Minimum wage notes | Does classical economics get it wrong?

Standard supply and demand theory claims the minimum wage increases unemployment.

But we have seen rising minimum wages in the West since the 1990s, with many economists finding no increase in unemployment.

So, did classical economic theory get the minimum wage wrong?

Below, I present economic analysis around the minimum wage.

For more economics resources like this, see the links below:

Contents

Definition and statistics

A minimum wage is the lowest wage level which employers, by law, must pay to their workers.

Currently in the UK, minimum wages vary by age. For example.

• For ages 23 and over, the minimum wage is £9.50 per hour (rising to £10.42 in April 2023). The Government also refers to this as the National Living Wage.
• There are lower wages for younger age groups, who receive the “National Minimum Wage”.
• For example, ages 18 and under, the minimum wage is £4.81 per hour (rising to £5.28 in April 2023)

(Source)

Supply and demand graph

Classical supply and demand suggests the minimum wage leads to unemployment.

See the diagram below. This shows the supply of and demand for labour.

A minimum wage must be set above the equilibrium wage w, to have an effect.

Suppose the minimum wage is set at w1.

At w1, labour supply exceeds labour demand.

So there is excess supply of labour. In other words, excess unemployment.

The minimum wage increases the wages of some workers up to q1. But it also increases the level of unemployment. In the diagram, there is unemployment of q1 to q2.

Monopsony diagram

The analysis above assumed a perfectly competitive labour market.

But what if the firm has market power?

Suppose the firm has monopsony power. They are the dominant demander of labour.

Think of the National Health Service (NHS) as an example. The NHS is the main consumer of labour for doctors and nurses in the UK.

First, a quick recap of monopsony power.

With their monopsony power, a firm can reduce its demand for labour, so that it can force down wages.

In the diagram, the monopsony firm maximises profits where MRPL = MCL. So the firm employs q1 amount of labour. The wage is the average cost of labour (all workers are paid the same here). So the wage paid is w1.

Suppose the market behaved like a perfectly competitive market. Then in equilibrium supply equals demand. So employment is at q and wage at w.

To compare the two, having a monopsony reduces wages from w to w1. It also reduces employment from w to w1.

Now consider the impact of a minimum wage at w.

This forces a wage rise from w1 to w. But it also increases employment from q1 to q.

Why does employment increase?

Without the minimum wage, the firm was holding back its demand for labour. So the firm can cut wages and hence costs, increasing profits.

However the firm can no longer cut wages because of the minimum wage. Hence, there is no incentive to hold back labour demand.

The monopsony causes a welfare loss (green area). But the minimum wage removes this welfare loss here.

Productivity

Eliminating or reducing the minimum wage is a type of market based supply side reform. In theory, removing the minimum wage decreases business costs.

It also makes the labour market more “flexible” – wages are able to adjust to changes in supply and demand. Also firms may find it cheaper and easier to hire workers.

But the minimum wage can increase productivity. For example:

• “Efficiency wage” theory. Workers are more motivated by higher wages, so they work harder.
• Fall in turnover costs. A higher minimum wage makes work more rewarding. This increases the incentive for workers to remain at the firm. So fewer staff leave and absenteeism falls. This means reduced business costs from hiring and training new workers.

Other effects of a minimum wage

Standard of living

The purpose of having a minimum wage is to raise living standards for those on low incomes.

Higher minimum wage increases income, all else equal. Increased income means increased disposable income. This means those on low incomes have more to spend and can cover necessities.

This assumes worker hours remain the same and the firm does not cut back on other perks of the job. See below for more discussion on this.

Also, suppose the minimum wage increases unemployment. Then those unemployed will be worse off.

The “ratchet” effect

Suppose the government sets the minimum wage at £10 an hour. This raises the wages of junior staff from £8 an hour to £10 an hour.

But suppose there are managers earning £11 an hour. Managers may consider it unfair that they are now only receiving an extra £1 an hour. So managers also request a higher wage.

So, a rising minimum wage does not only increase the wages of those working at or below minimum wage. It also increases the wages of those working near the minimum wage.

This is the “ratchet” effect.

Inequality and poverty reduction

There is a rise in living standards near the lower end of the income distribution. This will reduce poverty and income inequality, provided unemployment does not rise.

For those workers still working, they may be less eligible for welfare benefits. This is because their wages are higher.

So the government can pay out less in welfare benefits.

But if unemployment rises, there could be more spending on welfare benefits.

Other firm responses

The minimum wage may increase labour costs, if the firm does not reduce its number of staff.

But there are other ways the firm can cut its costs.

For example:

• Cut the number of hours worked for each worker.
• Remove perks of the job, such as staff discounts.
• Cut back on production.
• Reduce quality of products.

The firm could also increase prices to cover the extra labour costs.

