The Impact of an Increase in the Minimum Wage

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A Brief History of the Minimum Wage

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In the United States, the minimum wage was first introduced in 1938 via the Fair Labor Standards Act. This original minimum wage was set at 25 cents per hour, or about $4 per hour when adjusted for inflation. Today's federal minimum wage is higher than this both in nominal and real terms and is currently set at $7.25.  The minimum wage has experienced 22 separate increases, and the most recent increase was enacted by President Obama in 2009.  In addition to the minimum wage that is set at the federal level, states are free to set their own minimum wages, which are binding if they are higher than the federal minimum wage.

Most recently, the state of California has decided to phase in a minimum wage that will reach $15 by 2022. This is not only a significant increase to the federal minimum wage, it is also substantially higher than California's current minimum wage of $10 per hour, which is already one of the highest in the nation. (Massachusetts also has a minimum wage of $10 per hour and Washington D.C. has a minimum wage of $10.50 per hour.)    

So what impact will this have on employment and, more importantly, the well-being of workers in California?  Many economists are quick to point out that they're not sure since a minimum-wage increase of this magnitude is pretty much unprecedented. That said, the tools of economics can help outline the relevant factors that affect the impact of the policy.

02
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Minimum Wages in Competitive Labor Markets

In competitive markets, many small employers and employees come together to arrive at an equilibrium wage and quantity of labor employed.  In such markets, both employers and employees take the wage as given (since they are too small for their actions to substantially impact the market wage) and decide how much labor they demand (in the case of employers) or supply (in the case of employees).  In a free market for labor, and equilibrium wage will result where the quantity of labor supplied is equal to the quantity of labor demanded.

In such markets, a minimum wage that is about the equilibrium wage that would otherwise result will reduce the quantity of labor demanded by firms, increase the quantity of labor supplied by workers, and cause reductions in employment (i.e. increased unemployment).  

03
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Elasticity and Unemployment

Even in this basic model, it becomes clear that how much unemployment an increase in the minimum wage will create depends on the elasticity of labor demand- in other words, how sensitive the quantity of labor that companies want to employ is to the prevailing wage.  If firms' demand for labor is inelastic, an increase in the minimum wage will result in a relatively small reduction in employment.  If firms' demand for labor is elastic, an increase in the minimum wage will result in a relatively small reduction in employment.  In addition, unemployment is higher when the supply of labor is more elastic and unemployment is lower when the supply of labor is more inelastic.

A natural follow-on question is what determines the elasticity of labor demand?  If firms are selling their output in competitive markets, labor demand is largely determined by the marginal product of labor.  Specifically, the labor demand curve will be steep (i.e. more inelastic) if the marginal product of labor drops off quickly as more workers are added, the demand curve will be flatter (i.e. more elastic) when the marginal product of labor drops off more slowly as more workers are added.  If the market for a firm's output is not competitive, the demand for labor is determined not only by the marginal product of labor but by how much the firm has to reduce its price in order to sell more output.

04
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Wages and Equilibrium in Output Markets

Another way of examining the impact of a minimum wage increase on employment is to consider how the higher wage changes the equilibrium price and quantity in markets for the output that the minimum wage workers are creating.  Because input prices are a determinant of supply, and the wage is just the price of the labor input to production, an increase in the minimum wage will shift the supply curve up by the amount of the wage increase in those markets where workers are affected by the minimum wage increase.

05
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Wages and Equilibrium in Output Markets

Such a shift in the supply curve will lead to a movement along the demand curve for the firm's output until a new equilibrium is reached.  Therefore, the amount that quantity in a market decreases as a result of a minimum wage increase depends on the price elasticity of demand for the firm's output.  In addition, how much of the cost increase the firm can pass on to the consumer is determined by price elasticity of demand.  Specifically, quantity decreases will be small and most of the cost increase can be passed onto the consumer if demand is inelastic.  Conversely, quantity decreases will be large and most of the cost increase will be absorbed by producers if demand is elastic.

What this means for employment is that employment decreases will be smaller when demand is inelastic and employment decreases will be larger when demand is elastic.  This implies that increases in the minimum wage will affect different markets differently, both because of the elasticity of the demand for labor directly and also because of the elasticity of demand for the firm's output.

