Minimum Wages and Employment - Theory and Empirical Evidence with a special emphasis on Germany

Content

List of Figures

1. Introduction

2. The Theory of Minimum Wages
2.1. The Basic Competitive Labor Market Minimum Wage Model
2.2. The Model with Endogenous Effort
2.3. An Efficiency Wage Model
2.4. A Two- Sector Model
2.5. A Two- Sector Model with Searching for Covered- Sector Jobs
2.6. The monopsony Model
2.7. The Oligopsony Model
2.8. “Shock” Effects
2.9. Heterogeneous Workers
2.10. Lagged or Leaded Adjustment

3. The Empirical Evidence on Minimum Wages
3.1. A Short History of Empirical Research on Minimum Wages
3.2. The Minimum Wage Debate: Card, Krueger, Katz versus Neumark and Wascher
A. The Paper by David Card (1992a)
B. The Paper by Katz and Krueger (1992)
C. The Paper by Neumark and Wascher (1992)
3.3. Main Issues Raised about the Three Papers
A. Employment Effects and the School Enrollment Rate
B. The Appropriate Minimum Wage Measure
C. Lagged Minimum Wage Effects
D. The Utilization of Subminimum Wages

4. Minimum Wages in Germany
4.1. Research on Minimum Wages in Germany
4.2. State of Affairs in the German Minimum Wage Debate

5. Conclusion

References

List of Figures

Figure 1: The competitive minimum wage model

Figure 2: The efficiency minimum wage model with imperfectly observable work effort

Figure 3: The two- sector minimum wage model

Figure 4: The monopsony minimum wage model

Figure 5: The oligopsony minimum wage model

Figure 6: Employment losses when alternative minimum hourly wages are imposed

1. Introduction

One of the most important issues that was in the center of the political debate in Germany in the last few months is the introduction of minimum wages. It was caused by the politically forced imposition of a minimum wage in the sector for postal services which, in the view of many experts, provides a competitive advantage for the major postal service company “Deutsche Post World Net”^[1] compared to its competitors. Then it came to pass that the “PIN – Group AG” one of the most important domestic competitors of the “Deutsche Post World Net” was threatened by insolvency as its largest shareholder the publisher “Axel Springer AG” was no longer willing to invest money in the “PIN - Group AG”. Additionally, many newspapers published by Axel Springer AG wrote articles against the imposition of a minimum wage for many weeks and published many interviews with economic experts warning about the negative effects of a minimum wage on the overall German labor market. Furthermore, political considerations, e.g. by the secretary of labor, to introduce a federal minimum wage in Germany even caused the chairmen of the eight leading economic research institutes in Germany to publish a letter in the newspaper “Das Handelsblatt”^[2] where they advise politicians against the introduction of a federal minimum wage if (large) employment losses should be avoided. On the other hand, a few other researchers, experts and politicians like the “IAB”^[3] as a specific labor market research institute believe that minimum wages even could create jobs and must not necessarily destroy them.

This paper is motivated by this ongoing debate between economists and policymakers in the whole world. That is why in the first part of the paper the major theoretical framework which is used by economists to analyze and empirically assess the impacts of minimum wages on employment should be presented. In the second part, I will present a short history of the empirical work on minimum wages as well as different empirical papers that show ambiguous impacts of minimum wages on employment. The focus here lies on the effect of minimum wages on employment while effects on things like the overall wage distribution, aggregated output, prices or effects on particular groups of the population will be neglected because the major issue raised against minimum wages is the unemployment argument. In the third part of the paper, given the contemporaneous literature, the introduction of a minimum wage in Germany should be evaluated before some concluding remarks will be presented.

2. The Theory of Minimum Wages

In the following paragraph different theoretical approaches of the effect of a minimum wage on employment including the two most important and popular ones of a labor market under perfect competition and monopsony should be presented.

2.1. The Basic Competitive Labor Market Minimum Wage Model

This basic model focuses on a single competitive labor market where homogenous firms or workers maximize their profit or their utility, respectively. The labor demand and supply functions that arise from this optimizations can be seen in the wage- employment (Abbildung in dieser Leseprobe nicht enthaltennumber of workers or hours worked) diagram in figure 1.

illustration not visible in this excerpt

Figure 1 : The competitive minimum wage model

The free competitive market clears in the equilibrium at {E*, W*} determined by the intersection of the supply and demand curve. If a binding minimum wage above W*, that covers all workers in the market, is legally set labor demand declines to Abbildung in dieser Leseprobe nicht enthaltenand labor supply increases to Abbildung in dieser Leseprobe nicht enthaltenat the minimum wage rate of WM. Thus, this model predicts an excess supply of labor of Abbildung in dieser Leseprobe nicht enthaltenor is able to explain disemployment effects of a minimum wage, respectively. As Brown et. al. (1982, p.488f.) note, this excess labor supply does not necessarily mean an increase in unemployment as some of the persons within Abbildung in dieser Leseprobe nicht enthaltenmay not be willing to enter the labor force, i.e. are not actively searching for a job and thus do not count as (officially) unemployed.

