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December 10, 2006

Modern Labor Economics And The Minimum Wage

As I continue in my futile quest to catch up with all the blog reading that I have let slip, this post from early last week at Angry Bear caught my eye (I added the link to the Atrios site):

Duncan [Black] also recommends Monopsony in Motion: Imperfect Competition in Labor Markets by Alan Manning:

Much of labor economics is built on the assumption that all the workers will quit immediately. Here, Alan Manning mounts a systematic challenge to the standard model of perfect competition.

Simply because my aim here is to inform as best I can -- at least about the things I think I am qualified to be informative about -- I think it worthwhile to point out that this doesn't really describe the state of modern labor theory.  For a description of that, I'll turn to Rob Shimer, one of the guys at the top of the list of people actively creating modern labor theory:

I begin by describing the simplest version of the Mortensen-Pissarides matching model...

A central feature of this model is that the matched worker and firm are in a bilateral monopoly situation. That is, an employed worker could always leave her job and find another employer; however, because search is time-consuming, workers are impatient, and all jobs are identical, she prefers to work for her current employer. Likewise, a firm could fire an employee and attempt to hire another one, but this will take time and will not yield a better match. There are many wages consistent with the pair agreeing to match, and so the model provides little guidance as to how wages are determined...

Rob's article -- which is quite accessible -- is must reading for anyone with even a passing interest in what labor theory is all about these days.  My point in highlighting this passage is, of course, that the challenge to the perfectly-competitive spot market view is already well under way (even in macroeconomic models).  And as you can see, that theory is not built on the assumption that "workers will quit immediately."  Nor is it built on the assumption that employers will fire immediately.

What, then, does modern labor economics have to say about the minimum wage?  A complicated question that.  Here is a sampling of abstracts, generated by my highly scientific method of typing "minimum wage matching model"  into Google --

From Adrian Masters (in a paper published in a good peer-reviewed journal), the argument that wages may indeed be too low:

This article focuses on wage formation in an equilibrium (two-sided) model of search with match-specific heterogeneity. Despite a large number (a continuum) of employers, search provides sufficient isolation to generate market power. By posting wages, employers, without collusion, capture most of the surplus that accrues to any match. The equilibrium wage is below that which maximizes employment...

But be careful. From Michael Pries and Richard Rogerson:

So what happens when a policy, such as a minimum wage, interferes with that equilibrium wage rate? If the imposed minimum wage is higher than what the equilibrium wage would be, says Rogerson, there will be cases in which firms no longer want to enter the match to test it out. 

The reason, says Rogerson, is that raising the minimum wage raises the minimal level of match quality that a firm will accept to test out the relationship. The firm will still enter into some matches at above-minimum wage, but only those that show a higher potential of being good matches.

Rogerson explains the phenomenon through a car-buying analogy. "Imagine that a law was passed that said you could no longer test-drive a car," Rogerson says. "That deprives you of an important source of information. Although you can get some information from looking at a car, you have a much better idea after test-driving it than before." So what would the outcome of a test-driving prohibition be? "People would be less likely to find the car that best suits their needs, implying a loss in economic welfare."

Policies like the ones Pries and Rogerson analyze -- minimum wages, unemployment insurance, dismissal costs, and taxes -- are not the same as imposing a ban on test-driving automobiles. But their effect is to make test-driving an employee (hiring him to see through experience if he will be a good match) more costly, which means that firms will do it less often.

...The effects of other policies by themselves, including dismissal costs, unemployment insurance, and taxes, are minimal, write Pries and Rogerson. But the effects of those policies combined (as they often are in the real world) are quite large.

In fact, we should probably be thinking about labor market policies as a collection of interventions, rather than taking the piecemeal approach that characterizes how many of our policies are actually implemented.  From Pierre Cahuc and Andre Zylberberg:

We analyze how wage setting institutions and job-security provisions interact on unemployment. The assumption that wages are renegotiated by mutual agreement only is introduced in a matching model with endogenous job destruction à la Mortensen and Pissarides (1994) in order to get wage profiles with proper microfoundations... the assumption of renegotiation by mutual agreement allows us to introduce a minimum wage in a coherent way, and to study its interactions with job protection policies. Our computational exercises suggest that redundancy transfers and administrative dismissal restrictions have negligible unemployment effects when wages are flexible or when the minimum wage is low, but a dramatic positive impact on unemployment when there is a high minimum wage.

Just to make things more difficult, observing outcomes that we generally interpret as negative -- such as rising unemployment -- need not mean that a policy is misguided. From Christopher Flinn...

