Labour Market Power and the Effects of Fiscal Policy

Layer 1: Overview

This paper proposes a novel fiscal transmission channel through which government spending expansions reduce employer monopsony power in the labor market, generating larger fiscal multipliers and stronger distributional consequences than standard models predict.

Standard New Keynesian models rely on two transmission channels with contested empirical support: a negative wealth effect on labor supply (which moves workers to supply more hours when taxes rise) and countercyclical price markups (which fall in booms, raising labor demand). The evidence on both is ambiguous. This paper introduces a third channel — countercyclical monopsony power — that operates independently of, and interacts with, the other two.

The theoretical framework is a Two-Agent New Keynesian (TANK) model, extending Cantore and Freund (2021). There are two household types: workers (fraction λ = 0.8), who supply labor and have limited financial market access, and capitalists (fraction 1 − λ = 0.2), who earn profit income. Intermediate-good firms compete monopsonistically in local labor markets, paying wages below the marginal revenue product. The wage markdown μ = η/(η+1), where η is the wage elasticity of labor supply to the individual firm. Workers value both pay and non-pay job characteristics (firm location, culture, flexibility), with heterogeneous idiosyncratic preferences drawn from a type-1 extreme value distribution. This differentiation, following Card et al. (2018), gives firms wage-setting power because they cannot observe individual preferences.

The key mechanism is that η depends endogenously on workers’ labor earnings (wt·nt) and their marginal utility of income (uW_c,t): η = θ·uW_c,t·wt·nW_t + 1/φ. When government spending rises, it increases both labor income and — because higher current or future taxes reduce lifetime net income — workers’ marginal valuation of income. Both forces unambiguously raise η, flattening the firm-level labor supply curve, reducing the marginal cost of labor for firms seeking to attract workers, and driving wages up toward the marginal revenue product. Employment and output rise; profits fall and are redistributed toward workers.

In the calibrated baseline (steady-state markdown μ = 2/3, i.e., wages at two-thirds of marginal revenue products, calibrated to Yeh et al. 2022), the impact fiscal multiplier is approximately 0.6 under monopsonistic competition compared to slightly less than 0.4 under perfect competition — a difference attributable entirely to the countercyclical-monopsony channel. The wage markdown rises by approximately 0.3 percentage points on impact following a 1% of GDP government spending shock, roughly twice the response observed when the steady-state markdown is 0.9 rather than 0.67.

The amplification from countercyclical monopsony is strongest when the wealth effect on hours worked is near zero — the baseline calibration consistent with Schmitt-Grohé and Uribe (2012) and Galí et al. (2012). As the wealth elasticity of hours increases, the markdown and output response to spending shocks weaken, because a larger hours response implies a smaller consumption response, which reduces the marginal utility channel. The degree of price stickiness has little effect on the markdown response.

The channel is amplified when workers bear more of the fiscal burden — either through profit redistribution to workers (amplification rises from approximately 0.25 in the no-redistribution baseline to approximately 0.4 when half of profit income is redistributed to workers) or through regressive taxation. Progressively redistributing the tax burden toward capitalists weakens the countercyclical-monopsony channel, which runs counter to the standard cyclical-inequality channel (Bilbiie 2020) that predicts larger multipliers with progressive taxation.

The empirical validation uses an expectations-augmented VAR estimated on quarterly U.S. data from 1981Q3 to 2019Q4 (macroeconomic variables) and 2000Q4 to 2019Q4 (monopsony measure). Government spending shocks are identified via recursive ordering (government spending ordered first), controlling for professional forecasters’ spending growth expectations (following Auerbach-Gorodnichenko 2012), the real interest rate using the Wu-Xia shadow policy rate, and the average tax rate. The inverse monopsony measure — the wage elasticity of worker-firm separations — is estimated by extending Langella and Manning (2021) to quarterly frequency using SIPP microdata, controlling for demographics, industry, occupation, human capital, and time effects via complementary log-log regressions month by month. The VAR impulse responses confirm the model’s central prediction: government spending expansions raise the wage elasticity of separations (reducing employer market power), raise labor income, reduce profits, and generate substantial output increases.

Layer 2: Deep Dive

What is the identification strategy in the empirical VAR and what are the main threats to it?

