FAQ: Minimum Wage

(by /u/mrdannyocean)

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How does a minimum wage affect the labor market?

This is a big question, so let's start from an 'economics 101' perspective. The minimum wage is a type of price floor, where the good in question is labor (and specifically low-wage labor). Classic economic theory tells us that a sufficiently high price floor in a competitive market will lead to a surplus of goods as seen in this chart. When the law mandates a higher-than-equilibrium price for a good, there are more people willing to supply the good but fewer people willing to purchase the good. When labor is the good, we call this surplus 'unemployment' - people willing to supply labor (work) for the minimum wage, but not enough firms willing to purchase labor (hire) at that wage.

Firms are less willing to hire at the minimum wage because it becomes unprofitable to employ certain individuals at higher prices. Firms are generally profit maximizers and will not employ a worker unless the worker can produce more value than they cost in wages/expenses. Imagine an economy with 100 workers, where each worker 1-100 can produce a corresponding $1/hour, $2/hour, $3/hour, .... $99/hour, $100/hour of value with their labor. The current minimum wage in this group is $10/hour. Citizens 1 through 9 are unemployed, as no firm will hire them because they do not produce enough value to be worth the cost. Without a minimum wage, they could sell their labor at its fair value.

In this classical model of the minimum wage, it is very clear that a minimum wage will lead to higher unemployment among low wage workers. It's easy to imagine how this could apply in the real world with a sufficiently extreme minimum wage - if the minimum wage was raised to 100 dollars per hour in the United States (roughly 13x current levels), there are very few business who would retain all their low-wage staff at those wages. Instead, you would see unemployment, with huge numbers of workers willing to work for that wage but few companies willing to offer it.

Is the Econ-101 model the only way to model the impact of a minimum wage?

No, it isn't. It is absolutely true that in a certain type of idealized situation, a minimum wage must lead to unemployment. However, that situation comes with many assumptions. The removal or changing of those assumptions could change the conclusions we come to.

Monopsony

To begin, our introductory model implicitly assumed a perfectly competitive market - a market without any search costs or frictions, with a large number of firms but no firms with market power to set prices, homogeneous labor, perfect information, etc. If we assume that the labor market is monopsonistic (a situation where firms have some market power over employees) rather than perfectly competitive, our view of the effect of minimum wage changes. In this scenario, firms can use their monopsony power to reduce the wages they pay workers to below the level that they would pay in a more competitive environment. Monopsony is a form of market failure where workers are paid below their marginal product of labor In this environment, a minimum wage could actually increase employment and wages (for a further detailed breakdown, see here).

There are a few plausible ways monopsony power could exist. It could be that employees face significant search costs to change employers from on the job search. In this case, your current employer has monopsony power over you, because you have to incur costs to find another employment opportunity. Employers know this and use their monopsony power, lowering wages and employment across the board.

Another situation leading to monopsony power could be heterogeneous workplaces due to travel distance. It is possible for one job to pay more, but actually be a worse choice if travel costs are high. This is especially true if one is a low wage worker, who may have especially high travel costs (e.g. a car that breaks down). This model can also be generalized to where different “travel costs” act as an analogy for subjective workplace differences. Either way, imperfect substitution between workplaces give employers monopsony power over employees.

Of course, while perfect competition may not be a realistic assumption, monopsony power might not be either - many firms offer low wage work and such work is often highly similar. The existence of monopsony power is not a settled question for low wage workers.

Efficiency wages

Another assumption of the introductory model was a market without frictions - costless job searches. In reality, job searches and matching between firms and employees could be quite time consuming and expensive for both parties. Paying a wage above the market-clearing wage (an efficiency wage) could lead to less employee turnover and thus lower search costs associated with employee turnover, and therefore firms might rationally offer wages above the otherwise market-clearing wage. Additionally, Shapiro and Stiglitz theorized that efficiency wages could reduce shirking. Because firms cannot costlessly monitor all employee behavior, employees frequently have the incentive to shirk rather than produce as much as possible. Increasing wages might provide a greater disincentive to shirk than would exist at the standard equilibrium wage - the cost of being discovered and fired is now higher (since a job paying higher wages is more valuable). If firms can lower search costs and shirking costs by paying a higher efficiency wage, the prevailing wage will naturally rise beyond the 'perfect competition' equilibrium. This new market equilibrium will feature higher wages and unemployment as part of the equilibrium, but the existence of a minimum wage in this case would not necessarily have caused the unemployment - unemployment would have independently existed either way.

With all of these caveats, there are many plausible scenarios where the effect of a minimum wage is not as clear cut as the introductory economics-101 model implies. Our theoretical assumptions heavily impact the results of our model, and we must turn to the data to resolve the question.

