The Economic Debate over Minimum Wage Effects

A little bit of knowledge is a dangerous thing. How does extending the debate beyond Econ 101 levels of analysis change the nature of the debate?


A lot of virtual ink has been spilled in recent months over the proposal to implement a phased increase in the Federal minimum wage from $5.15 to $7.25. See here and here. (And some after I wrote this post, including David Altig, who undertakes a sophisticated discussion here, as well as Mark Thoma at Economists View, from a search theoretic perspective).

Figure 1 below shows the nominal (red) and real (2001$) minimum wage (deflated by the BLS’s research CPI series). As is clear from the graph, the real series has been trending downward for a long time; longer trends are depicted in my colleague John Kennan’s survey of the minimum wage (with graph in log terms here).


minwage.gif

Figure 1: Real minimum wage (2001$) deflated by CPI-RS (blue) and nominal minimum wage ($/hours). Sources: Federal minimum wage from About.com, CPI-research series from BLS; 2006 CPI data are CPI-urban.

The standard economic analysis I see is conducted in the framework of models with perfect competition, no information asymmetries, etc. In other words, the most basic, neoclassical supply an demand framework is utilized. In this context, placing a wage floor that binds causes excess supply.


I don’t deny that this framework is a powerful tool. Yet, I think it is all too easy to blithely adopt this approach without thinking about whether the labor market behaves in a way similar to the market for widgets and other commodities.


First, it is a well known fact that in a model with monopsony in factor markets, a wage floor like a minimum wage, can increase employment (the result is shown by Stigler (American Economic Review, 1946). The analogy that might be more familiar to readers is that of a price ceiling on a monopoly; that induces lower prices and greater production.


As Kennan notes (citing Stigler’s reasoning), even if there was monopsony power on the part of the firms emplying the relatively small segment of the work force, unemployment might still result since differing firms would have differing labor demand curves.


Another critique of this view is that monopsony is too strong a characterization of the market conditions facing firms that tend to hire workers. That is where I think this paper by Bhaskar and To (“Minimum wages for Ronald McDonald Monopsonies: A theory of monopsonistic competition,” Economic Journal, 1999; working paper version), comes in. They model firms as having some slight market power, and workers as being differentiated. From the abstract:


We develop a model of monopsonistic competition with free entry to analyze the effects of minimum wages, and our predictions fit the empirical results closely. Under monopsonistic competition, we
find that a rise in the minimum wage a) raises employment per firm, b) causes firm exit, c) may increase or reduce industry employment. Minimum wages increase welfare if they raise industry employment, but welfare e
ects are ambiguous if employment falls. Industry price
and employment are inversely related if the product market is competitive. However, if firms have product market power, a minimum wage which raises industry employment can also increase prices.

Now some might think that we should not deviate from models assuming homogeneity and perfect competition, in favor of such abstruse models. And I agree it’s an open question what is a better characterization of a markets in any particular instance. But I think it is also true that in macroeconomics and international trade theory, we have long ago moved away from assuming perfect competition in firm behavior, adopting monopolistic competition s the baseline. The dynamic stochastic general equilibrium (DSGE) models cited by Greenspan (Sigma) have this structure. The menu-cost based New Keynesian macro models the Mankiw developed have this flavor. Indeed, Ph.D. macro courses are now based on models with some type of imperfect competition in product markets; why not in factor (and hence labor) markets as well?


So this is a plea, not for thinking that minimum wage increases will necessarily have a positive net effect (The Bhaskar and To paper does not make that point), but rather for not blindly reaching for the standard off-the-shelf neoclassical model to answer policy questions. I think the case for a thorough and sophisticated debate is further buttressed by the fact that it has proven difficult empirically to identify negative employment effects from increasing the minimum wage.

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25 thoughts on “The Economic Debate over Minimum Wage Effects

  1. Joseph

    I find it interesting that the very same people that claim that a neoclassical model applies to the minimum wage issue also claim that a neoclassical model doesn’t apply to the illegal immigrant labor issue. I think the contradiction could be resolved if they would just admit that their political policy is low wages, economics be damned.