The paper uses a recursive (Cholesky) identification scheme with government spending ordered first, following Blanchard and Perotti (2002). The identifying assumption is that government spending does not respond to economic conditions within the same quarter due to decision and implementation lags. Anticipation effects are addressed by including a fiscal news variable — professional forecasters’ one-period-ahead spending growth forecast from the Survey of Professional Forecasters — following Auerbach and Gorodnichenko (2012). The innovation in government spending orthogonal to this forecast is taken as the exogenous surprise shock. The real interest rate (Wu-Xia shadow federal funds rate, which captures unconventional monetary policy at the zero lower bound) and the average tax rate are included to control for monetary policy stance and financing mix. A key threat the paper acknowledges concerns the separation elasticity estimates: the monopsony literature recognizes biases from insufficient controls for alternative wage offers, unobserved heterogeneity, and lack of firm-level exogenous wage variation. The authors follow Langella and Manning (2021) in arguing that these biases are roughly constant over time, so changes in the estimated separation elasticity still reflect changes in true monopsony power.

What is the key mechanism through which government spending reduces monopsony power?

Two reinforcing forces simultaneously raise the wage elasticity of labor supply to individual firms (η). First, higher government spending raises labor income, which increases the dollar magnitude of pay differences between firms, making workers more responsive to relative pay. Second, higher current or future taxes reduce workers’ lifetime net income, raising their marginal valuation of income (marginal utility of consumption, uW_c,t). Workers facing a tighter budget place greater relative weight on pay versus non-pay job characteristics, further increasing their responsiveness to firm-level wages. Both effects increase η unambiguously for government spending shocks (unlike productivity shocks, where the two forces can offset each other). Higher η flattens the firm-level labor supply curve, compresses the gap between the marginal cost of labor and the wage, and induces firms to raise wages toward the marginal revenue product. Employment and output rise while profits decline, redistributing income from capitalists to workers.

How is monopsony modeled, and why does the paper use a discrete choice rather than CES approach?

The paper adopts a discrete workplace choice model following Card et al. (2018), where workers draw idiosyncratic preferences over non-pay job characteristics from a type-1 extreme value distribution each period. Firms cannot observe individual preferences and set a posted wage. Standard logit calculations yield the wage elasticity of firm-level labor supply as η = θ·uW_c,t·wt·nW_t + 1/φ, where θ is the inverse importance of non-pay characteristics and 1/φ is the intensive-margin (hours) elasticity. Under CES preferences (used by Berger et al. 2022, Alpanda and Zubairy 2021), the wage markdown is constant in equilibrium — analogous to constant price markups under CES monopolistic competition — which eliminates the time variation in monopsony power that is the paper’s central object of study. The discrete choice framework generates endogenous variation in η through the endogenous terms wt·nW_t and uW_c,t. Berger et al. (2022) show that the CES approach is a special case of the discrete choice model under restrictive assumptions about individual hours responses; the paper intentionally avoids those assumptions.

What heterogeneity across calibrations is documented regarding the strength of the monopsony channel?

The paper documents several dimensions of heterogeneity: (1) Steady-state markdown: the relationship between the steady-state markdown and the markdown’s response to government spending is hump-shaped (inverted U-shape). At the baseline value of 0.67, the markdown rises by approximately 0.3 percentage points; at a steady-state markdown of 0.9, the response is roughly half as large. Perfect competition (markdown = 1) and maximum monopsony (markdown → 0) both imply no response. (2) Wealth effect on labor supply (χ): as χ increases from zero (baseline, near-GHH preferences) to one (strong wealth effect), the markdown response and the output amplification decline monotonically. With a near-zero wealth effect (baseline), amplification relative to the perfect-competition counterfactual is approximately 0.25 percentage points of steady-state GDP; it diminishes substantially as χ rises. (3) Profit redistribution (φd): output amplification rises from approximately 0.25 (no redistribution, baseline) to approximately 0.4 when half of profits are redistributed to workers. (4) Tax progressivity (φτ): the channel is stronger under regressive taxation (more of the burden falling on workers) and weaker under progressive taxation, in contrast to the cyclical-inequality channel. (5) Degree of tax financing (φg): higher contemporaneous tax financing strengthens the channel because it raises workers’ current marginal valuation of income more directly. (6) Price stickiness (ξ): changing price adjustment costs has little effect on the markdown response and the countercyclical-monopsony amplification.

How is the separation elasticity measured and linked to the model’s concept of monopsony power?

The separation elasticity γ is the wage elasticity of worker-firm separations: the percentage change in a firm’s separation rate in response to a 1% change in the wage. In the model, γ is shown to be proportional to η − 1/φ (the extensive-margin component of labor supply elasticity to the firm), because firm size and separation rate are linked through a constant elasticity derived from the logit choice structure. Empirically, the paper extends Langella and Manning (2021) to quarterly frequency using SIPP data from 2000Q4 to 2019Q4. Month-by-month complementary log-log regressions of separation dummies on residualized log hourly wages (purged of demographic, industry, occupation, human capital, and time effects) yield time-varying quarterly estimates of γ. A higher γ (less negative, since separations fall with higher wages) indicates lower monopsony power. The VAR incorporates this time-varying series as the inverse monopsony measure.

