May 1, 2007 Federal Reserve Bank of Cleveland The Minimum Wage and the Labor Market by Guillaume Rocheteau and Murat Tasci T he federal minimum wage was To assess whether the recent increase established in 1938 by the Fair Labor in the minimum wage is excessive or New models of employment show Standards Act. Initially set at 25 cents not, one must know what it is intended that there are some cases in which an hour, the wage has been raised peri- to achieve. The wage’s proponents odically to reﬂect changes in inﬂation have argued that it exerts positive a minimum wage can have positive and productivity. effects on labor market outcomes by effects on employment and social reducing employers’ excessive market welfare. The effects depend ulti- From September 1997 to the begin- power. Its opponents, however, believe mately on the prevailing market ning of 2007, the minimum wage stood that labor markets are competitive and wage and the frictions in the market. at $5.15 an hour, but its real value any wage regulation is bound to reduce Evidence to date does not support declined steadily from about 40 per- employment, especially among low- the view that raising the minimum cent of the average private nonsuper- skilled workers. wage will lead to positive employ- visory wage to a mere 30 percent. ment effects. Adjusted for inﬂation, the minimum This debate can be clariﬁed with the wage was lower at the beginning of aid of economic theories that analyze 2007 than at any time since 1955 the effects of the minimum wage on the (see ﬁgure 1). Meanwhile, the wage labor market. These theories can help us Competitive and affected fewer people, as the frac- answer questions such as: Does a mini- Noncompetitive Labor tion of hourly workers who earned no mum wage necessarily increase unem- Markets more than the minimum dropped from ployment? Does it expand the num- The effect of a minimum wage depends, around 15 percent in 1980 to just ber of people participating in the labor in part, on whether the labor market 2.2 percent in 2006. On May 24, force? Does it improve social welfare? is competitive—or not, in which case 2007, Congress passed a bill raising employers exert signiﬁcant power over the federal minimum wage to $7.25 in wage decisions. We review the employ- three phases over two years. ment effects of the minimum wage under two extreme assumptions: In the FIGURE 1 FEDERAL MINIMUM WAGE AND ﬁrst case, there are a lot of employers WORKERS AT OR BELOW IT competing to attract workers; in the sec- ond, there is a single employer. These Dollars per hour Percent extremes give us two benchmarks from 8.25 16.5 Real which we can discuss speciﬁc situations 7.50 15.0 and markets. Projected 6.75 13.5 6.00 12.0 A perfectly competitive labor market is a composite of many ﬁrms that are in 5.25 10.5 Portion of hourly paid competition for workers. Firms have no 4.50 9.0 power to set wages; the market deter- workers at or below 3.75 minimum wage 7.5 mines a competitive wage. If a ﬁrm 3.00 6.0 deviates from this wage, it either pays 2.25 4.5 less and loses workers or pays more, Nominal sustains losses, and exits the market. 1.50 3.0 0.75 1.5 At the other extreme is a labor market 0.00 0.0 that is a collection of small local 1947 1957 1967 1977 1987 1997 2007 markets. In each local market, some Source: U.S. Department of Labor, Bureau of Labor Statistics. ﬁrms are in a dominant hiring position (think of a large retailer near a small ISSN 0428-1276 city, for example). In such an employer- for workers declines (from N* to N1 in (right-hand panel of ﬁgure 2) ﬂattens dominated market (referred to as a the left panel of ﬁgure 2), whereas the until it intersects with the labor supply monopsonistic market by economists), number of people who want to partici- curve. This happens because the cost a major employer has the power to pate in the market rises (from N* to N2 of an additional worker is now simply set a wage unilaterally without fear of in the same panel). The labor market the minimum wage (as long as the ﬁrm competition. is thrown into disequilibrium. Some does not want to hire more workers than unemployed workers would gladly the number willing to work at or below In both extremes, there are large num- work for a lower wage but cannot ﬁnd this minimum wage). In this case, a bers of potential workers, each of a job, and some employers would be minimum wage increases employment whom has a wage below which he will happy to hire workers at a lower wage by mitigating the negative effects of a not