Economics (9640) | Minimum wage laws

Study Notes: Minimum Wage Laws (3.3.4.6)

Welcome to the Labour Market!

The labour market is unique because the "good" being bought and sold is human effort (labour). This chapter explores one of the most important and hotly debated forms of government intervention in this market: the Minimum Wage Law.
It’s a topic that constantly appears in news headlines, so understanding the core economic arguments—both positive and negative—is essential for your exams!

1. Defining Minimum Wage Controls

What is a National Minimum Wage (NMW)?

A minimum wage is a type of price control applied to the factor market for labour. Specifically, it is a price floor set above the current equilibrium wage rate.
Think of it like the government setting a minimum price for bread—except here, the 'price' is the wage a worker receives per hour.

Key Term: Price Floor


A minimum price set by the government, often done to protect producers (in this case, workers) and ensure they receive a fair income.

Primary Aims of Setting an NMW:

The government usually introduces an NMW with specific social and economic goals in mind:

1. Reduce Poverty and Inequality: By ensuring that low-skilled workers earn enough to cover basic living costs.
2. Increase Equity: Promoting a fairer distribution of income (a key macro-economic objective).
3. Boost Productivity: Higher wages may lead to improved worker morale, lower staff turnover, and ultimately, higher labour productivity (the efficiency wage theory).

Quick Review: Minimum Wage Basics

The minimum wage is a mandatory wage rate acting as a price floor in the labour market. Its main goal is welfare improvement and income redistribution.

2. Effects of NMW in a Perfectly Competitive Labour Market

In a simple, theoretical world of perfect competition, introducing a minimum wage often leads to the traditional predicted consequence: unemployment.

Model Assumption: Perfectly Competitive Labour Market

In this model, firms are wage takers. They have to accept the market wage (\(W_E\)), which is set by the total demand for labour (\(D_L\)) and the total supply of labour (\(S_L\)).

How the Minimum Wage Causes Unemployment

When the government imposes a statutory minimum wage (NMW) that is set above the equilibrium wage (\(W_E\)), two things happen simultaneously:

1. Quantity of Labour Demanded (Employers) Falls:
Firms face higher costs of production. Since the marginal cost of labour is now higher, profit-maximizing firms will reduce the number of workers they employ. Firms substitute labour for capital, or simply reduce output.

2. Quantity of Labour Supplied (Workers) Rises:
More people are willing and able to work at the higher wage rate. This may include people who were previously unemployed, or those who weren't in the labour force (e.g., students or early retirees).

The result is an excess supply of labour—the difference between the quantity supplied and the quantity demanded at the NMW.
This excess supply is known as unemployment.

Don't worry if this seems tricky at first. It is the fundamental law of supply and demand applied to workers. When the price (wage) goes up, buyers (firms) want less, and sellers (workers) want to supply more.

Common Mistake to Avoid

Do not say that the NMW shifts the demand or supply curve. The NMW is a mandated *price*, not a change in a determinant like productivity or preferences. It causes a movement along the existing demand and supply curves, creating a market disequilibrium.

Key Takeaway for PCL

In a perfectly competitive market, the minimum wage is predicted to cause a trade-off: higher wages for those who remain employed, but job losses for others (unemployment).

3. Effects of NMW in an Imperfectly Competitive Labour Market (Monopsony)

The real world rarely acts like the textbook model of perfect competition. In markets where employers have significant power (like a monopsony), the effects of the minimum wage can be dramatically different.

Understanding Monopsony Power (Prerequisite)

A monopsony exists when there is only one major buyer of labour in a local market (or when a few dominant firms collude).

Because the monopsonist is the sole buyer, they have the power to set the wage (they are a wage maker). To hire an extra worker, the firm must raise the wage not just for the new worker, but for *all* existing workers. This means the Marginal Cost of Labour (MCL) is higher than the Average Cost of Labour (ACL/Supply Curve).

The monopsonist exploits this power by paying a wage (\(W_M\)) that is lower than the competitive market wage, and employing fewer workers (\(L_M\)).