Suppose unemployment does not rise immediately after the minimum wage rise. The firm has the incentive to invest in new technology to reduce its dependence on labour. For example, replacing check out workers in shops with self-checkout systems. This is “capital-labour substitution”, replacing workers with machinery. The more costly workers are to hire, the more profitable the use of machinery becomes.

Demand

Minimum wage workers are likely to have a high marginal propensity to consume (MPC). For every pound earned in extra income, they are likely to spend most of it.

So higher minimum wages may boost demand for products. This could increase firm revenue.

The minimum wage increases firm costs. This reduces the profits available for employers to spend. But employers may have higher incomes than minimum wage workers. So have a lower MPC.

Overall, it is likely that demand will rise.

Other evaluation points

• Wage elasticity of demand (WED). Suppose labour demand is wage-inelastic. Then a minimum wage does not increase unemployment very much. For example it is difficult to replace workers with machines (social workers). Or if labour is a smaller percentage of firm costs (steel).
• Extent of market power. It matters whether the labour market is monopsonistic or perfectly competitive. Suppose the minimum wage rises. Then ,ore competitive labour markets are likely to see higher unemployment. But more monopsonistic labour markets may see higher employment. For example public sector workers where the government is the main employer.
• Rate of minimum wage rise relative to inflation. Suppose the minimum wage rises more slowly than inflation. Then higher minimum wages may not improve standard of living.
• The presence and density of trade unions. Suppose there are already trade unions present in the labour market. Also suppose most workers are members of a trade union. These trade unions give workers more bargaining power. So workers can raise their wages. There are trade unions present and already doing the work of the minimum wage. In this case, the minimum wage is irrelevant.
• Extent of compliance / coverage. Not all firms may follow minimum wage legislation. In this case, the penalties and degree of enforcement for not paying the minimum wage matter. In the UK, the Government “names and shames” firms that it says did not pay minimum wage. There are also fines and firms must make up any pay gap. However this list has included some large employers.
• Depends on the sector. For example with care homes, 30% of workers were working at minimum wage. So the unemployment effects may be larger (Manning 2021). It is also difficult to cover the informal sector. There are also many unprotected self-employed workers.

The evidence on minimum wages

Card and Krueger

Card and Krueger, two academic economists, looked at two bordering US states.

One state, New Jersey, raised their minimum wage. The other, Pennsylvania, did not. So they used Pennsylvania as a kind of “control group”. This gave rise to a natural experiment.

They looked at the change in employment in the fast food restaurants in each state.

Their finding was that the higher minimum wage did not reduce employment.

This was a remarkable result at the time. The consensus was that the minimum wage would increase unemployment. Yet this result went against this.

However the results did show rising prices in New Jersey relative to Pennsylvania. This is consistent with standard economic theory.

Card and Krueger – challenges to the result

However the paper was controversial and faced heavy challenge. This was in part because of its controversial conclusions. But also because of the importance of this paper to minimum wage policy. It also did face some serious methodological issues. Issues identified with the paper include:

• The authors observed the effect on employment within a year of the minimum wage rise. But perhaps, the effects of minimum wage changes on employment take time.
• The importance of variations in federal minimum wages. The study looked at state-level minimum wage variation.
• The validity of using a bordering state a as control group. But there can be significant labour market differences between the states.
• The use of telephone surveys of fast food restaurants. These surveys did not have the same data collection standards of other work.

(Neumark and Wascher, 2006)

Current state of the evidence

There are a few different ways academics have interpreted the available evidence.

There is certainly not a consensus on the results. Some studies find that higher minimum wages do not cause unemployment, like Card and Krueger (1993). Yet other studies have found clear evidence for higher unemployment (Neumark and Wascher 2006).

A middle ground is the interpretation of Alan Manning (2021). Sure, standard economic theory suggests a higher minimum wage leads to higher unemployment. But Manning vies this effect as been “elusive”, difficult to find. This is because of forces such as monopsony power or wage-inelastic demand.

Of course, if the minimum wage keeps rising, at some point firm costs will be too high. At this point, workers will have to be laid off.

Instead, the key question is: at what level of minimum wage are the unemployment effects large?

Minimum wages are rising further and faster, notably in the UK and US. So this question will be critical for future policy.

Conclusion

So, does the standard economic theory (supply and demand) hold up on the minimum wage?

Well, to some degree.

But monopsony power is also important to consider.

Also, other key factors include turnover costs and elasticities.

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Sources

Card and Krueger (1993), “Minimum wages and employment: a case study of the fast food industry in New Jersey and Pennsylvania”, working paper NBER.

Neumark and Wascher (2006), “Minimum wages and employment: a review of evidence from the new minimum wage research”, working paper NBER.

Manning (2021), “The Elusive Employment Effect of the Minimum Wage”, Journal of Economic Perspectives, Vol.35, No.1, Winter 2021.