Yesterday the minimum wage rose to $7.25, thanks to a bill signed by President Bush in May of 2007. I figure now might be a good time to examine the minimum wage and its effects on employment. Forewarning: this is a very long post and is very economic oriented, so bear with me.

In my freshman year at SCSU, I took a course on the principles of microeconomics (with Dr. Komai, an excellent professor) where we learned about price floors including a minimum wage. I found the topic interesting, and so wrote about it in a research paper for my English course. In it, I argued for an increase in the minimum wage and indexing it to inflation. (Note this was in 2006, prior to President Bush signing the minimum wage increase bill.) This is back when I considered myself a Republican (!) and when most Republicans and other economic libertarians were arguing for an abolishment of the minimum wage under the assumption that a minimum wage causes higher unemployment. Many microeconomists and other economists would agree with that assessment (see, for example, this blog post by Gary Becker made around the same time as I wrote my paper). Now in an intermediate microeconomics course, I was again presented the classical economic argument that a price floor like the minimum wage will create a surplus (i.e. unemployment). Why do economists make this argument and does it make a minimum wage undesirable?

I find using graphs the easiest way to understand price floors. First of all, a price floor is when the government sets a minimum price for a product or good. This typically occurs when it is perceived that the normal (i.e. equilibrium) price is too low and that a higher price would be more favorable (such a regulation on the price is meant to be beneficial to the supplier of that good—but more on that later).

Without outside regulation, a price can be determined where the demand of a good intersects or is equal to the supply of that good. Graphically, this can be represented as:
As you can see, if the price went down, the quantity demanded would increase, but the quantity supplied would decrease (creating a shortage of goods). If the price increased, quantity demanded would decrease, but quantity sold would increase (creating a surplus). A surplus will put a downward pressure on price until the quantity demanded is equal to the quantity supplied. A shortage will put an upward pressure on price until quantity demanded is equal to quantity supplied.

If the government stepped in and made it illegal to sell or purchase a good (labor in this case) below a certain price, a surplus of that good will exist if that new price is above the equilibrium price. Graphically, this can be represented as:
If the minimum wage is set above the equilibrium wage, then there will be a surplus of labor (i.e. unemployment) because the quantity of labor supplied will be higher than the quantity of labor demanded. This is why most Republicans and many economists argue against the government instituting a minimum wage. It creates more unemployment than there would be without a minimum wage. The higher the minimum wage is above the equilibrium wage, the higher the unemployment is going to get.

That is the classical economic model of the minimum wage (also known as the “textbook model”). This explanation is short and deliberately not thorough for the purpose of space and time, but accurately represents the typical example of a price floor. In understanding economic theory, however, you should always realize that certain assumptions are being made. To gauge the reliability of that theory, you would do well to also gauge the assumptions on which the theory is being made. Sometimes you may find that, while the theory looks nice, the assumptions on which it depends can be seriously strenuous. In this case, the classical economic model makes a number of assumptions that also happen to influence how the slope of the demand curve looks (i.e. the elasticity of demand). (All elasticity means is how sensitive people are to changes as measured through percent changes. It can measure, for example, how responsive people are to changes in price. Mathematically, this can be represented as %ΔQuantity/%ΔPrice.)

If the slope of the demand curve (i.e. the wage elasticity of demand) is changed, you’re going to end up with different results. Namely, unemployment is higher the more elastic the demand. Conversely, if the demand is fairly inelastic, unemployment will not be as high. Graphically, this can be represented as:
In this example, the D1 curve is more elastic than the D2 curve. With the minimum wage set above the equilibrium wage, the quantity of labor demanded is less for the elastic demand curve (Qd1) versus the inelastic demand curve (Qd2). Therefore, the unemployment resulting from the minimum wage is smaller when demand for labor is inelastic. So we must therefore ask how elastic the demand for labor is. However, we should also realize that this model is still based on classical economic model where a number of assumptions are being made.

Gary Fields, a professor of labor economics at Cornell University, questions one of these assumptions in a 1994 article. He argues against the “one-sector model which implicitly assumes that the minimum wage applies uniformly to everyone.” Instead, he claims a two-sector model, including a covered and an uncovered sector, is more appropriate based on empirical evidence that suggests two sectors (i.e. covered and non-covered) exist nearly everywhere. Fields concludes that actual theoretical results are less clear-cut than assumed in the textbook model, which “simply cannot be relied on” because it is unrealistic. Fields also stresses the importance of empirical studies to measure the real effects of the minimum wage, because theoretical models do not suffice.