2.2. The Model with Endogenous Effort

Despite the prediction of disemployment effects in the competitive model, a more recent approach of a perfect neoclassical information economy can show that even in such an economy employment measured in hours of work can increase after a minimum wage has been introduced (see Deltas 2007). Thus, the model besides others delivers a rationale for empirical findings of no or even positive employment effects. The only modification of the simple competitive labor market model is that endogenous, perfectly observable worker effort is introduced into the model. The objective of workers is to maximize their utility in finding an optimal combination of hours of work and effort given the labor demand and wages. As employers are able to perfectly observe worker effort, and thus worker compensation is an increasing function of the effort level of a worker, it is possible that a worker who increases his productivity can increase his real wage. A decrease in productivity can lead to a reduction in real wages or even a discharge of the worker. If a minimum wage is introduced, it sort of specifies a minimum demanded effort level of the worker. In this model the increase in demand for effort has a direct effect on hours worked. Holding constant the marginal revenue product of labor, increased worker effort can: (i) increase the income earned by a worker, leading to desire fewer work hours, (ii) increase the opportunity costs of working, i.e. the price of leisure, leading to desire more work hours, and (iii) decrease total utility, leading some workers to stop participating in the labor market (see Deltas 2007, p. 659). Hence, the model can explain a reduction as well as an increase in employment measured in hours worked. Furthermore, the model suggests two more interesting findings. First, it can be shown that increases in total employment after a minimum wage was introduced must lead to a decline in workers welfare. Although welfare is still positive, given that the workers decided to increase their effort in response to the minimum wage, employees work so much harder that the additional income is not worth the extra effort. Second, looking at the wage distribution empirics show that a lot of the hourly compensation of workers is concentrated around the minimum wage level and even shifts with a change in that level without significantly affecting the wage distribution at higher wage levels. This model with endogenous effort can explain these findings as it predicts that after the imposition of a minimum wage, workers initially earning less than the minimum increase their effort up to the point where they are able to keep their job. Workers who initially earned more than the minimum, i.e. who are not “constrained” by it, do not experience wage changes.

2.3. An Efficiency Wage Model

Another model developed by Rebitzer and Taylor (1991), that predicts positive employment effects of a minimum wage imposition, is an efficiency wage model similar to this derived by Shapiro and Stiglitz (1984). In those models employers pay there workers more than the market clearing supply- demand determined competitive wage in order to induce more efficiency or productivity, respectively, which pays for the higher wages. Although this model also relies on endogenous effort like the model above the approach is different in the way that it explains positive employment effects from the employer’s and not workers point of view. The two key assumptions in this model are that firms threaten with dismissal those workers found to provide sub- efficient work effort (“shirking”) and that the ability of firms to monitor work effort is a decreasing function in firm size. Hence, firms have to pay their workers a higher wage than the market clearing wage to discourage shirking. An individual firm faces the following problem^[4] Abbildung in dieser Leseprobe nicht enthaltensubject to the no- shirking conditionAbbildung in dieser Leseprobe nicht enthalten. The first- order condition yieldsAbbildung in dieser Leseprobe nicht enthalten. Thus, the firm’s optimal employment decision is given in Abbildung in dieser Leseprobe nicht enthaltenwhere the marginal revenue product (Abbildung in dieser Leseprobe nicht enthalten) equals the marginal labor cost (Abbildung in dieser Leseprobe nicht enthalten) as shown in figure 2.

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Figure 2 : The efficiency minimum wage model with imperfectly observable work effort

The imposition of a minimum wage WM decreases the marginal cost of labor inducing the employer to hire more workers as long as Abbildung in dieser Leseprobe nicht enthalten. In figure 2 the increase in employment is yielded byAbbildung in dieser Leseprobe nicht enthalten. The intuition behind the model is that the opportunity costs of losing the job for workers increase once a minimum wage that exceeds W0 is introduced. This increases the threat of discharging shirking workers and thus frees monitoring resources for the employer what makes it possible to hire more workers without increasing wages for the intra- marginal worker. As the whole model is based upon the assumption that monitoring costs increase with firm size the two authors derive another model with equal monitoring costs independent of the firm size. Again, they find that a minimum wage, given Abbildung in dieser Leseprobe nicht enthalten, can increase employment when firms discharge workers in response to uncertainty in product demand.

