Minimum Wages and Their Relationship With Employment and Unemployment

Introduction

Minimum wages and their relationship with employment and/or unemployment have been of great interest to economists. Theoretically, minimum wages, if set above the market-clearing wage rate, will reduce employment and increase unemployment. Most of the empirical results also tend to support this theoretical assertion. The effect of minimum wage on employment has been studied by many and there has been a contrasting report on the same (Campbell & Campbell 1969; Brown, Gilroy & Cohen 1982; Card & Krueger 2000). However, empirical researches have provided varied results regarding the effect of minimum wage on employment/unemployment. Due to increasing disagreement of literature, it is difficult to ascertain which point of view is correct. Therefore, this paper will aim to trace the theoretical underpinning of the relationship and the empirical support for the theory.

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In this paper, we will discuss the theoretical analysis of the effect of the introduction of minimum wage on the employment/unemployment rate. Then the paper will provide an analysis of the direct and magnitude of the effect of minimum wage on unemployment. The paper will present theoretical as well as empirical evidence in order to support the arguments presented in the essay.

Theory

On the theoretical level, first, a simple demand supply analysis of the price floor will be conducted in order to understand the effect of minimum wages on employment and then the outcome will be contrasted in the case of monopsony. A simple demand-supply model of minimum wage and its effect on employment/unemployment is a one-sector model i.e. its focus is on a single competitive labor market. Here the second assumption taken is of homogeneity of workers whose wage rate W0 will be lesser than the minimum wage rate, Wm, set by the government. Employers aim at minimizing cost in case of both before and after minimum wage law.

Minimum Wage and Employment
Figure 1: Minimum Wage and Employment in Competitive Market

In this respect, we assume that the worker’s skill and effort are identical and are determined exogenously. Another assumption is that all workers or laborers available in the market fall under the category of minimum wage. We do not consider the adjustment in the new model. In this model, we assume that the initial employment is E0, which is determined by the supply and demand of labor in the market.

As in figure 1, the E0 is determined by the interaction of the demand curve D and the supply curve S. When the minimum wage is introduced in this setting, employment falls from E0 to Em, the level demanded at the minimum wage rate, Wm. In this case, we see that the proportional reduction in employment (In Em – ln E0) or proportional increase in unemployment is equal to the proportional increase in wage (In Wm – ln W0) multiplied by the elasticity of demand (Brown, Gilroy & Cohen 1982).

If even after the introduction of minimum wage there is an increase in employment then the reduction of employment predicted by the model will lead to a low rate of growth of employment instead of a decline in the number of labor employed. In case if there is a decline in employment then it will indicate that the firms are not replacing the workers who quit instead of dismissing them (Brown, Gilroy & Cohen 1982).

Therefore, the model indicates that there exists an excess supply of labor at the minimum wage rate, which is indicated as Sm – Em. However, this excess supply does not indicate the official measure of unemployment (Brown, Gilroy & Cohen 1982). This does not even indicate an increase in the unemployment rate above the frictional level. In this model, Sm represents the number of laborers (or man-hour) who are willing to work at a given minimum wage rate Wm. However, some Sm – Em may also decide that given the dim prospect of finding a job, it is not worthwhile to try for a job. People who are voluntarily unemployed are not included in the unemployment count officially.

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Monopsony

One exception to the rule extended by the simple demand supply model that minimum wages increase unemployment is refuted in the case of monopsony (Stigler 1946). In the case of the absence of minimum wage, the monopsonistic firm’s marginal cost of labor always is more than the supply price. This kind of firm hires labor until the time marginal cost equals demand (see figure 2).

Monopsony
Figure 2

When a minimum wage is introduced, it makes the firm a price taker until the level of employment S (Wm). Therefore the minimum monopsony wage W0 and the competitive wage rate W1 is expected to increase employment (Brown, Gilroy & Cohen 1982). If we consider W1 to be the minimum wage rate Wm then this will bring down the employment to the competitive level E1. When Wm is equal to W1, any further increase of the minimum wage rate will reduce employment below the competitive level. However, this model did not attract a lot of academic attention as it is said to be of dubious importance in modern-day labor markets where wages are low (Brown, Gilroy & Cohen 1982; Lipsey & Chrystal 2007).

Therefore, overall in a competitive market, if the wage rate is set at a minimum floor price it will lead to excess supply of labor (Lipsey & Chrystal 2007). Thus, it will eventually lead to unemployment.

