Minimum Wage

The Minimum-Wage Controversy

The minimum wage sets a minimum on what employers are allowed to pay workers. In the United States, the federal minimum wage began in 1938 when the government required that covered workers in covered industries be paid at least 25 cents an hour. At that time, the minimum wage was about 40 percent of the average manufacturing wage. The minimum wage was raised occasionally, and by 1996 it had reached $4.25 per hour, which was only 33 percent of the average manufacturing wage rate. Because the minimum wage had declined relative to average earnings, President Clinton proposed and Congress passed a minimum-wage increase to $5.15 per hour in 1997. This is an issue that divides even the most eminent economists. For example, Nobel laureate Gary Becker stated flatly, “Hike the minimum wage, and you put people out of work.” Another group of Nobel Prize winners countered, “We believe that the federal minimum wage can be increased by a moderate amount without significantly jeopardizing employment opportunities.” Yet another leading economist, Alan Blinder of Princeton and former economic adviser to President Clinton, wrote as follows:

“The folks who earn the lowest wages have been suffering for years. They need all the help they can get, and they need it in a hurry. About 40 percent of all minimum-wage employees are the sole wage earner in their households, and about two-thirds of the teenagers earning the minimum wage live in households with below-average incomes. Frankly, I do not know whether a modest minimum-wage increase would decrease employment or not. If it does, the effect will likely be very small.”(New York Times, May 23, 1996)

How can nonspecialists sort through the issues when the experts are so divided? How can we resolve these apparently contradictory statements? To begin with, we should recognize that statements on the desirability of raising the minimum wage contain personal value judgments. Such statements might be informed by the best positive economics and still make different recommendations on important policy issues.

A cool-headed analysis indicates that the minimum-wage debate centers primarily on issues of interpretation rather than fundamental disagreements on empirical findings. Begin by looking at the graph below, which depicts the market for unskilled workers. The graph shows how a minimum wage rate sets a floor for most jobs. As the minimum wage rises above the market-clearing equilibrium at M, the total number of jobs demanded is shown as U. This represents the amount of unemployment.

Using Supply and Demand, we see there is likely to be a rise in unemployment and a decrease in employment of low-skilled workers. But how large will these magnitudes be? And what will be the impact on the wage income of low-income workers? On these questions, we can look at the empirical evidence.

Unskilled Labor

Setting the minimum-wage floor at Wmin, high above the free-market equilibrium rate at Wmarket, results in forced equilibrium at E. Employment is reduced, as the arrows show, from M to E. Additionally, unemployment is U, which is the difference between labor supplied at LF and employment at E. If the demand curve is inelastic, increasing the minimum wage will increase the income of low-wage workers. To see this, pencil in the rectangle of total wages before and after the minimum-wage increase.

Most studies indicate that a 10 percent increase in the minimum wage would reduce employment of teenagers by between 1 and 3 percent. The impact on adult employment is even smaller. Some recent studies put the employment effects very close to zero, and one set of studies suggests that employment might even increase. So a careful reading of the quotations from the eminent economists indicates that some economists consider small to be “insignificant” while others emphasize the existence of at least some job losses. Our example in the graph shows a case where the employment decline is very small while the unemployment increase is quite large.

Another factor in the debate relates to the impact of the minimum wage on incomes. Virtually every study concludes that the demand for low-wage workers is price-inelastic. The results we just cited indicate that the price elasticity is between 0.1 and 0.3. This implies that raising the minimum wage would increase the incomes of low-income workers as a whole. Roughly speaking, a 10 percent increase in the minimum wage will increase the incomes of the affected groups by 7 to 9 percent.

The impact on incomes is yet another reason why people may disagree about the minimum wage. Those who are particularly concerned about the welfare of low-income groups may feel that modest inefficiencies are a small price to pay for higher incomes. Others, who worry about the cumulative costs of market interferences or about the impact of higher costs upon prices, profits, and international competitiveness, may hold that the inefficiencies are too high a price. Yet another group might believe that the minimum wage is an inefficient way to transfer buying power to lower income groups; this third group would prefer using direct income transfers or government wage subsidies rather than gumming up the wage system. How important are each of these three concerns to you? Depending upon your priorities , you might reach quite different conclusions on the advisability of increasing the minimum wage.

Effects of Increasing the Minimum Wage

The minimum wage was increased to 4.25 per hour on October 1, 1996 and then to $5.15 per hour on September 1, 1997. ther was considerable debate among economist over the effects of these increases. D. Card and A. Krueger were among those who challenged the accepted view that a higher minimum wage tends to increase unemployment. But D. Deere, F. Welch, and K. Murphy insisted that the accepted view was correct.

a) If the labor market were perfectly competitive and if the minimum wage exceeded the equilibrium wage, would you expect that increases in the minimum wage would increase unemployment? Why or Why not?
b) Card and Krueger suggest that there may be monopsonistic features in the labor market. Suppose that the figure below displays, in the absence of a minimum wage, the supply curve for labor, the marginal revenue product curve for labor, and the marginal expenditure curve for labor. If the minimum wage were set at W0,how much labor would the monopsonist hire? Would there be unemployment? If so, how much?
c) If the minimum wage were set at W1, how much labor would the monopsonist hire? Would there be unemployment? If so, how much?
d) Does a minimum wage reduce unemployment under monopsony?
e) If an increase in the minimum wage affects unemployment in the long run but has a much smaller effect in the short run, can this help to explain why Card and Krueger found little relationship between the minimum wage and unemployment?
f) The 1999 Economic Report of the President noted that the 1996 and 1997 increases had little effect on employment. Could strong economic growth in the United States have played a role in this result?