How does the countercyclical-monopsony channel interact with the wealth effect and price markup channels?

The three channels interact in both complementary and partially offsetting ways. The wealth effect on hours worked (χ > 0) independently shifts the market labor supply curve rightward when taxes rise, increasing employment. However, a larger hours response implies a smaller consumption response, which reduces the increase in workers’ marginal utility of consumption. Since uW_c,t is a key driver of η, a stronger wealth effect on hours dampens the countercyclical-monopsony channel. Similarly, the countercyclical price markup channel (ξ > 0) raises the marginal revenue product of labor when government spending pushes up demand, boosting employment through an independent channel that also raises labor income — which in turn reinforces η. Yet changing price stickiness has quantitatively little effect on the markdown response in the calibrated model. Income redistribution between agent types mediates the interaction: when capitalists bear most of the tax burden (progressive taxation), workers’ marginal utility of income rises less, weakening the monopsony channel. When workers bear the burden (regressive taxation or profit redistribution), the monopsony channel is strengthened.

What are the distributional consequences of the countercyclical-monopsony channel?

When government spending rises, the reduction in employer market power forces firms to pay wages closer to the marginal revenue product, increasing labor income and decreasing profits. This redistribution from capitalists (profit recipients) to workers operates through the wage markdown declining (i.e., markup rising toward one). Under monopsonistic competition with endogenous employer market power, this redistribution is stronger than under perfect competition, where only the price markup channel operates. The VAR evidence confirms these distributional predictions: government spending shocks reduce corporate profits (after taxes) and raise labor income in U.S. data. In the model, this redistribution also feeds back into the mechanism: workers facing declining after-tax income (or receiving a portion of declining profits) place greater weight on pay in their workplace choices, further eroding employer market power.

How does this paper relate to Cantore and Freund (2021) and the TANK literature on fiscal multipliers?

The paper extends the worker-capitalist TANK model of Cantore and Freund (2021), who introduced capitalists that do not participate in the labor market to avoid the criticism (Broer et al. 2019, 2021) that the Bilbiie (2008, 2020) cyclical-inequality channel relies on countercyclical profit income inducing rich households to supply more labor. The Cantore-Freund framework delivers income redistribution between high-MPC workers and low-MPC capitalists without relying on labor supply responses of the rich. This paper adds monopsonistic competition to that framework, introducing a new form of cyclical variation in inequality through time-varying wage markdowns. The interaction with the Bilbiie cyclical-inequality channel is analyzed formally: in particular, tax progressivity has opposing effects under the two channels — progressive taxation amplifies the Bilbiie effect (redistribution to high-MPC workers) but weakens the monopsony channel (capitalists bear more of the tax burden, reducing workers’ marginal valuation of income).

What robustness is discussed or implied regarding the empirical VAR?

The paper addresses robustness primarily through the following design choices: (1) Use of the Wu-Xia shadow federal funds rate rather than the actual federal funds rate, to capture monetary policy stance during the zero lower bound period; (2) inclusion of the spending growth forecast variable to control for anticipation effects; (3) inclusion of the average tax rate as a control for fiscal financing; (4) detrending all VAR variables as deviations from linear trends. The separation elasticity itself is shown to be robustly procyclical across three detrending methods (linear, linear-quadratic, and HP-filter with λ=1600), with R² values of 49.9%, 43.6%, and 17.1%, respectively, and regression slopes of 1.52, 1.40, and 1.51 in each case. The paper notes that standard biases in separation elasticity estimation (from unobserved heterogeneity, inadequate controls for alternative offers, absence of firm-level exogenous wage variation) are likely roughly constant over time, which validates using changes in the estimated elasticity as changes in true monopsony power, following Langella and Manning (2021, p. 2942). The sample for the monopsony series (2000Q4–2019Q4) is shorter than the macro VAR sample (1981Q3–2019Q4) due to data availability.

What are the analytical results from the simplified model?

Under flexible prices (no price markup channel), no wealth effect on hours worked (χ = 0), no financial market access for workers (ψW → ∞), full tax financing, and no profit redistribution, the paper derives closed-form expressions for output, labor income, and profits following a government spending shock. Output and labor earnings respond positively to spending only when θ is finite (workers value both pay and non-pay characteristics, so η is endogenous). When θ = ∞ (workers only care about pay → perfect competition with constant η) or θ = 0 (workers only care about non-pay → constant η again), government spending has zero output effect. The parameter Γ = 0 in both limiting cases. For intermediate θ, Γ > 0, government spending raises output and redistributes income from capitalists to workers. This establishes that the countercyclical-monopsony channel is the sole mechanism at work in the simplified model and that it requires intermediate values of workers’ preference for non-pay characteristics.

What are the policy implications and their scope conditions?

