The Minimum Wage and the Labor Market by runout


									                                                                                                                                         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.
                  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-
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
                      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
                                                                                                                      minimum wage can, in theory, reduce
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-
                                                                                                                      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.
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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- 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-
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.

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