Solution:

(a) Yes. Increases in the minimum wage would result in a bigger gap between the quantity of labor supplied and the quantity of labor demanded.
(b) If the minimum wage is set at Wo, then the effective supply curve of labor to the monopsonist would be WoGS. The marginal expenditure curve would then be WoGHE, and the monopsonist would hire Lo units of labor. Why? Because this would then be the point where the marginal revenue curve (WoGHE) intersected the marginal revenue product curve. There would be no perceived unemployment.
(c) If the minimum wage were set at W1, then the effective supply curve of labor to the monopsonist would be W1K. This effective supply curve is horizontal. This means that the monopsonist would hire L1 units of labor. Since L3 units of labor would be supplied at this wage, there would be L3 – L1 units of labor trying to find jobs but not succeeding.
(d) A minimum wage of W0 would increase, not decrease employment. Without the minimum wage, employment would be L2; with it, employment would be Lo. If, however, the minimum wage were too high (W1 for example) then it would reduce employment. A minimum wage of W1 would, in fact, result in employment of L1 units, which is less than L2, the level of employment without a minimum wage.
(e) Yes. As they point out, their findings could change if a longer period of time were considered.*
(f) Absolutely. Higher labor demand associated with strong growth alleviates downward pressure on wages.

The Minimum Wage

One policy motivated by a desire for a more equitable distribution of income, at least for those at the bottom of the distribution, is the federal minimum wage law. When it was first established in 1938, the minimum wage was 25 cents per hour and applied to industries employing only 43 percent of the workforce. In early 2002, the minimum wage was $5.15 per hour and covered almost 90 percent of the workforce. Does the minimum wage create greater quality among American citizens?

To understand the effect of the minimum wage, we will divide the US Labor market in three parts:
(1) the market for skilled workers;
(2) the marker for unskilled labor in industries covered by the minimum wage law; and
(3) the market for unskilled labor in industries not covered by the law, either because it does not apply(waiters, house cleaners, and nannies) or because firms routinely violate it (typically, very small firms that are difficult to monitor).

The diagram below shows what the initial equilibrium in all three markets would be if there were no minimum wage. The wage rate in skilled labor market, where demand is high relative to supply, is $20 per hour. In the unskilled labor market, where demand is lower relative to supply, we assume that the wage would be $4.00. Notice that wages in both unskilled labor markets are equal, since in the absence of a minimum wage law, workers would migrate to the market with the higher wage.

In the absence of a minimum wage law, the wage in the market for skilled labor is high, say, $20 per hour. In the unskilled labor market, the wage is low - $4 per hour. If a minimum wage of $5.15 is imposed, employment in the covered unskilled sector-panel (b) – falls from N1 to N2. With a higher wage for unskilled labor, some firms will substitute skilled workers and capital equipment. This increases the demand for skilled labor and increases the hourly wage in panel (a) to $24. At the same time, some individuals who lose their jobs in the covered, unskilled market of panel (b) will move to the uncovered labor market – panel (c) –further depressing the wage there.

Now let us impose a minimum wage of $5.15 in the covered unskilled labor market and trace through the effects in the figure. First, employment in the covered unskilled labor market falls, from N1 to N2 in panel (b). Since quantity demanded is less than quantity supplied at a wage of $5.15, and since no firm can be forced to hire more workers than it desires, there will be an excess supply of labor equal to N3 – N2. Part of this excess is due to an increase in quantity supplied from N1 to N3; with a higher wage, more people want to work. But part of it is also due to a decrease in quantity demanded from N1 to N2. You can already see that while some unskilled workers benefit (they earn a higher wage) others are hurt (they lose their jobs). But this is just the beginning.

Some of those who lose their jobs in the covered sector will move to the only sector where jobs are still available (the uncovered sector). There, the labor supply curve will shift rightward, from LS1 to LS2 in panel (c), and the market wage will fall below its initial value ($3.00 in our example). Thus the impact of the minimum wage spills over into the sector not covered by it. Increased competition for jobs drives down the wages of all workers there, even those who were already employed before the minimum wage was imposed. More specifically, we would expect a decline in the wages of waiters, house cleaners, and unskilled workers who work in law-breaking firms.

What about skilled workers? Are they affected by the minimum wage legislation? You might think not, since they are already earning more than the minimum. But when the wage of unskilled labor rises in the covered sector, employees there will, to some degree, substitute skilled workers and capital equipment for unskilled labor. For example, a dishwasher might be replaced by a sophisticated dishwashing machine that requires maintenance and repair by skilled workers. An unskilled floorwasher with a mop might be replaced by a cleaning service that uses skilled workers operating high-tech equipment to clean and wax floors. Substitution toward skilled labor will shift the labor demand curve in panel (a) rightward, from LD1 to Ld2. Further, skilled labor is needed to design, produce and market the capital equipment itself, contributing to a further increase in demand. As a result, the wage rate in the skilled sector will increase, from $20 to $24 in our example.