Debunking the Myths of Minimum-Wage Economics

94/222/23-8/18/15Recent discussions over whether penalty-rates in Australia are too high has rekindled debate on an age-old economics chestnut – does increasing the minimum wage cause unemployment to rise? While conventional wisdom has tended to assert that a positive correlation does exist, many key thinkers have started to shift away from this view.

The standard textbook argument rests on the following premise: If the government raises the minimum wage above the level that would be set by the market – the “market-clearing wage” –employers will be less willing to employ people at that wage.

In a perfectly competitive market, the market clearing wage will always be equal to the value of increased output produced by an additional worker (known as “the marginal product of labour”). So if hiring an extra worker brings $10 more profit to the firm per hour, market forces would set a rate of wage of $10/hr. But if the government-mandated minimum wage was set at $11/hr, this presents a problem.

The hypothetical employer in this scenario would be accepting a loss of $1/hr if they were to hire this additional worker. And so, because firms cannot pay a worker more than the value the worker brings to the firm, employment levels may fall. Furthermore, some wage-level tasks could be capable of being performed by a machine for less cost than hiring a worker at the minimum wage, thereby generating structural unemployment.

However, there are number of strong responses to this traditional economic analysis. Firstly, firms can simply raise prices to account for the increased cost of labour. And because the demand for products that  are produced by minimum-wage labour is fairly constant, consumers will continue the buy the product at the higher price. Experimental studies have found that on average, a 10% hike in the minimum wage leads to a 4% increase in prices at companies affected.

Secondly, firms may actually save money from increases in the minimum wage by reducing turnover-costs. These are the costs involved in hiring a new worker and include such things as screening potential candidates and training future employees. Importantly, minimum-wage hikes encourages workers to stay on longer due to the higher wages. At the same time, employers have a larger incentive to improve the productivity of existing staff when labour costs rise. In this way, lower turnover costs could ease the costs of higher wages, creating a negligible impact on aggregate employment.

A third response challenges the core assumptions of the standard textbook model. For an increase in the minimum wage to decrease employment, the current market wage must be  equal to the marginal product of labour. However, this assumption may not always be true due to the presence of market asymmetries. In low-wage labour markets, employers commonly have more market power than employees due to information costs, declining levels of union membership and poor labour mobility. All of these factors give employers the power to set wages below what the market rate should be, a situation called monopsonistic competition. In this environment, an increase in the minimum wage may simply resolve this asymmetry, returning the wage-rate to the most efficient, market-clearing level.

The most comprehensive empirical study on the subject to date was published by David Card and Alan Krueger in 1994. In their paper the authors compared employment levels in the neighbouring states of New Jersey and Pennsylvania after the former introduced an 18.8% increase in the minimum wage. Surprisingly, the data showed a small increase in employment levels in the state that had increased wages. Subsequent studies have proved similarly inconclusive, with evidence supporting both sides.

For me, the impact of the minimum wage on total employment is best summed up in a 2002 paper published by Bhaskar, Manning and To which concluded that “a minimum wage set moderately above the market wage may have a positive effect or a negative effect on employment, but the size of this effect will generally be small.”

While the economic debate over minimum wages and penalty-rates will no doubt continue, it is clear that we must not be fooled by simplistic economic analysis. Labour markets are complex and should be treated as such.