  2. Economic Investigations

    (Un)Employment

    A few people returned, yet again, to the topic of minimum wage laws. To me, the obsession with this topic seems unhealthy. Even many of the supporters and producers of overcomplicated papers in support of it will agree that other measures would be bett…

  3. T.R. Elliott

    Menzie Chinn: Thank you for joining the debate on this topic. One of my desires is to see Economics–as a field of study, a science, and a profession–approach the complexities that exist in the real world with the greatest caution, to consider what the essential models are telling us, e.g. the neoclassical model, and to compare the modelled results with the real world.
    E.g. comparative advantage makes total sense to me. But I often wonder what comparative advantage means in a global economy with societies that are drawing upon the same knowledge base, the same essential sources for materials. I have no doubt some parts of the world can grow better bananas. But it’s not clear to me why one part of the world has a comparative advantage in assembling computers–other than labor rates. True, the people no longer assembling computers in the US can find other sources of employment, e.g. manufacturing houses, or opening a yoga business. And competition from global players–e.g. Japanese automative manufacturing, is useful. But mercantilistic policies must also be considered.
    So I wonder. I enjoy reading the economic posts at Econbrowser because of the honest attempt to consider the issues, to determine the truth of the matter.

  4. John Thacker

    I think the case for a thorough and sophisticated debate is further buttressed by the fact that it has proven difficult empirically to identify negative employment effects from increasing the minimum wage.
    At the same time, I think it’s a bit of a fallacy to look purely at net employment effects. If a higher minimum wage draws more middle-class teenagers to offer their labor in minimum wage jobs (such as the fast-food industry), and those teenagers then outcompete low-skill poorer workers (due to cultural and other advantages), then it’s not clear that it’s a good tradeoff. Similarly, if a higher minimum wage causes people to put off education that increases skills by making them more satisfied with their minimum wage jobs, then it’s also not clear that it’s a good thing.
    In any case, it’s not clear how much effect there will be when the percentage of workers actually making the minimum wage right now is so low. (Some 2% or less– though of course wages may still rise for others, particularly if the minimum wage is used as a “training wage” which then goes up by $.50 or $1 after initial training.)

  5. menzie chinn

    Joseph: Internal consistency is held at high premium only in a few places; I suspect the political arena is not one of them.

    T.R. Elliott: Thanks for the kind words. Comparative advantage can be driven by any number of things: technology (Ricardian model), factor endowments (Hecksher-Ohlin), a combination (Trefler). As long as endowments of factors of production differ, and as long as technology (broadly speaking incorporating as well the institutions of a country) differ, there will be a role for comparative advantage in trade. It is true that in models of trade with monopolistic competition (e.g., the “new” international trade of the mid-1980’s), there is some indeterminacy in terms of where goods are produced; but these motivations actually have to do with countries that we don’t typically worry about much, such as those in Western Europe.

    John Thacker: I don’t know if it’s a “fallacy” to look at net employment; however I agree it’s not the only dimension to look at. In the linked article from EJ, you’ll see a discussion of entry/exit decisions by firms, production cost implications, and the possibility that some workers gain and some lose. If you look at the discussion in Macroblog and Economists View, you’ll see other effects traced out, depending upon the modeling approach adopted. My main point was that a more nuanced approach to debating the minimum wage issue would be welcome.

  6. T.R. Elliott

    Menzie Chinn: Thanks for the response on comparative advantage. I have a question for you: Are there good references for debates on this topic. I find the minimum wage debate that is taking place to be very useful and long-needed (perhaps I’ve not been looking). I’d like to see a similar discussion on the topic of trade and comparative advantage, in particular taking into account the real-world conditions of, say, the last 50 years or so–post WWII. That would greatly interest me.

