A lot of economists just think it resembles a natural law of economics: minimum wages destroy jobs. If the price for labour is artificially fixed above its market level, demand will be lower and supply will be higher, the argument goes. That’s basic economics, stupid!
Well, it’s basic economic theory, at least. In real life, however, things are a little bit more complicated. The relationship between minimum wages and employment is not as clear cut as the basic “laws” of supply and demand suggest. Since the mid-90s a growing number of empirical studies question the detrimental employment effects of minimum wages. Those papers are not produced by some left wing nutters, but by researchers employed by leading universities like Berkeley, Princeton and the LSE. And they are published in word class peer reviewed academic journals.
The latest example recently came out in the “Review of Economics and Statistics”. It’s a study rather dully entitled “Minimum Wage Effects Across State Borders: Estimates Using Contiguous Counties” by Arindrajit Dube, William Lester and Michael Reich who are all affiliated with the Institute for Research on Labor and Employment of the Univesity of California, Berkeley.
The researchers analyzed the employment effects of minimum wages in the United States between 1990 and 2006. Their conclusion is rather straightforward: higher minimum wages did not destroy low paid jobs. “We find strong earnings effects and no employment effects of minimum wage increases”, the authors conclude.
Unfortunately the paper in itself is rather technical and is not easy to read. The results, however, are neatly summarized by the university in a press release however. And I think they deserve some more publicity. Leading labour economists regard the paper as a scientifc milestone. “This is one of the best and most convincing minimum wage papers in recent years”, the press release quotes Lawrence Katz, an economics professor at Harvard University.
Methodically the economists have broken new grounds in the minimum wage research. Hence they are able to settle long-standing contradictions of the existing minimum wage literature. The new paper gives more reliable answers about the costs and benefits of this kind of policy. “Compared to older papers the data set is much more detailed and the methodological design is much broader”, Joachim Moeller, director of the Institute for Employment Research in Nuremberg, Germany, told me.
The results support a number of papers which questioned the negativ employment effects of minimum wages. Most of these studies have been published since the mid-90s and are dealing with the US and the UK. The first one (“Minimum Wages and Employment”) came out in 1994 in the “American Economic Review”. David Card (Berkeley) und Alan Krueger (Princeton) conducted a detailed case study about the fast food industry of New Jersey und Pennsylvania.
In 1992 New Jersey had increased the minimum wage by almost 20 percent to $5.05. In Pennsylvania, however, the minimum wage remained unchanged at $4.25. What happened to low paid employment in both areas? The two economists made a mind blowing observation: Although unskilled labour became much more expensive in New Jersey, fast food restaurants did not sack workers. Actually, exactly the opposite happened: Restaurants in New Jersey hired more additional workers than their competitors in Pennsylvania. Some sceptical economists later challenged these results and questioned the quality of the data used by Card and Krueger. Finally, however, they were able to defuse these arguments. In 2007, Michael Reich conducted a similar case study in the San Francisco bay area. He did not observe employment gains, but there were no job losses either.
What’s the reason for this odd behaviour of the labour market? Most people I’m telling about the study intuitively (and wrongly) think that the employment gains are driven by demand effects. The low paid workers are getting more money, hence they are able to consume more and boost economic activity, their argument goes.
Again, however, things are a little bit more complicated. According to the economists the effect is driven by an entirely different force: market power of the employers. Imagine a fast food restaurant in a small city. Opening a second outlet might be profitable for the owner of the restaurant. However, he might have to pay higher wages for hiring the extra staff he needs in the second restaurant. Since he is not able to differentiate the wages between both restaurants, he would drive up his labour costs in the existing restaurant. This effect harms the profitability of the first restaurant less and might discourage the expansion of the business completely. However, if the government introduces a minimum wage, labour costs rise anyway and the second restaurant might become more attractive again.
A more formal and rigid version of this argument has been developed by the UK economist Alan Manning who teaches at the LSE. Due to frictions labour markets in the real world do not work as efficiently as economists use to assume in their models, Mannings monopsy theory goes. For one reason or another employers in the low paid segments of the labour markets are enjoying market power. They are able to push the wages of their staff below the equilibrium level of perfect competition.
How relevant is this point in real life? Regional case studies do have some weak spots. The results only hold for a certain geographical area and a relatively short period of time. Hence some economists prefer a different method for answering the question. They look at panel data for entire countries like the US and use cross-state variation in minimum wages. Compared to regional case studies those papers deal with the question from a bird-eye’s perspective. Usually they tend to support the arguments of opponents of minimum wages. The higher they are, the more severe are the negative employment consequences, those papers tend to find.
The Berkeley economists are the first who are able to reconcile the contradictions between both approaches. The researchers generalized and broadened the basic idea of the case study approach introduced by Card and Krueger. Dube, Lester and Reich use differences in the level of minimum wages between different US states. However, they did not restrict their analysis to a single region. They meticulously looked at regional labour markets all over the US.
The economists analyze the employment on the level of individual counties. They only compare counties which are directly adjacent to each other but which are located in different states where the minimum wages differ. The regional variation in minimum wages in the U.S. is quite significant. In the counties which are the basis for the paper the minimum wages differ by 7 to 20 percent.
The design of the study has several decisive advantages. Because the regions the economists are looking at are direct neighbours, they are very similar to each other with regard to other economic parameters. Apart from the differences in the level of the minimum wage local labour market conditions in neighbouring countries are more or less the same. Another strength of the paper is the long time horizon which is being analyzed. Former case studies usually dealt with a rather short period of time and were unable to detect potential long term consequences of minimum wages. However, Dube, Lester and Reich are using data from 1990 to 2006. This makes it possible to look at the long run impact as well.
First of all, the economists observe that higher minimum wages indeed increase the earnings of the workers who are eligible. This is an indication that employers were not able to circumvent the law. Although the labour costs rose, they did not sack workers afterwards. This is how this reads in the paper: “the local estimates of employment effects are indistinguishable from 0“.
The papers reveals why the studies using national panel data come to different conclusions: The reason for this is that local labour markets across the U.S. are extremely different. The existing studies dealing with the entire American labour market did not take care of this regional variation. Eventually, their authors compared apples and oranges.