... we analyze the effect of changes in minimum wages on labor market outcomes and welfare. While minimum wage increases invariably lead to employment losses in our model, they may be welfare-improving to labor market participants using any one of a number of welfare criteria... Direct estimates of the welfare impact of the minimum wage increase from $4.25 to $4.75 in 1996 provide limited evidence of a small improvement. Using estimates of the primitive parameters we show that more substantial welfare gains for labor market participants could have been obtained by doubling the minimum wage rate in 1996, though at the cost of a perhaps unacceptably high unemployment rate.

... and from a related paper (published in a very, very highly regarded journal):

Although minimum wage increases may or may not lead to increases in unemployment in our model, they can be welfare-improving to labor market participants on both the supply and demand sides of the labor market... We show that the optimal minimum wage in 1996 depends critically on whether or not contact rates can be considered to be exogenous and we note that the limited variation in minimum wages makes testing this assumption problematic.

So, is the minimum wage a good idea or not.  Our theories, and attempts to quantify them, speak clearly: It depends.

UPDATE: More links on the topic, at Economic Investigations.

December 10, 2006 in Labor Markets | Permalink


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So many things just went to the top of my read pile. Thanks! Also thanks for avoiding the dogmatic stance of some who think increasing the minimum wage is clearly a bad idea with the assertion that those of us who might think otherwise know nothing about economics.

Posted by: pgl | December 10, 2006 at 11:12 AM

Now, what should be said to all those people teaching the classic supply-demand model and claiming that they are right even though modern theory and the data shows their theory does not apply to this situation?

Posted by: spencer | December 10, 2006 at 12:46 PM

There is this farmer who is having problems with his chickens. All of the sudden, they are all getting very sick and he doesn't know what is wrong with them. After trying all conventional means, he calls a biologist, a chemist, and an economist to see if they can figure out what is wrong. So the biologist looks at the chickens, examines them a bit, and says he has no clue what could be wrong with them. Then the chemist takes some tests and makes some measurements, but he can't come to any conclusions either. So the economist tries. He stands there and looks at the chickens for a long time without touching them or anything. Then all of the sudden he starts scribbling away in a notebook. Finally, after several gruesome calculations, he exclaims, "I've got it! But it only works for spherical chickens in a vacuum."

Posted by: guest | December 10, 2006 at 01:10 PM

It's all very amusing to see the huffing and puffing around an issue like the minimum wage, where the bulk of empirical work has validated the plain vanilla Econ 101 approach to this issue, where low-skill labor markets actually do work very much like the neoclassical model. There might be lots of labor markets that deviate from the neoclassical model, but low-skill labor markets in reasonably populated areas just ain't one of them.

And then everybody also ignores the factual gorilla in the room, that most minimum wage workers aren't even from poor families, so your main beneficiaries aren't even poor.

This is a classic case of looking for more and more intricate models to support one's preferred policy prescriptions, even when the bulk of the empirical work supports the supply and demand approach.

Posted by: Keith | December 10, 2006 at 03:50 PM

Another important paper that looks at labor market policies --- including minimum wages --- from a modern search-theoretic labor market point of view is "Labor Market Policies in an Equilibrium Search Model" by Fernando Alvarez and Marcelo Veracierto, in the NBER macro annual 1999. See also the relatively friendly discussion of this paper in the same volume by Alan Krueger. Off the top of my head, Krueger starts by saying something like 'I'm used to being sent papers that find quantitatively small effects of minimum wages, but not papers with return addresses in Chicago'

Posted by: Chris Edmond | December 10, 2006 at 04:21 PM

Keith -- care to document some of your claims?

Posted by: spencer | December 10, 2006 at 04:36 PM

Keith -- Actually my gut tells that the minimum wage is a bad idea and, as I have written here many times, I much prefer things like the earned income tax credit as a way to deal with poverty (which I assume is mainly what we are trying to get at with the minimum wage). And I appreciate your argument about talking ourselves into possibilities that exist only in the abstract when experience tells us the truth is otherwise.

But I think most people agree that evidence of minimum wages being really harmful is pretty limited. I could say that maybe this is because the worst effects are only felt in the long run, as those who might learn work habits and social skills early in life by taking temporary low-wage jobs are excluded from the market. But then I would just be exercising that gut feeling, and I try to not do too much of that on this blog.

One of the reasons that pgl and I get along despite the fact that we sometimes disagree is that we both believe there is a reason we do the research. If the best theory and evidence we have going tells us that our presumptions are not so clearly right, we do people a disservice by not admitting it.

Posted by: Dave Altig | December 10, 2006 at 04:44 PM

I presume the question of minimum wage theory is whether it hurts or helps folks in the labor market. There is much theory but we have run several Continent wide experiments over decades.

