So Obama’s recent state address on the minimum wage has caused a lot of controversy with business and economics commentators. The president suggested that the minimum wage be increased from $7.25 to $9 an hour however as usual this has been met by the inevitable cries of fore coming unemployment and despair. Free market supporters have argued that such an increases could lead to large increases in low skilled worker unemployment. This argument however relies heavily on contested economic models such as the competitive labour model.
The model as shown above suggests that if a minimum wage (Wm) is set above the market clearing level (We) there will be an excess supply of labour over demand, more commonly known as unemployment. This is shown in the reduction of employment from Ne to Nm. In simpler terms this means that employers will face higher costs and will respond by either hiring less labor or making cutbacks. However such a model does not take into account market imperfections such as search costs, information costs and worker immobility which may lead to segmented and monopsonistic markets.
John Schmitt of the Center for Economic and Policy Research has argued that employers will not always respond to minimum wage hikes by reducing employment. His paper argues that employers may, among others, respond by cutting wages for higher paid workers, raising their prices or by becoming more efficient. For instance the efficiency wages theory argues that higher wages will promote greater worker productivity as the potential cost of shirking on the job increases.
So what does the empirical evidence say? It again is largely contested but as pointed out by the World Bank (2003, pp.11) “There seems to be an agreement that the overall employment effects of minimum wages – positive or negative – tend to be small”. For instance an OECD (1998) paper found across the richest nations that the minimum wage rises had an close to insignificant impact on young adults (aged 20-24) and no employment impact on prime age adults (25-54). However it must be noted that most studies are looking at moderate increases in minimum wage and teenagers are commonly found to be adversely effected by any increase.
If rises in the minimum wage do indeed have small negative or insignificant effects upon employment, a rise could be good for all. Firstly it could boost consumer demand by putting money into the pockets of the poorest members of society, in the case of America this amounts to 15 million people. Secondly it could reduce inequality which in turn promotes positive economic outcomes such as greater social cohesion. Thirdly it could promote labour force participation by making ‘work pay’; in effect encouraging those who are unemployed to actively search for work. This could reduce government expenditure as those on benefits find it more economically rewarding to move into work. Similarly those already in minimum wage jobs would become less dependent on government transfers.
Overall these effects could strengthen the economy and the recovery whilst simultaneous promoting greater equality within society. The conflicting empirical evidence shows that economic theory should not be accepted unquestionably and a stronger emphasis on such evidence is needed in policy decisions.