Economic consequences of a minimum wage
Warning: This post is very lengthy.
The minimum wage is a politically charged issue even among economists. Economist David Card (of the contentious 1994 study on minimum wage), for example is on the record for remarking that his writings have cost him friends and frayed good relationships:
I’ve subsequently stayed away from the minimum wage literature for a number of reasons. First, it cost me a lot of friends. People that I had known for many years, for instance, some of the ones I met at my first job at the University of Chicago, became very angry or disappointed. They thought that in publishing our work we were being traitors to the cause of economics as a whole.
Secondly, and more importantly, the minimum wage is an issue which is far more complicated than it first appears under cursory examination in Econs 101. It is for this reason I have avoided writing anything on the minimum wage until I have been satisfied that I know enough to be sufficiently confident of my opinion. Unfortunately, I have not met that requirement even till now, at least not to my liking. Therefore in the following post, I would not be suggesting any specific policy recommendations.
Despite that, there are a couple of points I would like to make. Before you read any further, please note that I’m writing with respect to Singapore, not America or some other Western nation. At the same time, I cannot help but draw on the literature, most of which is based in the States and/or other Western countries because of the paucity of research material available on possible effects of raising minimum wages in export-oriented countries in Asia (like Singapore). In any case, even if such studies have been conducted, it appears unlikely they would be written in English. Such an approach therefore, has its limits, but I believe it’s a reasonable one given the constraints.
Opponents of instituting a minimum wage in Singapore usually invoke the argument that having a minimum wage eats into firms’ profitability, forcing to either cut back on employment (therefore raising unemployment of lower-skilled workers) or raise prices so as to preserve their existing profit margins. Apart from that, they argue, a minimum wage would increase the purchasing power of the lower income groups and this may result in an inflationary wage-price spiral, especially since lower income groups tend to spend a larger percentage of their income.
These claims will be examined in greater detail below, in two sections.
Argument 1: A minimum wage increases unemployment
Firstly, despite what many think, it is far from obvious that having a minimum wage would raise unemployment. The standard argument (from econs 101) as to why it raises unemployment goes as follows:
To be meaningful, a minimum wage has to be set higher than the current equilibrium market rate. This leads to an artificial price floor for wages, for which a greater supply of labour exists than is currently demanded by firms operating under the assumption of perfect competition in the labour markets ie. more people are willing to work since the minimum wage exceeds the reservation wage (the lowest wage a person is willing to accept for a given job) of more people. This excess labour is also known as unemployment. See left picture (credits to Wikipedia)
Now this simplistic picture has been criticised on many grounds. Criticism centres on whether perfect competition is an accurate model for the labour markets (as opposed to monopsony, where there is essentially a single buyer or employer or more accurately whether the firm has some power in determining wages for its employees), whether one may simply adopt the demand-supply model of consumer goods and apply it directly to labour etc. This blog post does an excellent job of summarizing a number of problems with the classical picture.
Now the question is, how does the picture change when one assumes the monopsonistic, or more accurately “monopsonistic competition” framework? To begin, the concept of monopsonistic competition assumes that in the market, there are many buyers but these buyers have a certain level of control over the market, perhaps in their local niches. This is similar to the concept of monopolistic competition, where there are many firms but unlike in perfect competition, the firms have means to distinguish their products from each other (for eg. through advertising) and hence have more leeway in raising and lowering prices without a massive change in demand for their goods.
In this case, the market refers to the labour market instead of the goods market. Buyers are employers, since they seek to purchase (ie. pay wages) labour from potential employees. Suppliers or sellers are essentially employees who seek to sell (by sending out CVs and resumes to potential employers) their services (ie. skills) in return for wages. It turns out that once we accept this fundamental framework, we witness a drastic change in the consequences predicted by the model.
Wikipedia does a good job of explaining why in a monopsonistic framework, a minimum wage actually increases employment rather than decreasing it. The following would be my attempt to summarize why under monopsonistic assumptions, a minimum wage lowers unemployment instead of increasing it.
In a monopsonistic labour market the employer has two distinct cost curves, marginal cost (MC) of labour and marginal revenue of product (MRP) or the amount of productive labour the next employee may contribute to the firm’s revenue.
In the diagram below, the vertical w axis denotes the workers’ wages, while the horizontal L axis denotes the number of employees hired. S represents the supply curve for labour. It is upwards sloping because more employees are willing to work when wages are higher. MRP is downwards sloping because of the law of diminishing returns.
As may be expected in introductory microeconomics, the firm seeks to maximise profits by employing enough labour till a point where the marginal cost of employing an additional worker equal the marginal revenue product (ie. the famous MC=MR). This coincides at L, which means that to maximise profits, the employer will hire L number of employees, and they are all paid a wage w (not to be confused with axis label w as well).
