The Economics of Minimum Wages – There has been a large shift in the weight of academic opinion

A generation ago, the vast majority of economists would have said that a rise in the minimum wage inevitably costs jobs. This has changed, with two strands of research having the biggest impact. In the United States, the work of David Card and Alan Krueger, then both at Princeton University, shattered the cosy consensus and argued that the actual evidence linking the minimum wage to job losses was weak. Although their findings were controversial (and the debates rumble on to the present day), there has been a large shift in the weight of academic opinion.

The other strand of research that has been very influential examined the UK experience, with CEP researchers playing a sizeable role, though not the only one. Some people predicted that the introduction of the National Minimum Wage in 1999 would cause hundreds of thousands of job losses, but this simply did not materialise. Any impact on employment seemed to be tiny and LPC research has reached similar conclusions for subsequent years when the minimum wage rose faster than average earnings. In spite of this accumulating empirical evidence, it is still common to find economists fall ing back on the argument that a minimum wage must cost jobs because demand curves for labour inevitably slope downwards. Faced with a conflict between the evidence and twentieth century economic models, they reject the evidence rather than the theory – not an ideal template for scientific endeavour. But there are, in fact, uncomplicated theoretical reasons why the minimum wage set at modest levels has little or no effect on employment.

First, the increase in total labour costs associated with a given increase in the legal minimum wage is often considerably smaller than the numbers suggest. As the minimum wage rises and work becomes more attractive, labour turnover rates and absenteeism tend to decline. Moreover, the cost associated with losing a job rises; so, arguably, workers are inclined to work a bit harder and need less monitoring. Of course, an employer could voluntarily choose to pay higher wages if net labour costs actually fell, so a reasonable guess here is that these offsetting economies reduce, but do not eliminate, the impact of a rise in wage rates.

Then there’s the gap between employer perception and reality. Individual employers often view a rise in wages with horror, assuming it will drive them out of business. But all too often, they are implicitly assuming that they alone will suffer the cost inflation when it affects their competitors as well. Prices rise a bit and the effect on employment is only through the effect of a fall in sales, which may well be minimal.

But there is a more fundamental reason why there is no evidence of the job losses predicted by standard economic theory. The key assumption – that labour markets are highly competitive – is often wrong. The view of the labour market that underlies ‘Economics 101’ is not one that many people would recognise. For in this hypothetical world, losing a job is no big deal because finding an identical job is no harder than discovering that the local Sainsbury’s is out of milk and going to Tesco instead.

But that is not most people’s experience of labour markets. The reality is that competition for workers is not as strong as many economists would have you believe. An employer who cuts wages will find that most employees are unhappy, but that few will just walk out of the door. So it may make economic sense for employers to pay workers less than the marginal worker adds to revenues. In this more realistic world, a rise in the minimum wage will not necessarily price the marginal worker out of their job.

Chosen excerpts by Job Market Monitor. Read the whole story at 

 British Politics and Policy at LSE – Minimum wages: the economics and the politics.

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