  7. T.R. Elliott

    One other point: I think the issue I want to consider in the comparative advantage debate is as follows: I’m often told that trade is win-win. Ok, I’m with that. Question is: Who wins. The answer is often–as we seem to find–that those at the top of each respective trading-society win. Or at least win more. Then the response is as follows: those winning more should contribute (e.g. through taxation) to those not winning as much–or actually losing.
    So then I wonder: Ok, isn’t this a form of welfare? Is that a good thing? It is better to have a slightly less optimal society that does not rely on gifts from above but instead provides opportunities that are actually available below. There is a downside to this–as someone recently pointed out on another blog, you import less, you have to fire dock workers. I understand there are tradeoffs. I’d just like to understand them better.
    I realize this might not make total sense–what I’m saying. I think there is merit to this line of thought though. Everyone says “education” is the key to helping those who are not benefiting from trade. Is that true? Is that education money that is gifted from above actually efficiently used? Or would it be better to have a greater diversity of opportunities–e.g. computer assembly–in country.
    In the days when the idea of comparative advantage originated, populations were much smaller. The flow of ideas and capital much slower. Comparative advantage made total sense.
    And one can argue, for example, that we–America–needed the competition from mercantilistic exporters–as it seems the Japanese were for years–in order to set straight the lazy methods of American auto manufacturers. But why, in a country as large as the US, could competition within country not be sufficient?
    In addition, it seems that comparative advantage should be taking into account broader issues, ecological, sustainability, morality–e.g. working conditions and fair wages–etc.
    I’d be interest in seeing analysis on issues such as I’ve babbled about above.
    I’m not anti-comparative advantage. I’m aware of the many benefits an integrated world community has produced. But I’d like to see more than basic theories and anecdotal evidence. I’d like to see more comprehensive analysis that takes into account, say, the last 50 years of global integration, the benefits, and the possible downsides of comparative advantage.

  8. kharris

    I think we need to be cautious of the argument that teens take jobs from less qualified workers and that education is put off when minimum wages are higher. Those arguments have been around for some time, but seem pretty static. The first sally against the minimum wage is the blunt “it’s a job killer.” When that proves untrue, or at least not a strong or consistent enough effect to show up in the data, then arguments about second order effects crop up.
    It is a pretty sure bet that not all minimum wage jobs shift to capable teens when the minimum wage rises. Do we have any idea how many jobs are lost to less qualified workers due to teenage encroachment? If it is 5%, and the other 95% of minimum wage workers get higher pay, that’s a very different thing than if 50% of minimum wage workers are shown the door as bright-faced super-teens come in to replace them.
    Can we really assume that, because teen employment goes up, that new hiring of teens represents jobs lost to low-skill workers? Has anybody bothered to look into layoff patterns after minimum wage hikes? Wouldn’t we assume that employers would already offer higher wages for better qualified workers? After all, the pattern is for firms to keep minimum wage workers at the higher wage, not lay them off because they aren’t worth the higher wage. Setting the marginal this equal to the marginal that suggests firms should already be willing to pay those super-teens a market-clearing wage, regardless of the law.
    I worked while I studied. Why do we assume that education is put off because of a higher minimum wage? Who is putting off education? Surely, less experienced teens who still manage to out-compete more experienced minimum wage workers are not all on the verge of dropping out when wages go up. They are desirable because of their ambition, attitude and intelligence. Those attributes do not argue for a high drop-out rate.

  9. M1EK

    This unassailable point that teenagers re-enter the labor market and crowd out low-income workers seems counterintuitive to me. It seems more likely that an employer would rather hire a full-time adult worker when wages rise, since the adult worker is less likely to turn over. And I can certainly envision a higher minimum wage drawing back some discouraged adult workers, can’t you?

  10. praguetwin

    It will be very interesting to see what happens if the minimum wage is increased by the new Congress. Should the widely predicted slowdown (or crash landing) occur soon after , the minimum wage increase will be the scapegoat irrespective of its guilt.

