Policy Debate: Does an increase in the minimum wage result in a higher unemployment rate?

The minimum wage does not prevent everyone from getting any job. But the minimum wage does make it more difficult for those who already have a hard time getting a job - the least skilled - to begin or continue a career. Passing a law that forces people to earn a minimum amount in order to work seems a cruel policy in an already cruel world?
~Donald R. Deere

Our findings suggest that the efficiency aspects of a modest rise in the minimum wage are overstated.... [W]e find no evidence for a large negative employment effect of higher minimum wages. Even in the earlier literature, however, the magnitude of the predicted employment losses from a much higher minimum wage would be small: the evidence at hand is relevant only for a moderate range of minimum wages, such as those that prevailed in the U.S. labor market during the past few decades. Within this range, however, there is little reason to believe that increases in the minimum wage will generate large employment losses.
~David Card and Alan B. Krueger, Myth and Measurement: The New Economics of the Minimum Wage, (Princeton: Princeton University Press, 1995, p. 393).

Minimum wage laws in the U.S. were first introduced during the 1930s in response to the Great Depression. This period was characterized by falling output, falling prices, and falling employment. The National Industrial Recovery Act (NIRA) of 1933 attempted to stop this downward spiral by encouraging the formation of trade association agreements that established price floors and minimum wages. This was the first national attempt to introduce minimum wages in major industries. Those firms that participated in the trade association agreements were able to display a "blue eagle" logo in their establishments. In 1935, the U.S. Supreme Court ruled that the NIRA was unconstitutional, and these initial minimum wage agreements were terminated.

In 1938, the Fair Labor Standards Act (FLSA) established a national minimum wage of $0.25 an hour. (This act also established restrictions on child labor and required that overtime pay be provided for hours of work in excess of 40 hours per week.) This Act initially only applied to a relatively small share of the labor force, but has been revised over time so that it now applies to approximately 90% of all nonsupervisory workers.

Introductory economics textbooks usually first introduce the minimum wage as an application of demand and supply analysis. This initial discussion is usually based on the following assumptions:

• the labor market is perfectly competitive,
  
• the minimum wage covers all workers, and
  
• worker productivity is unaffected by the wage rate.

Under these assumptions, the effect of the minimum wage is quite straightforward: the introduction of a minimum wage results in unemployment in those labor markets in which the equilibrium wage rate is below the minimum wage. This is illustrated in the diagram below:

In the labor market illustrated above, the equilibrium wage would be w* and the equilibrium level of employment would be L* in the absence of a minimum wage. When a minimum wage of w_min is introduced, however, the level of employment falls to L_D. Notice that the quantity of labor demanded exceeds the quantity of labor supplied at this minimum wage. A total of L_S - L_D unemployed workers will be created by the introduction of this minimum wage.

While minimum wage increases generally receive substantial public support, economists have generally relied on the above analysis to argue that such legislation will result in an increase in the unemployment rate in low-wage labor markets. In recent years, however, a series of studies by David Card, Alan B. Krueger, Lawrence F. Katz, and others have suggested that small to moderate increases in the minimum wage will have no adverse effects on unemployment (and may even lead to reduced unemployment). There are a number of theoretical models that can explain such results. Among these are:

• monopsony models, and
• efficiency wage models.

In a monopsony labor market, there is a single employer of workers. This employer faces an upward sloping labor supply curve. Because the cost of hiring an extra worker (the marginal factor cost) exceeds the wage rate, a monopsony firm will hire fewer workers than would be hired in a perfectly competitive labor market. This is illustrated in the diagram below.

As the diagram above indicates, a profit-maximizing monopsonist will hire an optimal quantity of labor at the point at which the firm's marginal revenue product (MRP = the additional revenue associated with the use of an additional unit of labor) equals the firm's marginal factor cost (MFC = the additional cost associated with the use of an additional unit of labor). In this case, the optimal level of employment occurs at L_m. When this firm hires L_m workers, the labor supply curve indicates that it must pay a wage equal to w_m.

If a minimum wage is introduced into this labor market, the labor supply curve effectively becomes horizontal at this wage up to the point at which the minimum wage intersects the supply curve. This is illustrated in the diagram below. The thicker red line represents the labor supply curve in the presence of a minimum wage equal to w_min. Because the wage is constant in this portion of the labor supply curve, the marginal factor cost is constant and equal to the minimum wage in this range. Once the labor supply curve starts rising again, the marginal factor cost once again is above the wage (in the diagram below, this occurs once the level of employment exceeds L_min).

If a minimum wage equal to w_min is introduced into this market, the optimal level of employment for the monopsony firm will occur at L_min (since MRP = MFC at this point). Thus, it is possible that the introduction of a minimum wage will result in both higher wages and a higher level of employment. If the minimum wage is set anywhere between w_m and w', employment will increase in a monopsony labor market. A minimum wage equal to w' will result in the same level of employment as in the monopsony outcome (although with a higher wage). Employment will fall if the minimum wage is set above w' in this labor market.

The efficiency wage model suggests that firms that pay workers a wage above the equilibrium wage will find that the higher pay results in more productive workers. The higher pay results in less labor force turnover, lower training costs, and better motivated workers. If the increase in labor productivity is sufficiently large, an increase in the minimum wage need not reduce employment.

Much of the controversy surrounds a study conducted by David Card and Alan Krueger. In this study, Card and Krueger conducted a phone survey of 410 fast-food restaurants on both sides of the border between Pennsylvania and New Jersey prior to and after an increase in the state minimum wage in New Jersey. They found that employment increased by more in New Jersey in response to the higher minimum wage in this state.

Because of concerns about the Card and Krueger data, the Employment Policies Institute examined payroll records for 71 fast-food restaurants and found significant discrepancies between the Card and Krueger data and payroll records for these firms. They found significantly different results when their revised data was used for estimation purposes. Critics of the EPI study argue that the selection process used to generate the Employment Policies Institute sample appears not to be random (all Pennsylvania observations are Burger King restaurants owned by a single franchise owner).

Those who believe that increases in the minimum wage will not adversely affect employment argue that, even if there are some problems with the data used by Card and Krueger in their study of fast-food restaurants in New Jersey and Pennsylvania, there is a growing empirical literature that provides quite similar results. Card and Krueger present an extensive collection of such studies in Myth and Measurement (1995).

An issue related to that of a minimum wage is a growing movement for a "living wage." Living wage proposals suggest that the existing minimum wage is too low to allow families to exceed the poverty level. Advocates of this view support "living wage ordinances" that require the local government to only accept contracts from firms (or, in some cities, provide assistance to firms) that pay their workers a wage that is high enough to place the worker above the poverty line. Baltimore was the first city to adopt such an ordinance in 1994. Under Baltimore's "living wage" requirement, firms must pay a worker an hourly wage that will allow a full-time worker to receive an annual income greater than or equal to the poverty level for a family of three.

One of the reasons why the minimum wage is so often the focus of political debate is that it is set at a specific nominal value and is not indexed to inflation. Thus, as inflation occurs, the real value of the minimum wage declines until Congress decides to pass new legislation. (The highest real value of the minimum wage was reached in 1968.) Because of this, it is likely that the debate over the effects of the minimum wage will continue to remain a significant source of political and economic debate.

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