work (his reservation wage). As the but the law forbids it. monopsony’s power. All workers gain: market wage increases, more and more More of them have jobs, and those who people become willing to work. The Thus, in a competitive labor market, do receive a higher wage. The employer relationship between the market wage a binding minimum wage reduces loses because the minimum wage policy and the number of workers who want to employment and creates involuntary reduces its proﬁts. In fact, the optimal work for that amount is called the labor unemployment. level for the minimum wage is the com- supply; it is represented by the upward- petitive wage that maximizes employ- sloping curve in ﬁgure 2. Wage Setting in an Employer- ment (right-hand panel of ﬁgure 2). Dominated Labor Market The amount of output that one addi- Now consider a local labor market in Labor Markets with Search tional worker can contribute to the total which a large coal mine is the commu- nity’s dominant employer (a monop- Frictions output of the ﬁrm (the marginal prod- Of course, the previous descriptions are uct of labor) declines as the size of the sony). Because the mine has negligible extremely stylized and neglect several workforce grows. The diminishing mar- competition from other ﬁrms, it can aspects of reality. In actual labor mar- ginal product of labor, represented by set a wage that maximizes its proﬁts. kets, both ﬁrms and workers have some the downward-sloping curve in ﬁgure 2, Unlike a competitive ﬁrm, however, a power to set wages, and the market is is sometimes called labor demand. monopsony cannot hire as many work- not frictionless: It takes time and effort ers as it wants at a constant wage. If Wage Setting in Competitive for a worker to ﬁnd a job or for a ﬁrm to the mine wants to add workers, it must Labor Markets hire a suitable worker. offer a higher wage to attract new labor- When a large number of ﬁrms compete force entrants. Suppose, for instance, We can use the benchmark scenarios for workers, the market wage must be that 10 potential hires have reservation and a couple of new ideas illustrated equal to the marginal product of labor. wages below $5 and another candidate in ﬁgure 3 (and explained in detail in To see the intuition behind this statement has a $6 reservation wage. If the mine “Understanding Unemployment”; see suppose that the “marginal” worker pro- wants to hire 11 workers, it must raise the Recommended Readings) to dis- duces $5 worth of goods and services an its wage from $5 to $6 across the board. cuss the effect of a minimum wage in hour. If the market wage is $4, ﬁrms can Thus the mine’s cost of adding one a labor market with frictions. (This bid it up to $4.50, attract workers from worker, the marginal cost of labor, has approach is referred to as the search other ﬁrms, and still turn a proﬁt. If the two elements: the $6 hourly wage it pays model of unemployment.) market wage is higher, say $6, ﬁrms take one person plus a $1 hourly increase a loss because workers cost more than for each of the other 10. In this case, the In this model of the labor market, their production is worth. In this situa- marginal cost of labor is $16 ($6 + $10). workers are either employed or tion, ﬁrms cut their payrolls to restore unemployed, and jobs are either vacant their proﬁts. In this case, the market The ﬁrm maximizes its proﬁts when or ﬁlled. Unemployed workers look wage should be $5 (w* in ﬁgure 2). the cost of having an additional worker for jobs, and ﬁrms open vacancies equals the value of that person’s output. to maximize their proﬁts. The num- The market wage must also equal the Thus, in the right-hand panel of ﬁgure ber of vacancies that ﬁrms decide to highest reservation wage of workers in 2, the point where the marginal prod- post is given by the downward-slop- the labor force: Those whose reserva- uct of labor intersects with the marginal ing vacancy-supply curve in ﬁgure tion wage is above $5 stay out of the cost of labor is the employment level 3. Intuitively, when the wage is low, labor force, whereas those whose res- for a monopsonistic ﬁrm. Notice that each worker generates more proﬁts for ervation wage is below $5 enter it. In the employment level is lower than it the ﬁrm; as a result, ﬁrms post more other words, under competitive con- would be in a competitive labor mar- vacancies. The wage is determined by ditions, the wage adjusts to clear the ket. The wage, which can be read on the bargaining between ﬁrms and workers labor market, equalizing labor