The paper implies that fiscal multipliers may be larger than standard New Keynesian models predict if labor markets exhibit significant employer monopsony power — calibrated to produce a steady-state wage markdown of 2/3 (wages at two-thirds of marginal revenue products), consistent with empirical estimates for the U.S. The countercyclical-monopsony channel provides expansionary effects of government spending even in models where the wealth effect on labor supply is negligible and price markups do not decline. The distributional consequences of fiscal expansions are also stronger under monopsony: income shifts from profit recipients (capitalists) to wage earners more substantially. Scope conditions include: the channel is weaker with stronger wealth effects on hours worked; it is stronger when government spending is financed through current taxes rather than deficit (more tax financing raises workers’ marginal valuation of income more sharply); it is stronger under regressive rather than progressive taxation; and it is stronger when profit income is redistributed to workers. Progressivity of taxation affects the monopsony and cyclical-inequality channels in opposing directions, implying that the optimal tax structure from a fiscal multiplier perspective depends on which channel is quantitatively dominant.

What prior empirical literature on cyclical monopsony power does this paper build on and extend?

The paper builds on three prior empirical findings. First, substantial employer market power in U.S. labor markets (Berger et al. 2022; Langella and Manning 2021; Yeh et al. 2022). Second, unconditional countercyclicality of employer market power — Hirsch et al. (2018) for Germany, Bassier et al. (2022) for Oregon, and Webber (2022) for the U.S. all document that firms hold more monopsony power in slack labor markets. The paper’s own descriptive analysis confirms this procyclicality of the separation elasticity across multiple detrending methods. Third, Langella and Manning (2021) provide the estimation methodology for the separation elasticity using SIPP data. The paper’s extension is twofold: (a) it extends the Langella-Manning estimates to quarterly frequency and expands the sample to 2019Q4; and (b) it examines the conditional cyclicality of employer market power — specifically, how monopsony power responds to identified government spending shocks — which prior literature had not done.

Key Concepts

Countercyclical monopsony channel: The novel fiscal transmission mechanism proposed by the paper: government spending expansions endogenously reduce employer monopsony power by raising both labor income and workers’ marginal valuation of income, which makes workers more responsive to relative pay differences across firms (higher η), compresses wage markdowns, and raises employment and output. The channel is ‘countercyclical’ in that employer market power falls as spending rises.

Wage markdown (µ): The ratio of the wage paid to workers to the marginal revenue product of labor, defined as µ = η/(η+1), bounded between zero and one. A smaller µ implies a larger wedge between pay and marginal product, i.e., greater monopsony power. Perfect competition corresponds to µ = 1. In the baseline calibration µ = 2/3, meaning wages equal two-thirds of the marginal revenue product.

Wage elasticity of labor supply to the individual firm (η): The key measure of firms’ monopsony power in the model. Defined as η = θ·uW_c,t·wt·nW_t + 1/φ, where 1/φ is the intensive-margin (hours) elasticity. The extensive-margin component θ·uW_c,t·wt·nW_t determines how strongly a firm can attract workers from competitors by raising pay. Higher η means less monopsony power (wages closer to marginal revenue product); lower η means greater power.

Separation elasticity (γ): The empirical proxy for inverse monopsony power: the wage elasticity of worker-firm separations, measuring how steeply a firm’s separation rate falls when it pays higher wages. In the model, γ is proportional to the extensive-margin component of η. Estimated from SIPP microdata via month-by-month complementary log-log regressions of separation dummies on residualized log wages, following Langella and Manning (2021).

New classical (idiosyncrasy) monopsony: The modeling approach used in the paper, following Card et al. (2018), in which monopsony power arises from workers’ heterogeneous preferences over non-pay job characteristics (location, culture, flexibility) rather than from search frictions or geographic isolation. Firms differ in non-pay attributes, and because firms cannot observe individual preferences, they have wage-setting power even with frictionless worker flows between firms.

Cyclical-inequality channel: A fiscal transmission mechanism from the HANK/TANK literature (Bilbiie 2008, 2020): government spending redistributes income from low-MPC capitalists to high-MPC workers, amplifying the fiscal multiplier. The paper shows this channel interacts with the countercyclical-monopsony channel in conflicting ways — progressive taxation strengthens the cyclical-inequality channel but weakens the monopsony channel.

Wealth effect on labor supply (χ): Parameterized via the Jaimovich-Rebelo (2009) utility function, χ governs how strongly a decline in household lifetime income (due to higher taxes) induces workers to supply more hours. The baseline calibration sets χ → 0, consistent with near-GHH preferences and estimates in Schmitt-Grohé and Uribe (2012). A higher χ dampens the countercyclical-monopsony channel by reducing the consumption response and thereby the marginal utility response.