The figure shows that the MC of hiring an additional worker is higher than that cost of labour supply S. This is because it is assumed that to hire an additional worker, the employer has to increase wages offered to potential job-seekers. But since the employer does not have the ability to practice wage discrimination (akin to the concept of price discrimination for a monopoly) in this model, the employer has to pay all existing workers the same increased wage he is offering to the potential employee. The employer’s MRP may be interpreted as his demand curve for labour. As expected, the employer is willing to employ more workers when wages decrease hence the downward slope.
As a result, one can see that there is a deadweight loss associated with the current labour employment at L. This deadweight loss is the consequence of the economic benefit of employment forgone by employees who would willingly work for wages between higher than w, but less than w’.
To take an example, supposing a perfect competition framework where workers are hired at a constant wage of $1000 monthly. In the case of monopsonistic competition, because MC is not the same as the supply curve for labour, the employer pays a lower rate of $800 where MC=MRP. The economic benefit lost in such a scenario refers is shouldered by potential (unemployed) employees who are willing to work for a wage higher than $800 but less than $1000 ie. who would be employed under Pareto efficient conditions.
In such a scenario, how does government regulation help? By mandating a minimum wage at w”, the government coerces the employers to pay a higher wage rate than he would pay under unregulated conditions. Because the employer cannot pay a wage rate lower than the legally mandated w”, the wage floor (min. wage) effectively becomes the new MC curve (MC’). This higher wage rate at w” incentivises more employees to offer their services, hence creating unemployment since at wage level w”; at point B there are more employees willing to offer their labour than the employer(s) require. However, unlike the previous case, more workers are hired overall; L” employees are hired compared to the lower L figure previously. In other words, the “new unemployment” is now due to the influx of more job applicants, rather than the net retrenchment of existing ones. Because more employees now offer their services for this wage level w”, the firm is then able to employ all the people it needs due to the excess job applicants without having to raise wages even more, so the new MC’ curve is essentially flat.
As the Wikipedia article notes, in theory the government could achieve Pareto optimality if it were able to set a minimum wage which coincides exactly at w’ in the picture above as achieved under perfect competition. However, doing so may prove impossible because of numerous practical considerations such as employer heterogeneity, lack of economic and political precision in fine-tuning etc. Despite the failure to do so, one should note that overall employment still increases upon imposition of a minimum wage, despite the fact that the picture indicates that there is still unemployment due to the increased number of employees willing to work for that wage level.
Effectively, unemployment has decreased but not totally. Government intervention in this case may be likened to state involvement in alleviating worker exploitation.
This is completely contrary to the conclusion of the classical picture in the first diagram above under perfectly competitive conditions.
Justification and empirical evidence
At this point the reader may wonder, despite the theoretical evidence provided above, if there is any reason to believe that labour markets are more monopsonistic rather than perfectly competitive. Intuitively this assumption becomes easier to believe in when one considers the fact that employees look for jobs and offer their services much the same way firms advertise their product to consumers. In the Singaporean context, where workers are afraid to stay away from work despite being ill, this assumption appears to be even more reasonable. The classic model also unrealistically assumes that firms have little say in setting wages since a wage cut would entail mass resignations as workers flock to the next available firm offering higher wages.
For Singapore, one thing should be clear at the outset: If implemented (not that it ever will be), the minimum wage must not disproportionately hurt employment of locals relative to foreign workers. For this, an accompanying motion to raise the foreign worker levy to a comparable level should be undertaken, otherwise employers will begin retrenching local workers en masse in favour of employing cheaper foreign labour.
On a side note: Tan Kin Lian is an advocate of minimum wage legislation in Singapore.
Numerous papers and at least one book have been written on monopsonistic competition being a better model for the labour market as opposed to the classical one. Here’s an incomplete listing: Bhaskar, Manning & To 2004, Krueger 2001, Fiorillo, Santacroce & Staffolani 1998, Addison, Blackburn & Cotti 2008. A November 2008 paper by Marios Michaelides provides empirical evidence of how worker immobility may contribute to monopsonistic power of firms to set wages lower than the marginal product of labour; ie. evidence of monopsonistic power. For opinion on the Web in favour of the monopsonistic argument, see here, here and here. See here for dissenting viewpoints.