supply labor supply curve for the monopsonis- (the wage-setting schedule in ﬁgure 3). with labor demand. Figure 2 (left panel) tic employment level (denoted wM in shows the market wage as the intersec- ﬁgure 2), is lower than the competitive When vacancies outnumber unem- tion of the downward-sloping demand wage. So a monopsonistic ﬁrm employs ployed people, ﬁrms may infer that curve (the marginal product of labor) fewer workers and pays them less than workers have better job prospects else- and the upward-sloping supply curve. their marginal product. where. As a ﬁrm’s vacancies increase, the bargained wage rises. Finally, with Suppose that Congress introduces a Suppose that Congress sets a federal a given number of vacancies, the Bev- mandatory minimum wage of $6 (w). minimum wage that is higher than the eridge curve, which summarizes the Because it is more than the market monopsony’s wage but still below the matching process of unemployed work- wage, the minimum wage is binding. competitive one. In that case, the curve ers and vacancies, speciﬁes the econo- At this higher wage, ﬁrms’ demand representing the marginal cost of labor my’s unemployment rate. Labor market FIGURE 2 COMPETITIVE AND MONOPSONISTIC LABOR MARKETS If the market wage is high, a binding Competitive Monopsonistic minimum wage might discourage work- (Marginal) (Marginal) ers from looking for a job because there Labor demand product of labor cost of labor are fewer vacancies. Labor supply Labor supply The search model’s results are con- Unemployment sistent with the monopsony model: A w minimum wage can, in theory, reduce unemployment. Optimal w* minimum wage One can also show that workers’ search wM effort and social welfare move together. The wage that maximizes one also max- N N imizes the other. Because of that fact, N1 N* N2 N M N* if the market wage is small enough, a FIGURE 3 MINIMUM WAGE IN A SEARCH MODEL minimum wage improves labor market Vacancies Vacancies conditions and increases social welfare. Another interesting result of this model Wage Beveridge setting curve is that the minimum level of unemploy- ment occurs when the market wage is below the one that maximizes workers’ search effort. This means that a mini- V* mum wage can make workers better off even if it increases unemployment. Labor Force Participation Vacancy If we focus instead on workers’ deci- supply sion to participate in the labor force (the analog of labor supply in the fric- w* w Wage U* U Unemployment rate tionless models), we can use logic sim- ilar to that followed above: If the mar- outcomes such as wages, the number ing their search efforts. The net effect ket wage is very low because workers of vacancies, and the number of unem- depends on where the wage stood have little bargaining power, they ployed are determined by these three before the increase. To see this, consider might decide not to search for a job at building blocks—the vacancy-supply two extreme cases where wages initially all. They have no incentive to enter the curve, the wage-setting schedule, and are either high or low, depending on the market because nonmarket activities the Beveridge curve. extent of workers’ bargaining power. (such as gardening) are more valuable than working; hence, employment is Suppose the government introduces a First, suppose that workers have no bar- low. Conversely, if the market wage is minimum wage that exceeds the market gaining power, ﬁrms post wages uni- very high, ﬁrms are not hiring, unem- wage (ﬁgure 3). The wage-setting curve laterally, and workers search until they ployment spells are long, and workers then has a vertical portion at the mini- ﬁnd an acceptable wage offer. Since stay out of the labor force. In general, mum wage. As higher wages cut into employers appropriate the entire sur- employment is a hump-shaped func- their proﬁts, ﬁrms open fewer vacancies, plus from their relationship with labor, tion of the wage. and the unemployment rate increases unemployed people have little incentive (from U* to U in the ﬁgure). So in this to search actively for a job; the result But unlike the model with workers’ scenario, a binding minimum wage is high unemployment. Next, consider search effort, unemployment always raises both wages and unemployment. the other extreme, where workers have decreases with the wage. Although par- all the bargaining power to set wages. ticipation is weaker when wages are Workers’ Job-Search Effort Firms make no proﬁt from hiring more low, ﬁrms still create jobs because their Let’s