Empirical Research

Empirical research to has supported the theoretical model historically. Defenders of minimum age had disregarded the unemployment caused by minimum wage and stated that it created a balance among the working poor who were left better off. In other words, they indicated that people with jobs were given higher income, which offset the lower income of unemployed people (Levitan & Belous 1979). However, there has been extensive study, which lent support to the theory that minimum wages reduced employment (Brown, Gilroy & Cohen 1982; Campbell & Campbell 1969; Stigler 1946). Other studies have shown that minimum wages reduced employment more for teenagers than for adults (Welch & Cunningham 1978; Adie 1973; Neumark & Wascher 1992). A study by Forrest (1982) showed that youth employment reduced, as there was an increase in the minimum wage. The study was conducted in Canada, which showed that youth unemployment increased by 40 percent in Canada since 1950 as the minimum wage rate was set at a high rate.

However recent studies on minimum wage since the 1990s prove otherwise. The genesis of these studies can be traced back to the study of Card and Krueger (1994).

Most of the empirical research also suggested that the theory is consistent with the findings of the surveys or empirical data. However, a paradox was found in the study conducted by Card and Kruger (1994) who demonstrated that their results refuted the theoretical and all other previous validation of the theoretical model. According to their view, in the competitive model, a higher minimum wage rate leads to lower employment, less output and therefore higher output prices. In addition, in the case of a monopsonistic model, they predict higher employment followed by an increase in minimum wage rate and therefore greater output and thus lower prices. They thus state:

A standard competitive model predicts that establishment-level employment will fall if the wage is exogenously raised. For an entire industry, total employment is predicted to fall, and product price is predicted to rise in response to an increase in a binding minimum wage… An alternative to the conventional competitive model is one in which firms are price-takers in the product market but have some degree of market power in the labor market, If fast-food stores face an upward-sloping labor supply schedule, a rise in the minimum age can potentially increase employment at affected firms and in the industry as a whole… Although monopsonistic… models provide a potential explanation for the observed employment effects of the New Jersey minimum wage, they cannot explain the observed price effects. In these models industry prices should have fallen in New Jersey relative to Pennsylvania…” (Card & Krueger 1994, pp. 790-91)

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This paradox in the finding of Card and Krueger may be summarized in the following words. The economic theory postulates that as there is an increase in the minimum wage, which binds employers, there is an increase in unemployment and a decline in output prices. However, they feel that it is not capable of increasing both prices and employment as they found to occur in New Jersey. Therefore, they refute the theory and feel that with an increase in the minimum wage rate there is bound to be an increase in unemployment.

Similar responses have been traced from the findings of Bazen (2000)He states that that the “latest studies of the experience of the USA and the UK, in general, find no evidence of negative effects on youth employment” (p. 64). A similar response has been found in the findings of Flinn (2006) who believes that the more recent literature on minimum wage has indicated that the traditional theory of minimum wage in the competitive labor market “may have serious deficiencies in accounting for minimum wage effects on labor market outcomes” (pp. 1013-4). Studies have ranged in their derivation of the relation. For instance, Newman and Wascher (1992) have found a there is a negative relationship between minimum wage rate and employment and there are other studies that showed that there is a positive or no relation between the two (Card & Krueger 1994).

On the other end, there are groups of economists who feel that no convincing conclusion can be drawn from the findings suggesting that a positive or negative relation is equally likely. One such has been presented by Lemos (2004) who states, “… there is no consensus on the direction and size of the effect on employment” (p. 219). Consequently, Stewart (2002)states that some work on the effect of minimum wage on employment has found positive as well as negative relations between the two.

Further many researchers believe that minimum wage affects the employment rate of low-wage workers and teenagers (Kosters 1996). These researchers feel that the effect of minimum wage is more serious on black teenagers than on white teens. (Neumark & Wascher (1992) have studied data on state minimum wage and the economic conditions for the years 1973-89. Their study suggests that a 10 percent increase in minimum wage will lead to a 1.5 to 2 percent decline in employment mostly for young adults. The authors thus state, “… youth subminimum wage provisions enacted by state legislatures moderate the disemployment effects of minimum wages on teenagers.” (1992, p. 55)

Other studies, which challenged the findings of the time series studies conducted earlier, were that of Wellington (1991) who found that due to inclusion in the sample period of the 1980s, when the real minimum wage rate fell, which reduced the disemployment level. She argued that for a 10 percent rise in the minimum wage, employment fell by 1 percent of teenagers, and almost zero percent of young adults. Similar results have been found by Card (1992) who draws similar data from 1989 to 1990. Finally, Katz and Krueger (1992) surveyed fast-food restaurants in Texas and found no existing evidence, which could validate a negative relationship between both i.e. minimum wage and employment. Therefore, the disagreement on the effect of minimum wage on employment is extensive and the direction and the amount of effect are also wide-ranging.

