the same number of units – for instance, doubling productivity would mean that the cost of paying each worker is now spread over twice as many units, reducing the costs of production per unit; and second, the wage that the firm’s marginal worker commands – before considering any change in the level of production – is lower, as the firm needs fewer workers.

As we should expect, once both these effects reduce the marginal cost of producing a particular quantity, firms can produce more, which affects outcomes in both the product and the labour market.

• In the product market, prices fall to attract more customers at the new level of production; and
• In the labour market, wages increase as employers move along the new supply curve to attract more workers.

However, it is now possible for the wage paid after the no-poach agreement, w2, to exceed the wage paid before the agreement, w1. The circumstances that make that possible depend on how the wage per marginal worker is affected by three forces: (a) the increase in monopsony power, (b) the increase in productivity and (c) the increase in production.

Figure 5 examines the impact that each force has on the wage set by the marginal worker.

• Initially: the firm pays its workers w1 to produce q1 goods.
• The monopsony effect: The increase in monopsony power reduces the cost per worker because the firm’s purchasing power in the labour market increases, meaning that it can pay less to acquire any given number of workers than it could before the agreement. To produce q1, it would pay wa rather than w1.
• The productivity effect: The increase in productivity requires fewer workers to produce q1. Unlike before, productivity has changed. The productivity improvement does not change the slope of the labour curve; each worker is no more able to demand higher wages due to the productivity improvement. Rather, the firm needs fewer workers to produce q1 units, which is represented by a downward shift along the curve. That would reduce the wage set by the marginal worker from wa to wb.
• The production effect: The reduction in marginal costs will incentivise the firm to increase its production, and this increase requires the firm to hire more workers to produce q2. This, as we should expect, requires the firm to move back along the labour curve, paying a higher wage to attract more workers to meet the new level of production. Wages set by the marginal worker increase from wb to w2.
• The combined effect: Together, the impact these forces have on wages can vary. The first two forces in isolation will reduce wages, and the last force in isolation will increase wages.

However, wages can increase, so that w2 exceeds w1 – as shown in Figure 5. This is because wages are being spread over more units, so it is possible for the increase in production to more than offset the impact that the first two forces have. The marginal cost of reduction will still be lower than before the agreement, even though the wage set by the marginal worker is greater.

Figure 5: The combined impact of monopsony, productivity, and production on wages

Merger application: the “not so simple” relation between worker and consumer welfare

In this section, we look at the specific case where firms compete horizontally both on the product and labour markets – this case is particularly relevant since introducing labour market dynamics, which in practice are typically not looked at in merger control, can affect the standard results which are based on looking only at product markets.

When and why does a merger affect both markets?

A horizontal merger can reduce the competitiveness of both product markets and labour markets. However, it may be the case that a merger reduces competition on the labour market while leaving product market competition unaffected. For example, a merger between a soda producer and an alcohol producer would probably have little or no effect on product markets, as these products would not be considered as substitutes, but the two firms may compete for similar types of worker.

When firms compete in both markets, a merger reduces the number of sellers on the product market and the number of buyers in the labour market. The Oligopoly-Oligopsony framework, in this context, allows us to identify and balance the effects of reduced competition in both markets, providing novel insights.

Insight 1: A horizontal merger does not necessarily lead to an increase in product prices

A horizontal merger can reduce prices, even though reducing competition in the product market increases sellers’ power in that market. This is the scenario set out above in Figures 1 to 3.

Conventionally, a horizontal merger between rival sellers in a product market reduces competition, which can reduce quantity and increase prices. This is the effect shown in Figure 1. In the Oligopoly-Oligopsony Model, firms compete in quantity to sell undifferentiated products, so there is a clear relationship between the merger and a price increase.[8]

Concentration in the product market also affects outcomes in the labour market. While total quantity decreases, individual firms have an incentive to increase their individual output, even though the total output in the industry reduces as the number of active firms becomes smaller. In the absence of any impact on labour market competition, this makes the firms increase their demand for labour, which can translate into higher wages.

However, in this case, the merger also reduces competition between rival employers in the labour market. That reduction in competition means that they exert lower competitive pressure on each other, i.e., they can attract the same number of workers for a lower wage. Importantly, this in turn has repercussions in the product market – by reducing the cost of producing the same quantities, the reduced labour market competition can benefit end-customers, resulting in higher quantities and lower prices. This is the effect represented in Figure 2 above.

Finally, when we analyse the impact that increasing concentration in both markets has, product prices might not increase. In situations where there was intense competition between employers in the labour market – such that firms had to offer high wages to attract workers – a merger may reduce product prices, as the downward pressure that follows the reduction in labour costs is larger than the upward pressure of reduced product market competition. This is the combined effect represented in Figure 3. This effect will be amplified if there are merger-specific synergies.

Insight 2: A horizontal merger does not necessarily reduce wages

A related result from the Oligopoly-Oligopsony Model is that a horizontal merger might not reduce wages, even though it increases concentration in both product and labour markets – the impact depends on the degree of competition in the labour market in the first place.

Concentration increases product market power which, in isolation, has the same impact as before (Figure 6).

Figure 6: The impact of a reduction in product market competition

In the labour market, however, things play out differently. As before, concentration in the labour market means a reduction in competition between rival employers. However, in this scenario, competition between employers was already weak before the merger – not due to concentration but for other reasons, such as high search costs for workers seeking comparable jobs with better terms. In this instance, the increase in concentration in the labour market from the merger will have little impact on wages. In other words, since firms initially had little influence on each other’s labour supply, the elimination of a competitor by a merger has minimal impact on their individual labour supply. In such cases, the firms already had sufficient bargaining power to operate as de facto “monopsonists”, exerting little competitive pressure on one another prior to the merger.