enrich our description of the workers. Because opening and advertis- proﬁts are high. This swells the number labor market now by assuming that ing vacancies is costly, ﬁrms do not do of vacancies relative to the number of workers can choose the intensity with so, and unemployment is high. job seekers, making it more likely that which they search for a job—how they will ﬁnd work. much time they spend looking for a This means that in markets which job, how many application letters they tend to be dominated by employers or, If the market wage is too low and work- send out, and so on. equivalently, in markets where work- ers lack bargaining power, the intro- ers’ bargaining power is not too high, duction of a binding minimum wage Under these conditions, a higher wage a compulsory increase of the wage strengthens labor force participation, exerts two opposing effects: It raises the can lead to higher search intensity and even though the duration of unemploy- payoff when workers ﬁnd a job, which higher employment. If the market wage ment increases. In contrast, if the mar- motivates them to look harder. At the is low, a binding minimum wage can ket wage is high, a minimum wage same time, it weakens ﬁrms’ incen- make employment more attractive to reduces the supply of vacancies and tives to create jobs, making workers workers, which strengthens their search increases unemployment duration, less likely to succeed and so dampen- efforts and so reduces unemployment. PRSRT STD Federal Reserve Bank of Cleveland U.S. Postage Paid Research Department Cleveland, OH P.O. Box 6387 Permit No. 385 Cleveland, OH 44101 Return Service Requested: Please send corrected mailing label to the above address. Material may be reprinted if the source is credited Please send copies of reprinted material to the editor. which discourages workers from enter- Recommended Readings ing in the labor force. Bureau of Labor Statistics. 2007. Char- Guillaume Rocheteau is an economic acteristics of Minimum Wage Workers: advisor at the Federal Reserve Bank of Ultimately, then, we need to know the 2006. Cleveland, and Murat Tasci is an econo- prevailing market wage and the extent Pierre Cahuc, and Andre Zylberberg, mist at the Bank. of market frictions before we can deter- mine whether raising the minimum 2004. Labor Economics, Cambridge, The views expressed here are those of the wage will improve or harm social wel- Mass.: MIT Press. authors and not necessarily those of the fare. Christopher Flinn tried to do just David Card, and Alan Krueger. 1994. Federal Reserve Bank of Cleveland or that when he estimated workers’ bar- “Minimum Wages and Employment: A the Board of Governors of the Federal gaining power in a 2006 study. He ﬁnds Case Study of the Fast-Food Industry in Reserve System or its staff. that the market wage exceeds the wage New Jersey and Pennsylvania.” Ameri- that maximizes workers’ participation can Economic Review, 84, 772–93. Economic Commentary is published by in the labor market, which seems to rule the Research Department of the Federal out positive welfare effects of a mini- Christopher Flinn. 2006. “Minimum Reserve Bank of Cleveland. To receive mum wage: “Our estimates of the bar- Wage Effects on Labor Market Out- copies or be placed on the mailing list, e- gaining power parameter...yield an opti- comes under Search, Matching, and mail your request to 4d.subscriptions@ mal minimum wage rate less than the Endogenous Contact Rates,” Economet- clev.frb.org or fax it to 216.579.3050. then current value of $4.25.” rica, 74, 1013–62. Economic Commentary is also available David Neumark, and William Washer. on the Cleveland Fed’s Web site at www. The Weight of Evidence 2006. “Minimum Wages and Employ- clevelandfed.org/research. The analysis presented here omits sev- ment: A Review of Evidence from eral important elements of actual labor the New Minimum Wage Research,” markets. Many empirical studies have NBER Working Paper no. 12663. sought to quantify the employment effects of a minimum wage. According Christopher Pissarides. 2000. Equi- to David Neumark and William Washer, librium Unemployment, Cambridge, who surveyed this literature thoroughly, Mass.: MIT Press. most evidence suggests that a minimum Guillaume Rocheteau. 2006. “Under- wage leads to greater unemployment. standing Unemployment,” Federal And contrary to popular belief, most Reserve Bank of Cleveland, Economic evidence suggests that the least-skilled Commentary (October 15). workers are those most likely to be harmed the most.