  11. DickF

    T.R. Elliott,
    On comparative advantage don’t get locked into the idea that it means there must be an absolute advantage in some form of production by the producers. It is possible to increase the total wealth of the system with comparative advantage even though one contributor produces everything more inefficiently than the other.
    Also, it is difficult to measure comparative advantage in real world situations because the use of capital is actually shifted to other forms of production to another because of production mix changes due to the comparative advantage. This obscures quantitative analysis.
    Concerning the minimum wage, the only way it works is for it to be below a level where it would have any real effect. If this was not true then the minimum wage would be increased 10 fold or more. The debate over minimum wage is in large part meaningless because the economy quickly adjusts to any real effect it might have.
    Now if we lived under a non-inflationary monetary standard the minimum wage would be significant because we would not be able to inflate the effects away.
    It is interesting to note that today many countries have minimum wages but almost all came about after the culture of inflation came into being, many actually after currencies were floated. Also many of the more socialist countries have no minimum wage laws actually allowing collective bargaining to establish wage rates.

  12. John Thacker

    There are some studies which do suggest that jumps in the minimum wage decrease the percentage of people who seek college education.
    Yes, Mr. Dahmus, higher minimum wages can also draw demotivated higher-skilled adults back into the workforce. And yes, while many of the teenagers coming from affluent families could be hired at higher wage rates under certain situations– but not necessarily, especially in the fast food industry.
    However, first, many low income jobs have fairly fixed wage rates across jobs and are seen as skilled labor. Second, for many of these minimum wage jobs there are choices between capital and labor investment.
    For example, a job may have the choice between employing low skilled individuals at a lower wage, or investing in a great deal of computers and automation that will increase productivity of each worker, but require more training, intelligence, and computer-savvy on the part of the workers. Without the minimum wage law, the most cost-effective strategy may be to employ a larger number of low-skill employees with a small amount of capital investment.
    With the minimum wage law, the company may be forced to invest in additional technology and forced to use employees with greater computer and other skills. Note that the “superteens” and other potentially more qualified employees offer essentially no benefit in the low-capital investment scenario. The more highly skilled employees are only more useful when the entire work situation is restructured to demand their skills– which may only happen with the wage floor. (Since, without it, the low capital strategy may be superior.) Thus the more highly-skilled workers will NOT be hired at a higher wage under the no-law scenario (and thus may not seek the jobs at all), but with the law they will be hired and will replace the low-skill employees.
    It is thus in some sense not surprising that large corporations right now are okay or supporting (as Wal-Mart is) of a minimum wage hike. Large corporations and franchisees are more likely to have access to the technology and capital investment mentioned above.

  13. T.R. Elliott

    DickF: I agree on your point about ineffiency. I believe that’s why they call it comparative advantage–it’s different than absolute advantage. Country A might be better at everything, but there still exists a comparative advantage for Country B in certain exportable activities.
    Part of the heartburn I’ve had when discussing issues like this with economists is their assumption that I simply don’t unstand comparative advantage. Then I’m told about Countries A and B, which produce X and Y.
    My points is that the world is more complex and I would like understand the downside of free trade, in a mercantilistic world (or not) as expressed in my comment above.
    Since the original post concerned minimum wage, I don’t want to detract. But I think minimum wages and trade might interact.

  14. T.R. Elliott

    DickF: I understand. Not feeling judged here.
    I just wanted to clarify that the key issue I’m considering is the following: what is the cost benefit analysis for free trade. The world in aggregate benefits from trade and comparative advantage. But there is also a question of allocation of these gains. And reallocation, whether in the form of education or training or unemployment welfare, is a redistribution that has efficiency and moral implications. And by moral, I mean in the positive and negative sense. Welfare has many negatives–though when considered as insurance, at a systemic level and a personal level, it is also a good.
    So I’m curious about the tradeoffs. In the past 20 years the US has exported production capabilities. I think increasing energy prices may put a crimp on economic growth in the coming years. The US will not as easily be able to grow out of these imbalances. So the imbalances will unwind or rebalance. Production capacity offshored will have to come back. Or we do with less.
    So then the question arises: are there any constraints on trade or the economic system overall that might minimize imbalances, similar to the way in which attempts are made to avoid short-term imbalances in currency and financial markets.
    I’m not saying one can. And even considering this raises a whole host of other issues. The more I read about Milton Friedman after his death, the more I wonder whether he was no better than a Keynesian, trying to control the business cycle through the money supply. Has the US overinvested in housing because of easy money? Or have we overinvested because of insufficient regulation on the housing loan market. Or is the level of investment in fact fine.
    Enough though. Big questions. And the data and analysis for these issues, including minimum wages, is no doubt ambiguous.

