Minimum Wage

MINIMUM WAGE IS A government intervention in the labor market that does not allow employers to pay a wage below a set minimum. This applies even if both the employer and employee want to agree to a wage below the legal minimum. The idea behind such legislation is to help low-skilled workers to achieve some minimum standard of living. In the United States, the federal government sets a national minimum wage, at $5.15 in 2005. However, individual states are free to set [Page 719]higher minimum wages. Some cities, such as Boston, Massachusetts, and Ann Arbor, Michigan, have established living-wage laws whereby wages are generally significantly higher than the national minimum wage. The prevailing view in economic theory is that minimum wages lead to fewer jobs for low-skilled workers. However, some economists argue that a minimum wage could lead to increased employment if employers possessed significant power in the labor market. Consistent empirical support in either direction has proven elusive. The minimum wage could also have significant effects on the education decisions of teenagers. There is also a question of whether this legislation truly targets the working poor or simply serves as a wealth transfer to teenagers from middle-income households.

In the United States, the minimum wage was established in the Fair Labor Standards Act of 1938 and is supervised by the Department of Labor. Prior to 1938, some states pursued their own minimum wage policies. In 1912, Massachusetts was the first to do so. Often the minimum wage varied across industries, taking industry-specific factors into consideration. In all cases, the minimum wage applied only to women and minors. Men were not covered until the national minimum wage was established in 1938.

The standard theory predicts that firms will hire fewer workers as a result of the higher wage. Thus while some workers benefit from the higher wage, others lose when they lose their job. Furthermore low-skilled workers are likely to enter the labor force in response to the higher wage. There are more low-skilled workers in the labor force, but fewer of them are employed, thus the unemployment rate for these workers increases. Employers who traditionally hire low-skilled labor will over time adjust their production process away from labor and toward machinery. The transition may take some time, making it difficult to determine the employment effects of the minimum wage in practice. However, studies traditionally found a negative correlation between the minimum wage and employment for the least-skilled members of the workforce.

Newer studies contradict these findings. They argue that the minimum wage can simultaneously raise wages and employment for targeted workers. This argument rests on the assumption that employers have significant power in the labor market, allowing any individual employer to have an impact on the wage rate. In order to have market power, the employer must employ a sizable fraction of the local labor force. If this is true, then the employer will face an upward-sloping supply of labor; in order to hire more workers, the firm will have to pay a higher wage to all workers. In this case, the cost of hiring an additional worker will be greater than the wage; it is equal to the wage paid to the new employee plus the wage increase given to the existing employees. Call this cost of hiring the last worker “c.” Instead, if the company faces a minimum wage (greater than the prevailing wage), then the cost of hiring an additional worker is simply the mandated wage. Call this cost “c*.” If the minimum wage is not set too high, then c* will be less than c, so employers will hire more workers when there is a minimum wage than they would without one.

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