The Minimum Wage Solution in Monopsony

When the government imposes an NMW above the current monopsony wage (\(W_M\)), but below the competitive wage, the outcome changes:

1. The MCL curve is eliminated up to the NMW level.
Since the firm is legally obligated to pay the NMW, the Marginal Cost of Labour (MCL) curve becomes horizontal (perfectly elastic) at the minimum wage level up to a certain employment quantity. The firm no longer needs to raise the wage for existing workers to hire a new one.

2. The Firm's Incentive Changes.
The firm now has an incentive to hire more workers, as the marginal cost of hiring remains constant (at the NMW) until the quantity supplied equals the quantity demanded at that wage.

The Result:
The NMW can lead to an increase in both the wage rate and the level of employment, moving the market closer to the efficient, competitive outcome.

Did you know? This is the primary economic justification used by advocates of the minimum wage: that many labour markets have monopsony elements, meaning that a carefully set NMW can be welfare-improving for all.

Key Takeaway for Monopsony

In a monopsony, the minimum wage can increase wages and employment, eliminating the exploitation caused by the firm’s buying power.

4. Advantages and Disadvantages of a National Minimum Wage (NMW)

The true impact of an NMW is complex and depends heavily on factors like the level at which it is set, the structure of the specific labour market, and the state of the economy. Here is a balanced evaluation.

A. Advantages of the NMW

1. Reduction in Poverty and Inequality

The most direct benefit: it raises the income of the lowest-paid workers, reducing absolute poverty (not being able to afford necessities) and improving the Gini coefficient (reducing inequality).

2. Increased Worker Motivation and Productivity (Efficiency Wages)

Higher wages can improve worker morale, increase effort, and reduce absenteeism and staff turnover. This can lead to increased labour productivity, potentially offsetting the higher wage costs for the firm.

3. Increased Aggregate Demand (AD)

Low-income workers have a high Marginal Propensity to Consume (MPC). When their income rises, they are likely to spend most of it, injecting demand into the economy. This can lead to a positive multiplier effect, boosting economic growth.

4. Dynamic Efficiency for Firms

By forcing up the price of low-skilled labour, the NMW pressures firms to become more efficient. They are incentivized to invest in technology, training, or capital equipment to improve labour productivity, rather than relying on cheap labour.

B. Disadvantages of the NMW

1. Unemployment (The Traditional Argument)

As demonstrated in the perfectly competitive model, if the NMW is set too high, it will lead to unemployment, especially amongst young, low-skilled workers. This can damage the job prospects of those who need experience most.

2. Increased Costs Leading to Higher Prices (Cost-Push Inflation)

For firms in competitive product markets, higher labour costs cannot always be absorbed. They may pass these costs on to consumers through higher prices, leading to cost-push inflation.

3. Reduced Competitiveness

If the NMW raises production costs significantly, domestic firms may become less competitive globally. This can harm the balance of payments (current account deficit) if exports fall and imports rise.

4. Reduced Non-Monetary Benefits

If firms are forced to pay higher wages, they may cut back on other employee benefits to control costs. This could include reducing workplace training, ending sick pay schemes, or cutting holiday allowances.

5. Impact on Small Businesses

Large firms (which may operate as monopsonies or have high profits) can often absorb minimum wage increases better than small businesses operating on thin margins, potentially leading to small business failures.

5. Final Evaluation and Conclusion

The Setting of the Minimum Wage is Key

The ultimate economic effect of the NMW depends crucially on where it is set relative to the equilibrium wage and the level of monopsony power in the market:

1. If set too low (below the current equilibrium), it is ineffective and has no impact.
2. If set very high (far above equilibrium), it causes significant unemployment (as per the PCL model) and inflation.
3. If set optimally (in markets with monopsony power), it can raise wages and employment simultaneously, achieving policy objectives without the cost of job losses.

In reality, economists believe the true effects are small, but positive. The key benefit is often redistribution (equity) rather than efficiency (economic growth).

Summary: Minimum Wage Trade-Offs

The NMW is a highly effective tool for promoting equity and fighting poverty. However, its effectiveness is often balanced against the potential risk of causing job losses and contributing to inflation. Governments must use detailed economic analysis to find the "sweet spot" that maximizes social benefits while minimizing the economic costs.