  15. menzie chinn

    T.R. Elliott: I recommend Douglas Irwin’s Free Trade under Fire, 2/e (Princeton, 2005). A more formal exposition can be found in Paul Krugman and Maurice Obstfeld’s International Economics 7/e (Addison-Wesley). If you really want to see why many of the counter-arguments to the theory of comparative advantage don’t make sense, then reading through the first 1/3 of the textbook will be well worth the investment.

  16. DickF

    T.R Elliott wrote:
    I think increasing energy prices may put a crimp on economic growth in the coming years. The US will not as easily be able to grow out of these imbalances. So the imbalances will unwind or rebalance. Production capacity offshored will have to come back. Or we do with less.

    T.R.,
    Interesting. It is possible that energy will become the scapegoat for the coming decline in world living standards but I take a different position, more in line with this thread. There are three major forces that will push the government to constant inflationary mode.
    1. Minimum wage – Politically the minimum wage is a winner. The states are now passing minimum wage laws and the congress passes minimum wage laws. The only way this can continue without creating serious economic problems is to follow Keynes formula of inflating away the effects of wage increases.
    2. Social Security – Once again inflation is the political solution to the coming Social Security problem (since it appears that Democrats will be successful in destroying personal savings accounts). Congress will raise payroll taxes, but they will consider it politically impossible to raise taxes sufficiently to cover the shortfall. Cutting benefits is also politically dangerous.
    3. Socialized medicine – This is coming and it will absorb all of the current shortfall of medicare. When socialized medicine hits it will already be over subscribed and the negative side of the Ponzi effect will already be in effect. Inflation will be necessary to curb costs.
    We will see a decline in the world standard of living and we will also see increases in the gap between the rich and poor as socialism shifts more and more resources to the government bureaucracy.
    But to accomplish all of this the governments of the world need floating currencies. They cannot create the necessary inflation on a gold standard, even a modified gold standard. If the currency/gold exchange rate was fixed and dollars were allowed to be exchanged for gold, the government would not be able to afford the necessary inflation.

  17. T.R. Elliott

    menzie chinn: I will look at those two references. And I appreciate your taking the time provide information on my somewhat off-topic comments. Thanks.

  18. Kurt L

    I don’t think any minimum wage increae will be effective as long as we have such high levels of illegal immigration. Entry level, unskilled American workers will have to compete with all the illegal workers who don’t get the benefit if the increased minimum wage. The most effective way to really increse the wages of low skilled workers is to eliminate illegal immigrants from the work force, leading to a shortage of entry level workers.

  19. DickF

    Kurt L,
    There is a lot of anecdotal evidence given of illegal immigrants working for low wages, but I think if you actually analyze it the illegal immigrants are working for about the same wages as everyone else in the same industry. This is especially true of illegals working below minimum wage.

