Minimum Wage: The Nobel Thing to Do

Two weeks before President Obama announced an increase in the minimum wage for federal contractors in his State of the Union speech this year, the Economic Policy Institute (EPI) released a letter signed by 75 economists – including seven Nobel prize recipients – advocating an increase in the minimum wage. One of the key arguments the EPI letter made in favor of the policy was the lack of empirical evidence that higher minimum wages increase unemployment.

This apparent departure of labor market behavior from classical economic theory continues to be a puzzle. Textbook economics predicts that a minimum wage higher than that determined by the market forces of demand and supply would result in more people willing to work and fewer firms being able to afford to pay higher remuneration. This should lead to job destruction accompanied by unemployment. However, very little support for this claim can be found in empirical studies. In this article, we summarize three essays by Nobel laureates Joseph Stiglitz, George Stigler, and Dale Mortensen, offering competing explanations for why standard economic theory inaccurately models the wage-unemployment link.

In a 1999 paper on Household Labor Supply, Unemployment and Minimum Wage Legislation, Kaushik Basu, Garance Genicot, and Nobel-winning economist Joseph Stiglitz question the responsiveness of labor supply to wages, an idea that is central to the classical theory of economics. The authors argue that at low wage levels, households are financially insecure and would therefore be willing to supply more labor to hedge themselves against economic shocks. This is called the “added labor effect.” At low wages, this effect may be so high that it might contribute to unemployment rates as people struggle to find more jobs than the economy has to offer. Curbing unemployment, therefore, requires mitigating households’ risk exposure by offering higher minimum wages.

An older paper by George Stigler—The Economics of Minimum Wage Legislation, published in 1946—has a less radical take on the unemployment-wage link but reaches a similar policy recommendation regarding minimum wages. Stigler grants that a higher minimum wage will lead to a reduction in job creation but goes on to argue that the society will still be better off with the regulation because of productivity gains. Essentially, Stigler attacks the constant returns to scale assumption that underlies most of standard economic analysis, contending that if minimum wage is higher than the market-clearing wage, it will induce labor to work harder. According to Stigler, a higher minimum wage serves as an “efficiency wage” that increases motivation. Moreover, knowing that there are people outside the employment pool who are willing to work for less creates a threat of job loss that acts as a motivation to work harder. He further criticizes the assumption that firms will continue to face the pre-minimum wage production functions after wages have been exogenously increased, given that firms will invest in technology and innovate to offset the increase in wage bill. These two factors will increase overall productivity in the economy, argues Stigler.

Mortensen also believes in efficiency creation led by a minimum wage, but for a different reason. In his 1998 paper titled Equilibrium Unemployment with Wage Posting: Burdett-Mortensen Meets Pissarides, he claims that the labor market is already inefficient without exogenous wage posting by the government. Mortensen’s critique of efficiency in the free market is based on the dispersion of wages observed in most markets. When employers have near-monopsony powers and the cost of changing and searching for jobs is non-trivial, employers will always offer the lowest “retention wage” needed to hire an unemployed person. Either the level of unemployment benefits will determine this retention wage, or the minimum wage posted by the government. In the absence of such price supports, firms will pay the lowest possible wage to each worker. Contrary to economic theory, the offered wages may not be commensurate with the marginal value of output produced by that worker. Setting a minimum wage, therefore, induces efficiency by curbing monopsony powers and market frictions.

These three articles together bear evidence that despite the overwhelming academic support for the textbook outcome of price regulation, prominent economists have been cognizant that labor markets are more complex than that. While the papers by no means provide a comprehensive answer to why the minimum wage-unemployment causality is tenuous, they certainly make a case for a finer analysis of job markets mechanics for better policy outcomes.

Article Sources:The Economics of Minimum Wage Legislation, George J. Stigler, The American Economic Review, Vol. 36(3), 1946.Household Labor Supply, Unemployment and Minimum Wage Legislation, Kaushik Basu, Garance Genicot, and Joseph E. Stiglitz, World Bank Working Paper, 1999. Equilibrium Unemployment with Wage Posting: Burdett-Mortensen Meets Pissarides, Dale Mortensen, 1998.

Feature Photo: cc/(Eszter Hargittai)