2.4. A Two- Sector Model

Because a minimum wage in reality often does not cover all labor markets in an economy, it can be useful to consider a model with partial minimum wage coverage. A simple two- sector model is going back to Finis Welch (1974) where he distinguishes between a covered (denoted as C) and an uncovered sector (denoted as U). In the sector covered by the minimum wage workers will be discharged if the minimum level Abbildung in dieser Leseprobe nicht enthaltenexceeds the competitive equilibrium wage Abbildung in dieser Leseprobe nicht enthaltenlike in the diagram on the left hand side in figure 3. The workers laid- off in the covered sector migrate to the uncovered sector which leads to a shift in the labor supply curve to the right (Abbildung in dieser Leseprobe nicht enthaltento Abbildung in dieser Leseprobe nicht enthalten).

illustration not visible in this excerpt

Figure 3 : The two- sector minimum wage model

Again, assuming profit maximizing employer behavior and no labor market rigidities the wage decreases to Abbildung in dieser Leseprobe nicht enthaltenand employment increases from Abbildung in dieser Leseprobe nicht enthaltento Abbildung in dieser Leseprobe nicht enthaltenin the uncovered sector. Nevertheless, as wages fall in the uncovered sector those discharged in the covered sector as well as those workers originally working in the uncovered sector are not necessarily going to work there again, because the reservation wage of some workers, i.e. the wage rate for which an individual worker is willing to start to work in a particular job, might be higher than Abbildung in dieser Leseprobe nicht enthalten. Hence, the labor participation rate can decline. “Therefore, the effect of the minimum wage on total employment depends on the elasticity of labor supply and the reservation wages of those who do not obtain covered sector work, as well as more obvious factors such as the size of the covered sector and the elasticity of labor demand.” (Brown et al. 1982, p.490).

2.5. A Two- Sector Model with Searching for Covered- Sector Jobs

Another model going back to Mincer (1976) and Gramlich (1976) extends the model of Welch (1974) from above. In addition to either being employed in the covered or uncovered sector or not to participate in the labor force because one’s reservation wage is higher than the market wage in the uncovered sector, the authors suggest that a worker remains unemployed because he is searching for a job in the sector with the highest expected wage (which is likely to be the covered sector). Besides unemployment due to not participating in the labor force, this model introduces unemployment interpreted as searching for a covered- sector job. As Brown et al. (1982) mention, this model relies on the strong assumption that workers can not search for a covered- sector job while employed in the uncovered sector and thus are “forced” to remain unemployed. In the Mincer- Gramlich model the rate of unemployment is an increasing function of the minimum wage and the amount of covered sector employment before the minimum wage was introduced. Hence, the larger the labor market where the minimum wage should be introduced and the higher the minimum wage level the more unemployment will increase after the imposition of a minimum wage. In conclusion, this model is another explanation for why minimum wages might cause unemployment even if the minimum wage coverage is incomplete and other uncovered sectors could absorb (homogenous) discharged workers from the covered sectors.

2.6. The monopsony Model

In contrast to some models from above, the monopsony model which was already known in 1946 (Stigler, 1946)^[5] is used to explain empirical findings of positive employment effects. In this model a profit

maximizing firm is a single buyer of labor in the market facing an upward sloping labor supply function. The firm has to solve the following problem Abbildung in dieser Leseprobe nicht enthaltenwhere E denotes employment, R(E) is the firm’s total revenue function which increases in E, w(E) is the wage rate which depends positively on E as the firm has wage setting power and v*K are capital costs (Boal and Ransom 1997, p.87). The first order condition (FOC) is given byAbbildung in dieser Leseprobe nicht enthalten. Here, the first term Abbildung in dieser Leseprobe nicht enthaltenis the marginal revenue product (MRP) of labor while the term in brackets is marginal labor cost (MLC). The optimal employment for the monopsonist is EMo where MRP=MLC (see figure 4). The corresponding wage rate is WMo which is determined with the help of the supply curve as workers are only willing to supply EMo units of labor at this wage rate. Hence, the monopsonist, just like a monopolist that sets the price of his product too high, sets his wage too low to minimize his costs. The difference Abbildung in dieser Leseprobe nicht enthaltenis often called the “firm’s vacancies” because if the firm could hire the amount of workers it wanted at WMo it would set employment to Abbildung in dieser Leseprobe nicht enthalten(Boal and Ransom 1997, p.87). If a minimum wage is introduced, the firm can no longer set the price and becomes a price taker up to the level of the minimum wage. Hence, a minimum wage below WMo has no effect since it is not binding and a wage between WMo and W* increases wages and employment as it brings the market to, or at least closer to the competitive wage- employment level. A minimum wage above W* again increases wages but reduces employment like in the competitive model above.

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Figure 4 : The monopsony minimum wage model

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^[1] The “Deutsche Post World Net” or “Deutsch Post AG” used to be the “Deutsche Bundespost”, a public firm that was privatized in 1995.

^[2] http://www.handelsblatt.com/News/Politik/Deutschland/_pv/_p/200050/_t/ft/_b/1403154/default.aspx/im-wortlaut-der-brandbrief-der-wirtschaftsforscher.html (03/12/2008).

^[3] „Institute für Arbeitsmarkt- und Berufsforschung“ („Institute for research on occupations and the labor market”).

^[4] Where R is total revenue, E is employment v*K are capital costs, w is the wage,is the utility of an unemployed worker, e yields a high intensity of work effort, r is the discount rate, q is the probability of retiring in each period and D is the probability of shirking to be detected.

^[5] The idea of monopsony was developed first in the late 1920s by Joan Robinson in her paper “The Economics of Imperfect Competition.” (1933) London: St. Martin’s Press.