The Whole Truth about Minimum Wages

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.

7 Comments

Filed under Labour Market

7 Responses to The Whole Truth about Minimum Wages

  1. mifotiadis

    Interesting, important, true! Seems main-stream economics has received a late wake-up call with respect to minimum wages, and stood up to reject worn-out doctrines. Should also be an advice for the real economy to follow this simple rule and insight.

  2. Alfred Garloff

    Indeed, a very compelling study and a very intersting result: there are no employment effects and strong income effects of the minimum wages paid in the US. This is indeed challenging for economists (think of the letter the “Wissenschaftlicher Beirat am BMWi” wrote to Michael Glos ).
    A problem with the generalisation of the results remains: for WHICH minimum wages there is no employment effect. A question most economists would point to.

  3. Pingback: Quotes of the Week(s) « Seeing Beyond the Absurd

  4. Emperor Palpatine

    Many points could be contested in this entry but let me cut it short.

    First, researchers at the universities of Berkeley, Princeton and the LSE can have political motivations just the same as other researchers.

    Second, two simple, natural conclusions can be drawn from the study.

    - Employers prefer not to sack their existing employees when labour costs increase.

    - Small variations in the minimum wage have small effects on the economy.

    Frankly, those are the only conclusions an honest man could make. One cannot conclude from the study that basic economics have been proven wrong.

    Even though the study itself may be honest and genuine, to draw the conclusion that the minimum wage doesn’t affect the employment market would be dishonest and disingenuous. Otherwise, why don’t you go ahead and call for a minimum wage that is ten times higher? After all, an increase in minimum wage wouldn’t have any effect, right?

    When minimum wages increase an employer naturally prefers not to let it affect its workforce. Sacking people is costly and dangerous for employee morale. However, employers adjust their expansion plans and naturally decide not to hire as much in the future. So you may not see any job cuts, but you will not see a high level of job creation either.

    The real question about minimum wages isn’t ‘what would be the effect if we increased it by 20%’. It’s ‘how much better could we be without minimum wages?’. The study ought to compare a situation with minimum wages to one without.

    Show me a country with high minimum wages and other government burdens on employers, and I’ll show you a sluggish, unemployment-ridden economy. Examples: too many to mention.

    Show me a country without minimum wage and little government burden on companies, and I’ll show you a vibrant economy that functions without unemployment. Examples: Switzerland expects an unemployment rate of less than 3% in 2012. Singapore has an unemployment rate of around 2%.

    • “Show me a country with high minimum wages and other government burdens on employers, and I’ll show you a sluggish, unemployment-ridden economy. Examples: too many to mention.”

      How does Australia do it?

      There are also plenty of countries with no minimum wages that are sluggish and unemployment ridden.

      • huscfmfa

        http://acoss.org.au/images/uploads/paper_131_hidden_unemployment.pdf

        “Hidden Unemployment in Australia”

        “In this paper we propose a method of quantifying hidden unemployment that captures the majority of people who have maintained what the ABS calls a ‘marginal attachment’ to the labour force (referred to as excluded jobless people), and people who are working for less than sixteen hours per week and would prefer to work more hours (referred to as severely underemployed people). [...] By counting together the number of unemployed people (as measured by monthly ABS statistics), plus the number of hidden unemployed people, we are able to measure the overall extent of job deprivation in Australia. [...]

        Using this [method], the unemployment plus rate for September 2002 was found to be 12.9 per cent – just over double the official unemployment rate.”

  5. daveinoz

    i live in the state of West Australia where there is currently a labour shortage. the minimum wage is approx $15 and, if the person is not a full time, permanent employee (20 days holiday,10 days sick pay, etc) the min wage is just under $20.
    it’s possible that one of the reasons why any ‘hidden unemployed’ in the rest of Australia are not coming to WA to fill these roles (and approx 1000 Australian/New Zealand^ people a week are) is the cost of relocation/housing. the weekly rent starts at $300, and a typical 12 month tenancy requires the ‘rent in advance’ (4 weeks) and ‘damage bond’ ($1000). A lot of money for someone that has endured a period of lower than normal income. .
    What i think we need to ask is: in an uncapped rental market that also has a 10% “restriction” on Y/Y % rental increases (Australia) , how much of any increase in the min wage (typically +2.5% PA) is absorbed by increases in rent at the ‘bottom’ end of the housing rental market? taking from the economically productive and handing it to those living on rentier income, doesn’t strike me as being a recipe for any ‘growth’ in GDP whatsoever. Further, as rents increase, so does the pressure for a higher min wage.increase each year.
    I’m someone with no training in economics so please forgive me if the comment is clumsy. Any feedback welcome. thanks

    ^NZ citizens have the right to live and work without restriction in Australia, and vice versa.