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Wages and Equilibrium in Output Markets in the Long Run

In the long run, in contrast, all of the increase in the cost of production that results from a minimum wage increase is passed through to consumers in the form of higher prices.  This doesn't mean, however, that elasticity of demand is irrelevant in the long run since it is still the case that more inelastic demand will result in a smaller reduction in equilibrium quantity, and, all else being equal, a smaller reduction in employment.

07
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Minimum Wages and Imperfect Competition in Labor Markets

In some labor markets, there are only a few large employers but many individual workers.  In such cases, employers may be able to keep wages lower than they would be in competitive markets (where wages equal the value of the marginal product of labor).  If this is the case, an increase in the minimum wage might have a neutral or positive impact on employment!  How can this be the case?  The detailed explanation is fairly technical, but the general idea is that, in imperfectly competitive markets, firms don't want to increase wages in order to attract new workers because then it would have to increase wages for everyone.  A minimum wage that is higher than the wage that these employers would set on their own takes away this tradeoff to some degree and, as a result, can make firms find it profitable to hire more workers.

A highly-cited paper by David Card and Alan Kruger illustrates this phenomenon. In this study, Card and Kruger analyze a scenario where the state of New Jersey raised its minimum wage at a time when Pennsylvania, a neighboring and, in some parts, economically similar, state did not. What they find is that, rather than decrease employment, fast-food restaurants actually increased employment by 13 percent!  

08
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Relative Wages and a Minimum Wage Increase

Most discussions of the impact of a minimum-wage increase focus specifically on those workers for whom the minimum wage is binding- i.e. those workers for whom the free-market equilibrium wage is below the proposed minimum wage.  In a way, this makes sense, since these are the workers most directly affected by a change in the minimum wage.  It's also important to keep in mind, however, that a minimum-wage increase could have a ripple effect for a larger group of workers. Why is this? Simply put, workers tend to respond negatively when they go from making above the minimum wage to making minimum wage, even if their actual wages haven't changed.  Similarly, people tend to not like it when they make closer to the minimum wage than they used to.   If this is the case, firms may feel the need to increase wages even for workers for whom the minimum wage isn't binding in order to maintain morale and retain talent.  This isn't a problem for workers in itself, of course- in fact, it's good for workers!  Unfortunately, it could be the case that firms choose to increase wages and reduce employment in order to maintain profitability without (theoretically at least) decreasing the morale of the remaining employees.  In this way, therefore, there is a possibility that a minimum wage increase could reduce employment for workers for whom the minimum wage is not directly binding.

09
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Understanding the Impact of a Minimum Wage Increase

In summary, the following factors should be considered when analyzing the potential impact of a minimum wage increase:

  • The elasticity of demand for labor in relevant markets
  • The elasticity of demand for output in relevant markets
  • The nature of competition and degree of market power in labor markets
  • The degree to which changes in the minimum wage would lead to secondary wage effects

It's also important to keep in mind that the fact that minimum wage increase can lead to reduced employment doesn't necessarily mean that an increase in the minimum wage is a bad idea from a policy perspective.  Instead, it just means that there is a tradeoff between the gains to those whose incomes increase because of the increase in the minimum wage and the losses to those who lose their jobs (either directly or indirectly) due to the increase in the minimum wage.  An increase in the minimum wage might even ease tension on government budgets if the workers' increased incomes phases out more government transfers (e.g. welfare) than displaced workers cost in unemployment payments.

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Beggs, Jodi. "The Impact of an Increase in the Minimum Wage." ThoughtCo, Mar. 28, 2017, thoughtco.com/increased-minimum-wage-impact-4019618. Beggs, Jodi. (2017, March 28). The Impact of an Increase in the Minimum Wage. Retrieved from https://www.thoughtco.com/increased-minimum-wage-impact-4019618 Beggs, Jodi. "The Impact of an Increase in the Minimum Wage." ThoughtCo. https://www.thoughtco.com/increased-minimum-wage-impact-4019618 (accessed April 23, 2018).