Conclusion

The essay reveals that theoretically when there is an increase in minimum age it leads to a decrease in employment. Overall, the essay shows that the main determinants of the effect of minimum wage on employment are supply of labor and market condition. If the market for labor is competitive then the effect of the minimum wage will be negative on employment. This is because the employers have to pay a higher wage than the one determined by free-market equilibrium and therefore reduces the employment, as employers are less willing to employ labor given a higher wage rate. Thus, this increases unemployment. Further, in the case of monopsony, a minimum wage increases employment, as employers are more willing to hire at a fixed wage rate rather than a monopolistic labor market. This is more evident in unionized markets. Empirical research on minimum wage and its effect on employment traditionally has supported the model. Traditional empirical research validated the theory, however; studies that are more recent have refuted the argument put forth by the theory as well as the previous researches. This shows that the effect of minimum wage on employment is a debatable topic as there are varied findings on this. Even the direction and amount of the effect cannot be ascertained, as the findings of these empirical researches do not agree upon a close enough result. Therefore, in conclusion, it must be noted that even though there is no consensus on the direction of the effect of minimum wage there are more researches, which supports the negative relation than the positive. Moreover, in terms of relation, it can be stated that if the relationship is negative then a 10 percent increase in minimum wage will reduce employment by 1-3 percent (Neumark & Wascher 1992).

References

Adie, DK 1973, ‘Teen-Age Unemployment and Real Federal Minimum Wages ‘, Journal of Political Economy, vol 81, pp. 435-441.

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Bazen, S 2000, ‘The Impact of the Regulation of Low Wages on Inequality and Labour-Market Adjustment: A Comparative Analysis’, Oxford Review of Economic Policy, vol 16, no. 1, pp. 57-69.

Brown, C, Gilroy, C & Cohen, A 1982, ‘The Effect of the Minimum Wage on Employment and Unemployment’, Journal of Economic Literature, vol XX, pp. 487-528.

Campbell, CD & Campbell, RG 1969, ‘State Minimum Wage Laws As A Cause Of Unemployment’, Southern Economic Journal, vol 35, no. 4, pp. 323-332.

Card, D 1992, ‘Do Minimum Wages Reduce Employment? A Case Study of California, 1987-1989’, Industrial and Labor Relations Review, vol 46, no. 1, pp. 38-54.

Card, D & Krueger, AB 1994, ‘Minimum wages and employment: A case study of the fast-food industry in New Jersey and Pensylvania’, American Economic Review, vol 84, pp. 772-793.

Card, D & Krueger, AB 2000, ‘Minimum Wages and Employment: A Case Study of the Fast-Food Industry in New Jersey and Pennsylvania: Reply’, The American Economic Review, vol 90, no. 5, pp. 1397-1420.

Flinn, C 2006, ‘Minimum Wage Effects on Labor Market Outcomes under Search, Matching, and Endogenous Contact Rates’, Econometrica, vol 74, no. 4, pp. 1013-106.

Forrest, D 1982, ‘Minimum Wages and Youth Unemployment: Will Britain Learn from Canada?’, Journal of Economic Affairs, vol 2, pp. 247-250.

Katz, LF & Krueger, AB 1992, ‘The Effect of the Minimum Wage on the Fast Food Industry ‘, Industrial and Labor Relations Review, vol 46, no. 1, pp. 6-21.

Kosters, MH 1996, The effects of the minimum wage on employment, American Enterprise Institute, Washington, DC.

Lemos, S 2004, ‘Minimum Wage Policy and Employment Effects: Evidence from Brazil’, Economia, vol 5, no. 1, pp. 219-66.

Levitan, S & Belous, RS 1979, ‘The Minimum Wage Today: How Well Does It Work? ‘, Monthly Labor Review, vol 102, pp. 17-21.

Lipsey, RG & Chrystal, KA 2007, Economics, 11th edn, Oxford University Press, Oxford.

Neumark, D & Wascher, W 1992, ‘Employment Effects of Minimum and Subminimum Wages: Panel Data on State Minimum Wage Laws’, Industrial and Labor Relations Review , vol 46, pp. 55-81.

Stewart, MB 2002, ‘Estimating the Impact of the Minimum Wage Using Geographical Wage Variation’, Oxford Bulletin of Economics & Statistics , vol 64, pp. 583-605.

Stigler, G 1946, ‘The Economics Of Minimum Wage Legislation ‘, American Economic Review, vol 36 , pp. 358-65.

Welch, F & Cunningham, J 1978, ‘Effects of Minimum Wages on the Level and Age Composition of Youth Employment ‘, Review of Economics and Statistics, vol 60, pp. 140-145.

Wellington, A 1991, ‘Effects of the Minimum Wage on the Employment Status of Youths: An Update’, Journal of Human Resources, vol 26, no. 1, pp. 27-46.

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