Although literature on the topic is relatively scarce with respect to Singapore, I came across a paper titled Growth accounting for a technology follower in a world of ideas: The case of Singapore by two Singaporean professors published in Dec 2008, a study on the sources of GDP growth in Singapore from 1970-2004, where they endorse the idea that employers enjoy a certain degree of monopsony in Singapore:
Kee (2004) obtained a value of a = 0.3749 compared to Young’s (1992) a = 0.53 by taking into account imperfect competition in the product market but retained the assumption of perfect competition in the factor market. However, the existence of monopsony power in the labor market is another theoretical reason why a could be overestimated. Acemoglu and Pischke (1998) argue that the prevalence of general worker training paid for by ﬁrms in Germany is evidence of monopsony power in the labor market. In Singapore, the National Trades Union Congress, which is made up of 63 trade unions with a membership of half a million workers making up about 20% of the employed workforce, is actively involved in the general training and upgrading of the workforce. The government of Singapore, as a major employer, is equally supportive of general training.Moreover, there is a Skills Development Fund generated from the mandatory contributions of employers that ﬁnances workers’ general training. The prevalence of employer-funded general training in Singapore is indicative of a certain degree of monopsony power in the labor market, which would indicate that the true a is probably even lower than Kee’s estimate of 0f 0.3749.
Given the above, it’s isn’t entirely unreasonable to believe that a minimum wage might have zero or even positive effects on employment in Singapore.
Despite the arguments above for monopsonistic labour markets, some research studies have found that raising minimum wages do in fact increase unemployment. Here’s one for example. A recent news report also lends weight to the notion of increasing unemployment. Factoring all of these into account I think it’s only reasonable to conclude that the jury is still out on this one, but one thing we can be sure of is that it’s no longer automatically obvious that increasing the minimum wage would definitely hurt employment.
Argument 2: Minimum wage causes inflation
This is an argument which opponents of the minimum wage often cite. The reasoning behind this appears simple; when hit with a minimum wage hike firms, seeking to protect their profit margin, invariably raise prices. But such a consideration does not take into account that a price hike may drive down demand for its goods; rival companies who do not raise their prices in response would witness an increased demand for their goods as substitutes.
The argument above is sometimes offered in conjunction with another which says prices would increase, but not because firms raise them to preserve profits, but because the increased spending power of minimum wage workers would drive up demand for (necessary) goods and thereby increase prices. However, it may be observed that firms which raise prices may be missing out the most of this increased demand for goods.
The latter argument also has arguably limited persuasive power in small countries like Singapore, where retail prices (of imported goods) are largely determined by import prices which are external factors. Hence with such in mind, the possibility of a wage-price spiral due to a minimum wage is greatly diminished. In fact it may be argued that government taxation policies such as GST have a much more direct impact on prices, since the final cost of the goods is borne entirely by consumers. Instead of worrying if minimum wage legislation would cause inflation, opponents should be largely concerned with the negative impact of GST on consumer prices.
Secondly, it is also often argued that it makes no sense to raise consumption in Singapore because Singapore imports most of its goods and increased domestic consumption may simply mean that the extra money spent effectively leaks out of the economy and dampens the Keynesian multiplier effect on the domestic economy. See here for an example of this argument. But this argument effectively weakens the previous argument of a wage/price spiral effect. This effect is due to firms raising prices in response to rising wages which eats into profits, which in turn exert an upward pressure on wages.
Opponents of minimum wage cannot simultaneously claim that most consumer spending leaks out of the economy, rendering consumption-boosting policies ineffective whilst also asserting that a minimum wage would ignite a wage-price spiral.
The additional fact that Singapore is a hugely export-oriented country mean that the spiraling effect becomes more limited than it would otherwise be, since rising wages would force firms to raise prices overseas rather than in domestic markets. Raising export prices overseas on the other hand, makes exports less competitive and the firm may choose not to do so and simply accept a diminished profit margin.
Justification and empirical evidence
Let us now review the empirical evidence: A 2000 paper by Chinkook Lee, Gerald Schluter and Brian O’ Roark found that a rise of US$0.50 would raise prices by 1% or less. Echoing a similar conclusion, a more recent 2005 paper by Draca, Machin, and Reenen found the following:
For our producer price analysis we examine the relationship between price changes and the proportion of sub-minimum wage workers across 240 industries. While our price effect estimate is positive (0.034 or a 3.4% increase for the most affected industry) it is not statistically significant.
Our analysis of retail prices in 3 catering industries (canteens, restaurants and takeaways) does not indicate that prices in these industries were differentially affected according to their exposure to the minimum wage. Surprisingly, the only evidence of any price effect is found in the canteen industry where prices rose by a modest 1% in April 1999.
A 2004 minimum wage literature review by Sara Lemos drew the following conclusion:
Despite the different methodologies, data periods and data sources, most studies found that a 10% US minimum wage increase raises food prices by no more than 4% and overall prices by no more than 0.4%. This is a small effect. Brown (1999, p. 2150) in his survey remarks, “the limited price data suggest that, if anything, prices rise after a minimum wage increase”.