The European (England, Ireland, France, etc. -- Germany has sector-wide contracts) minimum wage is about twice America's federal minimum wage -- with health care provided publicly. We already tried the European minimum wage level in 1968 -- at half today's productivity! Maybe those Europeans could do a lot better.

Europeans at least adjust their (1968 American level) minimum wages for inflation and RAISE them for economic growth on a yearly schedule.

How many rounds of wage/price hikes did it take to require $9.50 in 2006 to purchase what $1.60 would pay for in 1968? When prices rise, workers ask for a raise -- causing prices to rise some more and so on: the normal experience (experiment) being inflation, not unemployment.

American minimum wage workers have had just two (two-step) raises since Jimmy Carter was president.

You know what?; you want to be good market devotees? Let the minimum wage people be the ones to decide if they are willing to chance unemployment by getting government to make a wage demand for them. By all means don't be a liberal social engineer deciding what is not good for them. :-)

If the will had existed after L.B.J. departed public life to keep his $9.50/hr minimum up with inflation and either Nixon or Kennedy had gotten their national health plan through congress, we might have had 2006 European minimum labor standards in America in 1974. (Nixon did sign an $8.00/hr minimum -- at 60% of today's average income.)

What has happened to American labor could not be simpler to understand. A complete lack of labor bargaining power -- and not a terrible amount of interest in rectifying same -- has resulted in 10% of all income shifting from the bottom 90% to the top 1% (along with 2-12% to the next to top 9%).

It is surprising that such a dearth of labor bargaining power has lead to a shift of ONLY one-eighth of income -- but that is all it took to reduce today's minimum wage to F.D.R.'s level ($4.20/hour w/o taxes).

A $500/hr minimum wage would add 3 1/2% to the cost of GDP output -- and harmlessly shift 5% of income to the bottom.

Harmlessly because low end goods would cost somewhat more but low pay people would earn a lot more -- while high end goods would hardly be affected.

Highest labor cost by far, fast food, would rise 50% (a Big Mac meal would rise from $5.00 to $7.50). The latter is more affordable to a $500/worker than the former is to a $200/wk worker.

Posted by: Denis Drew | December 10, 2006 at 06:00 PM

Well this isn't based on formal research just on past experience of about 10 yrs in the food industry at close to or at min wages;
Getting a job in academia resembles the search/matching model.
Getting a job after college resembels the search/matching model.

Getting a job at Burger King involves walking in, asking "Are you hiring", if yes then you fill out an application and get your uniform, if no, then you walk across the street to the Wendy's. In other words the market for unskilled labor much more closely resembles the standard supply and demand than a search model. And I really like search models and think they have a lot of important things to say about the labor market and even business cycles - but the number of workers affected by the minimum wage are small relative to the whole economy.

If there's a market with monopsony power it's most likely a market for some kind of skilled labor but there it's more likely to be the case of double monopoly (as in the standard search models).

One particular exception may be industries which employ a lot of illegal immigrants. The threat of deportation, the lack of information on part of the migrants and, lack of social/family safety net basically means that the employer has a much better threat point than the employee. So I'm perfectly willing to believe in monopsony there. As a result I was glad that the The Justice For Janitors got their contract recently in Houston as a second best result (it's my assumption that there's a lot of illegals among the janitors. If not, then I take it back, I'm not glad they got their contract.)

Some people want to fine employers who hire illegal immigrant workers. I wanna fine employers who fink on illegal immigrant workers.

Posted by: radek | December 11, 2006 at 10:43 AM

Burkhauser, Richard V. and Joseph J. Sabia. (2004) Why Raising the Minimum Wage is a Poor Way to Help the Working Poor, Employment Policies Institute.

This study reveals that the majority of beneficiaries from a minimum wage hike are not in poverty nor are they the primary earner in their family. In fact, according to U.S. government data, employees earning the minimum wage are more likely to live in families earning three times above the poverty line than in poor families. The authors found that the vast majority of families who are living in poverty will not benefit from the proposed increase. Only 15 percent of the benefits from a wage increase to $7.00 an hour would go to families in poverty, 60 percent of the benefits would go to families earning more than twice the poverty line.

The authors also found that the majority of beneficiaries are not the primary earner in their family. While supporters of wage increases often claim that the increase will help sole earners attempting to raise a family on a minimum wage income, (particularly single females), these individuals represent a dramatically small minority of beneficiaries. Only 12.6 percent of beneficiaries from the proposed increase are unmarried women with children. Over 82 percent are either not the highest earner in their family, single adults, or are married without children.


Posted by: Euthydemos in Athens, GA | December 11, 2006 at 02:07 PM

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