  20. Keith

    I’ve seen a bit of this latest “don’t blindly apply the neoclassical model” as applied to the minimum wage, and it still strikes me that low-skill labor markets are a pretty lousy area to reject the supply-and-demand framework.
    Low-wage markets really do seem to follow the neoclassical model. The vast majority of empirical work finds disemployment effects of the minimum wage, and the small handful of studies that claim otherwise have appeared to suffer from methodological problems, that, when corrected, then yield predictions consistent the neoclassical model.
    In short, this “open-mindedness” on neoclassical models and their application to the minimum wage seems rather selective, and not entirely intellectually honest.
    If you wanted to apply some of these more interesting imperfectly competitive labor models to professional athletes or professors, then maybe you’d have something.
    But it really looks like the neoclassical model has yielded predictions consistent with reality when it comes to low-skill labor markets.
    Given all the other areas where one can profitably deviate from the neoclassical model, it looks to me like some economists are casting about for other models and calling for open-mindedness on this particular issue because they don’t like being disliked by people who insist on raising the minimum wage.
    In addition, I think there’s a bit of confirmation bias following self-interest among some economists (though I don’t think Menzie’s guilty of that). If you want a job in a Democratic administration, it helps you to please them by thinking of some alternate model that jusitifies raising the minimum wage. Since we still like to think of ourselves as swell unbiased scientists, then the incentive to suddenly consider all those other approaches makes one a lot more “open minded,” even in cases where the neoclassical model still works.
    In short, there’s ample opportunity to question the straight-up supply and demand model in many cases, but it looks to me like people’s preferred results are determining when they do the questioning, and that ain’t right.

  21. Ben

    Great job framing this debate. This blog does a great job taking an issue and, rather than just pushing one side or an argument, pausing to reflect on how the argument should be conducted. This is an extremely valuable thing to do, since it gets people to actually listen to each other. Kudos.

  22. Keith

    To put a finer point on things, I’ve seen a lot of energy expended by economists to apply monopsony models to low-skill labor markets, where those monopsony models don’t apply well. I’ve seen less effort on applying monopsony models to other input markets in order to defend other types of minimum prices.
    This, despite the fact that imperfect monopsony competition applies to a lot of input markets far better than it applies to low-skill labor markets. This disproportionate difference in effort sure seems to correlate highly with political preferences of some economists and thier peer group.
    Finding a way to justify minimum wages gets you liked by a lot more people than finding a way to justify minimum wholesale beef prices, even if the meatpacking industry is far more monopsonistic with respect to ranchers than the low-skill labor market is with respect to low-skill workers.

  23. menzie chinn

    KurtL: I would tend to agree with your conclusion in a partial equilibrium context. But the ceteris paribus assumption is probably ill advised in this case. See the Economist‘s survey article on the subject here:

    “To gauge the full effect of immigration on wages, therefore, you need to know how quickly capital adjusts and how far the newcomers are substitutes for local workers….If the capital stock is assumed to adjust, Mr Borjas reports, overall wages are unaffected and the loss of wages for high-school drop-outs is cut to below 5%.

    Gianmarco Ottaviano, of the University of Bologna, and Giovanni Peri, of the University of California, Davis, argue that Mr Borjas’s findings should be adjusted further. They think that, even within the same skill category, immigrants and natives need not be perfect substitutes, pointing out that the two groups tend to end up in different jobs. Mexicans are found in gardening, housework and construction, while low-skilled natives dominate other occupations, such as logging. Taking this into account, the authors claim that between 1980 and 2000 immigration pushed down the wages of American high-school drop-outs by at most 0.4%.”

    Keith: Well I haven’t advocated minimum prices/price ceilings everywhere, but I do see monopolistic competition and monopsonistic behavior in lots of places, and I think it makes sense to think about public policy in that context. And if I thought there was monopsony in, say, Palladium, I wouldn’t disagree with the view that some sort of offsetting distortion might be beneficial. Not that the case is made, but I would retain an open mind. Thanks — perhaps an idea for a later post.

  24. TedL

    Probably far too late to make a difference, but I can’t help but note something factually incorrect. DickF wrote:
    It is interesting to note that today many countries have minimum wages but almost all came about after the culture of inflation came into being, many actually after currencies were floated.
    Not really. For example, American states began adopting minimum wage laws in the 1900s and 1910s, the progressive period, in the context of a long history of product prices that were as often deflationary (if not more more often) than inflationary. The current U.S. federal minimum wage law (FLSA) was enacted in 1938, again in the context of deflation in product prices and wages. (There almost certainly would have been an earlier federal act, but for concerns about the limits of Congress’ power to adopt such a law under the Commerce Clause.)
    For background, see: http://www.agh-attorneys.com/4_west_coast_hotel_v_parrish.htm

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