On the dissenting side, Aaronson, French and MacDonald argue in a 2005 paper that prices increase when minimum wages rise:
We offer new empirical evidence using output prices both at the store-level and aggregated to the city-level. In both cases, prices unambiguously increase in response to a minimum wage change.
In addition, Neumark, Schweitzer and Wascher also concluded earned income declined for low-wage workers after an imposition of a minimum wage in a 1999 paper:
The evidence indicates that workers who initially earn near the minimum wage are most adversely affected by minimum wage increases; higher-wage workers, in contrast, are little affected. Although wages of low-wage workers increase, their hours and employment decline, and the combined effect of these changes is a decline in earned income.
Neumark also wrote an article summarizing the negative economic effects of a minimum wage here.
What can we conclude from the above? The effects of a minimum wage are far from obvious, and the standard elementary textbook treatment does not do sufficient justice, especially in the case of Singapore where employers enjoy more monopsonistic power over their employees as compared to the US, where workers generally have more rights.
The evidence from the literature on the effects of minimum wage on prices is mixed at best, and most of them are drawn from studies conducted in countries where domestic consumption consists of a much larger share of GDP than Singapore’s paltry 40%. It may require further study in a unique small country such as Singapore to better understand the effects of a minimum wage on the labour markets and prices.
It was recently reported that Hong Kong would be considering minimum wage legislation to be passed by 2011. It would be interesting to study the impact of the minimum wage on its economy and workers, especially since Hong Kong is very much economically similar to Singapore.
Apart from the above there are some arguments I would like to address as well as some points I would like to make.
1. The minimum wage need not be universal ie. enforced with no regards to corporations and companies’ competitiveness.
This at first may appear to undermine proposals for a minimum wage. After all, what good use is minimum wage legislation if a large segment of employers are not legally required to enforce them?
Like many things, it may require fine-tuning. The argument that enforcing a minimum would drive up labour costs and make Singapore a less attractive place for MNCs should give us some pause. It is one thing to legislate a minimum wage for low wage jobs such as cleaners, service workers, where the corporations involved do not have to worry about not being able to compete on the international scene for export prices. For others, it may be a different story.
Despite this, again it’s not automatically true that implementing a minimum wage would increase the chances it would go out of business. Economist Mark Thoma noted a May 2008 paper which concludes that while a minimum wage eats into profit margins and raises wages, the probability that it would be driven out of business has not changed in any statistically significant manner.
Apart from this there’s also the question as to whether the minimum wage should be mandated on school teenagers looking to earn some quick money during school summer vacations and other temporary workers. At the same time, we cannot allow firms to exploit this loophole by indefinitely re-hiring temporary staff as a way of getting around minimum wage legislation.
2. Other means to help low-wage workers obtain a larger living monthly disposable income should be considered.
At present, workers earning between a paltry $50 and $500 a month still have to contribute 14.5% of their monthly to CPF. Those earning $500-$750 have to contribute 14.5% and 48% of the difference between their monthly wages and $500.
Those earning between $750 and $1200 contribute 14.5% plus $120 plus (I’m reminded of Orwell’s 1984 notion of double-plus-good here for some reason) 24% of the difference between their wages and $750.
The official data in tabulated form may be found here.
Easing the CPF contribution rates, for example by allowing these low income individuals to decide how much to contribute would aid them even in the absence of a minimum wage. Personally I would favour if CPF were to allow individuals to exercise some degree of autonomy over contribution rates regardless of how much they earn, but that’s another story for another time.
In addition, Ng E-Jay argues that business costs due to rent has been driven up artificially due to speculators and tax evaders stashing their funds.
3. The minimum wage may be a boost to the economy in times of recession such as the present.
No really I’m not kidding or making stuff up. Reuters reported this back in late May. The reason? The Keynesian spending multiplier effect.
This has got to be one of the longest posts I’ve ever written to date. As it current stands the word count is about 3.8k, and of course this includes quoted text. If you’ve read most of the above, I’ll like to thank you for taking time to do so. I expended a lot of effort in researching the literature and Web for arguments and evidence, and this post was actually written over the course of a few days so don’t think it’s the result of a few hours work because it’s not. In the course of researching, I’ve learnt much about labour economics which I was admittedly hitherto quite ignorant of .
As I’ve said above at the start, I don’t believe I am learned enough to draw any conclusions or argue for any particular recommendations regarding minimum wage legislation since the original focus of the post was to address and rebutt some widely-held misperceptions of the minimum wage and its effect on the economy and welfare. I hope that readers who have perused the above have learned something new at least. Thank you again for your attention.
Here are some links and papers I consulted for the above post.
Minimum wage: Proceed with caution Perspectives on the minimum wage in Singapore