Other assumptions being made have also been challenged. For example, it’s likely the case that employers of labor have monopsonistic power—that is, where few buyers (or employers of labor) face a large amount of suppliers. Without going into detail, this would suggest a higher minimum wage would also increase employment (up to a certain point of course). Again, other assumptions can be challenged (and have been) and so it is important to not only rely on theoretical models but to also look at empirical data gathered from real-world situations.

One study I looked at was a 1994 paper by Richard Freeman, a respected labor economists at Harvard. He found that pre-1980 minimum wages had a “modest adverse effect on employment,” where a 10% increase in the minimum wage would increase joblessness by 1 to 2%, implying the minimum wage is an “effective redistributive tool.” During the 1980s when the minimum wage was held stagnant and the real value of minimum wage decreased, unemployment of low-skilled labor actually increased. In surveying three studies on employment after the early 1990s minimum wage increases, Freeman found that two reported insignificant unemployment effects and a third reported an increase in employment (suggesting employers were monopsonistic). Freeman goes on to cite other empirical studies that show moderately adverse or even positive effects on employment through minimum wage increases, again suggesting the minimum wage is an effective redistributive tool.

A highly influential paper on the effects of the minimum wage on employment was done David Card (UC Berkeley) and Alan Krueger (Princeton University) in 1992. In it, they found that employment went up after a minimum wage increase from $4.25 to $5.05 in New Jersey (while Pennsylvania’s stayed at $4.25). Classical economic theory would have suggested employment would decrease. Of course, Card and Kreuger’s work was heavily criticized, for example by George Mankiw, an influential Harvard economics professor, and Gary Becker (who I noted earlier in this post). Others, such as Joseph Stiglitz and Paul Krugman, both influential Nobel laureates, accepted Card and Kreuger’s findings. Surveys of economists have shown a decreasing amount of economists who believe the minimum wage result in significant negative employment effects, partly due to Card and Kreuger’s research (see, e.g., here). (Still, however, a majority agree a minimum wage does increase unemployment.)

Finally, in a 2004 paper by David Neumark (UC Irvine) and Olena Nizalova (MSU) find that in states with higher minimum wages, workers of ages 16 through 19 experience higher unemployment; in the 20 through 24 age range, however, the unemployment difference is smaller; and within the 25 through 29 age range, there is even higher employment in states with higher minimum wages. This suggests that young teenagers, ones most likely to live with their parents or be second income earners, take the brunt of any unemployment caused by the minimum wage. William Maloney and Jairo Mendez affirm in a 2004 paper, “[unemployment] effects [from the minimum wage] have traditionally appeared to be weak in the US, perhaps with the exception of young workers.” Those who are in most need of the minimum wage increase—those more likely to be older and have children—are the ones who seem to be the least affected by any unemployment effects the minimum wage has. The minimum wage, therefore, is a fairly well targeted policy that has the potential to help low-income families when it is raised. Indeed, Sara Lemos proclaims in a 2006 paper, “The minimum wage has a concrete potential to serve as a policy to alleviate inequality and poverty without undesirable side effects.”

Many Americans happen to agree. One reason why people tend to favor the minimum wage over other redistributive tools and transfer payments is because it creates an incentive to work. As Richard Freeman points out, a minimum wage requires no taxes or government borrowing. This is contrast to other policies such as earned income tax credits or subsidies for employers of low-skilled labor, which must come out of the government’s budget.

Critics, on the other hand, maintain the minimum wage causes prices to increase. Daniel Aaronson and Eric French, writing for a paper published by the EPI in 2006, explicitly find that prices rise about 0.4 to 1.5 percent with a ten percent minimum wage hike. This makes sense because a higher minimum wage imposes higher costs for firms who hire at the minimum wage. “Higher labor costs are pushed on to consumers in the form of higher prices,” they write. However, this reason alone should not be used to detract the minimum wage. In a 2003 paper, Sanjiv Sachdev finds that most people prefer to redistribute their income (e.g. through increased prices) in such way that rewards those who work, not to those who do not. The minimum wage acts like a redistributing tool for the poor, but unlike other means of doing so (e.g. welfare), it rewards those who work. We must therefore weigh the cost of higher prices to the rewards that the minimum wage brings.

Millions of people today work at the minimum wage, and many more are affected by the minimum wage by so-called “knock-on effects,” and whose collective bargaining is weak (Stephen Bazen, 2006). With researchers suggesting ambiguities in the classical theoretical model of the minimum wage and empirical studies showing only moderately adverse, insignificant, or even positive effects on employment, I think the minimum wage can be used as an effective policy for raising living standards of low-skilled workers. It effectively targets those who work and those most likely to be breadwinners of the household. With the new minimum wage hike passed by President Bush, I hope new studies can come out that can either confirm or deny these findings. Time will tell.