Empirical Studies

Until the 1990s, there was widespread consensus among economists that minimum wage reduced employment among low skilled workers - 90% agreed in a 1978 survery. In 1994, David Card and Alan Krueger published an analysis of New Jersey and Pennsylvania restaurants which cut against the conventional wisdom. New Jersey had increased their minimum wage while Pennsylvania's minimum wage remained the same. Card and Krueger examined the employment data at restaurants in both states, where standard theory would predict New Jersey's relative unemployment to increase. Instead, they found no significant effects on employment from the increase in minimum wage.

This study set off intense debate among economists, and led to a wealth of new studies examining the real impact of minimum wage in practice. Unfortunately, the evidence gathered has been contradictory and does not point in a single, clear direction. As a very brief review of the evidence is below (dozens of additional studies could be cited, but are not in the interest of brevity):

• Neumark and Wascher also examined NJ and PA restaurant data and found contradictory results to Card/Krueger - a significant negative effect on employment.
• Card and Krueger published a convincing rebuttal of this Neumark/Wascher work citing BLS data to back up their original telephone survey data. The whole kerfuffle was later reconciled as different results for different sets of employers.
• A 2010 study by Dube, Lester and Reich examined border counties on states raising MW nationwide for employment effects, and found no evidence of detrimental effects on low-wage employment.
• Baskaya and Rubenstein find negative employment effects on teen employment rates
• A 2006 meta analysis from Neumark and Wascher claims most studies find negative employment effects (though not always significant effects).
• Meta analyses from Card and Kruger and also from Doucouliagos and Stanley show no evidence of employment effects. In fact, they present a strong case for the existence of publication bias (bias towards publishing negative results).
  

Stanley and Doucouliagos's meta-analysis presents a concise funnel graph of estimated effects found by 64 different studies of the minimum wage. These effects are centered around zero, indicating that the true effect is likely to be zero or some very small negative number (as a technical note, the leftward skew of the funnel plot is potential evidence of publication bias towards publishing negative results).

Economists are still divided about the impact of minimum wages today. A 2006 survey of economists by Robert Whaples found that 47% of economists wanted the minimum wage abolished, but 14% would leave it unchanged and 38% would increase it. A 2013 IGM survey found 34% of leading economists thought a 15% increase in the minimum wage would make it harder for low-skilled workers to find employment, while 32% disagreed and 27% were uncertain. With surveys of economists, the specifics of the question often make a large difference. For instance, labor economists in a 1998 survey were split as to whether the minimum wage should be increased, but agreed that such an increase would specifically decrease teen employment. At larger levels of minimum wage increases economists have more certainty - an EPI survey of labor economists found that 73% believed a 50% increase in the minimum wage would decrease employment. The 2013 IGM survey above found most leading economists believed the benefits associated with a minimum wage increase to $9.00 would be worth the distortionary costs.

The most comprehensive summary that can be made about the minimum wage literature is that while the evidence is sometimes contradictory, small minimum wage increases seem to either have no employment effects or at least quite small employment effects in the short run. Estimates of long-run impacts, or the impact of large minimum wage increases are presently unknown.

Further Context

Does a MW help people?

The general body of research (such as Dube and the CBO) suggests that minimum wage increases do increase earnings for low wage workers.

However, not all economists are convinced that the minimum wage is an effective policy to aid low-wage workers. Several arguments advanced against the minimum wage include:

• Employers may simply decrease other job benefits and amenities to offset the increased labor costs, leaving total well being for minimum wage employees unchanged.
• The minimum wage is not necessarily an effective tool for fighting poverty because it does not target the poor well. According to the BLS in 2015, about half of minimum wage workers were 24 years old or younger and those young workers tend to be part of middle class households. In addition to potentially targeting non-poor workers, minimum wage also does not impact the poor without jobs, such as retired persons, the disabled and unable to work, the unemployed, etc.
• Many economists consider policies like the EITC and transfer programs to be superior to minimum wage increases. EITC has the potential benefit of increasing employment (rather than potential employment decreases with a high minimum wage), while transfer programs can more accurately target all of the poor (and their benefits don't accrue to the non-poor). These arguments don't necessarily imply that a minimum wage is bad, but simply that it is inferior to other policy options.

The impact of minimum wages is still contentious, but as noted in the IGM poll above, a majority of economists believe the benefits of an increase to $9/hour in the US would be worth the costs.

If there's going to be a minimum wage, how should it be set?

Arindrajit Dube, a prominent minimum wage researcher, has written a policy proposal on how states and cities should set the minimum wage. He proposes three main strategies:

• Using 50% of the local area median wage as a starting point for MW levels. This would mean that places like rural Kansas have lower minimum wage than places like San Francisco, as wages are much higher in San Francisco than in Kansas.
• Adjusting minimum wages for local cost-of-living considerations, including indexing increases to a regional CPI.
• Coordinating state and local governments to lessen any adverse impact.

Dube is careful to note that many of the current minimum wage proposals are 'out of sample' for current research. There is a large body of evidence about the employment impact of small minimum wage increases - usually little to no employment impact. For larger increases in the minimum wage such as a 15MW, there is not good data to describe the potential impacts and larger employment effects are possible.