This is represented in Figure 7. Post-merger, the supply curve shifts up and to the left. To visualise why this happens, consider the following scenario. Before the merger, there are only two producers of a specific product (say, an electronic component). They are located on opposite sides of the world, so while they compete directly in the global product market, they are effectively local monopsonists in their local labour markets – workers are “locked-in” to their local labour pool, such that none would move to the other region. After the merger, the firm closes one of the two plants, and increases production in the remaining plant. Previously, it employed enough local workers to meet half of global demand in the product market. But now it needs enough workers to meet all global demand. The local labour pool is no bigger, meaning that the local labour curve is as it was before. So, the employer shifts along that local curve to gain more workers, increasing wages to do so. From the perspective of the global labour market, this is represented as an upward shift of the supply curve – essentially because it has half the number of workers in it.

Clearly, this is an extreme example for illustrative purposes. But the dynamic of “sticky” local labour pools is common, suggesting it is likely to have some effect in more conventional cases.

Figure 7: The impact of a reduction in labour market competition when competition was already weak

On the product market side, firms have an individual incentive to increase their output (even though total output decreases because of the elimination of a competitor). This boosts the firms’ demand for labour, as they need to increase their output, which then increases wages. Therefore, in this situation the impact of a merger on local wages can be positive – since competition for labour was already weak, the increase in wages due to growing labour demand that stems from reduced competition in the product market will dominate. This is represented in the combined effect of Figure 8.

Figure 8: The combined effect on the product and labour market when labour market competition was already weak

Insight 3: Unless there are synergies, a merger cannot benefit both consumers and workers. But outcomes for consumers do not always trump outcomes for workers

Without synergies, a merger cannot benefit both workers and consumers, as the conditions under which a merger can reduce prices and the conditions under which it can increase wages are never met at the same time.

• A merger reduces prices when the labour market is very competitive before the merger. In this case, concentration lowers wages and harms workers. This reduces the cost of production, which reduces prices and benefits consumers.
• A merger can increase wages if labour market competition is limited pre-merger. In this case, the firms’ ability to increase their output individually sparks additional demand for labour and, as a consequence, higher wages. Higher wages increase the cost of production, which increases prices and harms consumers.

However, if there are merger-specific synergies, a merger can benefit both consumers and workers at the same time. Synergies provide firms with incentives to increase their output and therefore their wages – as a result, a merger can now increase wages even if competition in the labour market is intense.

This reveals a challenge for competition authorities: if there are no synergies, then a merger can benefit either workers or consumers but not both. What welfare standard should competition authorities adopt when assessing such mergers?

In the Oligopoly-Oligopsony Model it is possible to calculate combined welfare by adding up consumers’ welfare, measured as the difference between consumers’ willingness to pay and the price of the product, and workers’ welfare, measured as the difference between the wage they receive and the wage that they are willing to work for. Note that this is not “social” or “total” welfare, as it excludes firms’ profits.

It is then possible to compare combined welfare pre- and post-merger to take into account how the merger affects welfare when its impact on both consumers and workers is taken into account. This helps with identifying the overall impact of a merger, rather than its impact on one group only. Combined welfare can increase if the wage loss that workers suffer following a merger is more than offset by reduced consumer prices, or vice versa.

We can then identify the conditions under which workers’ and consumers’ welfare increases or reduces. The two key parameters that affect these conditions are the degree of pre-merger competition in the labour market and the magnitude of merger-specific synergies, as summarised in Table 1.

Table 1: Effects of a merger on consumers and workers

The importance of analysing effects

While the Oligopoly-Oligopsony Model is fairly simple, stylised and static, i.e. it does not capture the long-run impacts of competition on product and labour markets, it is a useful tool for analysing how product and labour markets interact. It makes it possible to disentangle the complex and interlinked relationship between product and labour market competition.

By identifying the key mechanisms through which the two markets are linked, we can analyse how changes in competition on one side will affect outcomes on the other side. Moreover, while the model demonstrates that the effects are generally ambiguous, it helps us to identify what are the factors that determine whether a change in competition in labour or product markets will benefit or hurt workers and consumers.

Despite its relative simplicity, the Oligopoly-Oligopsony Model provides insights that are relevant for policy:

• Looking at labour market power is far from irrelevant; while it does not directly harm consumers, it can affect product market outcomes indirectly. Moreover, overall welfare effects can only be determined once impacts are known both for labour and product markets – a conduct that harms a firm’s consumers can often benefit its workers, and vice versa.
• In particular, in the absence of efficiencies there is an inherent tension between the welfare of a firm’s consumers and its workers – lower wages reduce the firm’s cost of production, which will translate into a lower price that it charges its customers. On the other hand, an increase in prices due to reduced competition in the product market can translate to higher wages, as the firm will increase its production in reaction to the increase in prices.

However, enforcers should not automatically view all reductions in labour prices or volumes as issues to be addressed by competition policy – rather, in the presence of efficiencies the tension between workers and consumers falls apart, as the conduct can then benefit both groups. Given the relationship-specific nature of human capital investments, such efficiency considerations can be a rationale for agreements that restrict employees’ ability to switch jobs.

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