The Effect of the Minimum Wage Has on Unemployment

David Metcalf has concluded that the implementation of the minimum wage appears to have had no negative impact upon Employment. Critically examine the possible explanations for this outcome.

The minimum wage was implemented and became law on the 1st April 1999 this helped prevent unfair low pay and “levelled the playing field” (http://www.businesslink.gov.uk/bdotg/action/layer?topicId=1074402393) for employers as companies could compete on quality of goods rather than setting a reduced price based on low pay. It applies to most workers and sets hourly rates below where pay is not allowed to decrease; these rates are recommended by the Low Pay Commission (LPC). At first the adult rate was set at £3.60 per hour for adults in the first 6 months of their job with sufficient training, there was also a lower youth rate of £3.00 per hour for those aged 18 – 21.(Stuart p5) Presently the minimum wage stands at £5.52 per hour for ages 22 and over and £4.60 aged 18-21. (http://www.is4profit.com/business-advice/employment/minimum-wage-and-statutory-pay-obligations_2.html). Neo-classical economic analysis suggests that an individuals wage should equal their marginal product of labour, “as wages constitute the individuals reward for their personal contribution to output of a firm” which resembles that of perfect competition. ( Forth & O’Mahoney p4) The implementation of a minimum wage leads to a rise in wage rates for those that were previously paid unfairly which theoretically has a positive impact on employment. Therefore workers that previously got paid below the minimum wage will likely surpass their marginal product. Figure 1 illustrates the impact of the implementation of a minimum wage, the model assumes a competitive market where homogenous workers earn W0 and then earn Wm after the minimum wage is introduced. If demand and supply measures were used to determine employment then the initial equilibrium would be at point E0 and after the implantation of the minimum wage it will be at point Em. It is clear from figure 1 that this would cause an excess supply of labour as shown by point Sm. Economically this could be caused by the substitution effect where a wage increase will decrease the hours worked due to an individuals specific level of utility or satisfaction. Therefore it is apparent that their will be an increase in unemployment as shown by Em to Sm. In theory a profit maximising firm would be likely to decrease the quantity of labour demanded especially those “whose marginal product is lower than the statutory minimum” (Forth & O’Mahoney p5). This is shown by Figure 2 where demand (D) is based on the Value of marginal product of labour (MVP). The market determined wage rate (Wo) is replaced by the minimum wage(Wm) causing a decrease in demand of quantity of labour (Lm-Lo) resulting in firms employing fewer workers. The perfectively competitive model of labour assumes that each firm in the industry faces the same competitive price regardless of quantity of output sold and also that each firm pays all its workers an equal wage. However by using alternative market structures such as monopsonistic competition it is apparent that a fixed wage could increase both employment and wage itself. Monopsony is a firm that faces an upward sloping supply curve of labour and in order to hire workers it must pay higher wage to provide incentive. In figure 3 assuming perfect competition, equilibrium is shown by Wpc and Lpc where demand meets supply. However in a monopsonistic market if a minimum wage was proposed the employer must raise the wage rate from Wm in order to hire more workers. If a monopsonist charged a wage rate below Wpc workers would be more inclined to work at the rate of the minimum wage as it is higher. The monopsonist, therefore, must then raise its wage rate to Wm2 in order to provide the required amount of incentive for workers. As the monopsonist must increase the wage rate the marginal cost of labour curve would also be upward sloping and lie above the supply curve (MCe). The profit maximising monopsonist would be likely to hire up to the point where the marginal cost of labour is equal to the marginal cost of marginal productivity so would set a wage at point X. This could result in an increase in wages and employment as well as providing incentive for workers. Neo- classical theory seems to suggest that an implementation of the national minimum wage is likely to create a rise in unemployment however evidence disproves this theory. Figure 4 illustrates the unemployment rate from 1992-2005 as the National minimum wage was implemented in 1999 unemployment will only be analysed within this time period. As the graph shows, the introduction of the minimum wage did not have any significant negative effect on the rate of employment. The graph shows that since 1999 the level of unemployment has decreased proving that the Neo-classical theory of the minimum wage could be faltered. However as the national minimum wage is more likely to affect firms in the long run, as can be seen by the diagram the ages 18-24, 25-49 and 50+ seem to be at a steady constant rate of employment. Another worrying factor is the employment of teenagers aged 16 to 17, the figure shows that the unemployment rate has increased showing that the imposition of the minimum wage could have a negative effect supporting neo classical theory. An explanation of this could a rise of participants in higher education Examination of the growth of the overall employment rate would also be useful to see whether employment has increased since the administration of the minimum wage. An example of the hotel and construction industry will be used to identify any trends in the rate of employment as shown in Figure 5. Geoff Riley mentions that general workers unions most affected by the minimum wage have claimed that employment has “continued to rise… and that a series of increase in value has little or no negative effect on employment” (Riley p1). The higher rate of pay was expected to impact lower level jobs such as those in construction, catering and in hotels where employers would have to employ fewer workers to cut costs. However as the graph shows that there is a notable, steady rise in employment of these industries since 1999 instead of a downturn which classic economic theory suggests. David Metcalf suggests a critique that is derived from the lack of compliance of the minimum wage, it is clear to see from evidence that not everyone is protected by the minimum wage in the UK. This can be seen as important as any affects of unemployment in terms of the minimum wage are likely to be not measured properly and results would not be completely valid or efficient. It has been noted recently that estimates from the Annual Survey of Hours and Earnings (ASHE) show that, “the number of jobs paid below the national minimum wage in the UK was 292,000 in spring 2007”(ONS http://www.statistics.gov.uk/CCI/nugget.asp?ID=591&Pos=1&ColRank=2&Rank=1000), this amounts to 1.2% of total jobs within the Labour market. Metcalf also puts forward the idea that rather than cutting employment of workers, employers are more likely to adjust the amount of hours. So a reduction in costs can be acquired through the “extensive margin- workers or the intensive margin- hours”(Metcalf p12). Lower level occupations such as those in retail, cleaning and hospitality need workers to function and cannot be replaced by capital for instance a computer could not sell a mobile phone on its own. Therefore it would be likely for employers to cut a workers hours to reduce costs which would not harm employment. There are also laws (for example rules against unfair dismissal) regarding the dismissal of workers which could act as a constraint on employer’s wanting to downgrade their worker capacity. People who seek second jobs are usually unhappy with the insufficient rate of pay Metcalf implies that the imposition of a minimum wage will, “tend to reduce the supply of individuals willing to take second jobs” (Metcalf p12). This could have a knock on effect as it would increase the supply of jobs available and could help decrease unemployment. As the minimum wage is more likely to effect those in lower level occupations Figure 6 depicts what happens to the rate of employment in occupation sectors such as retail, hospitality ,social care, agriculture, textiles, and hairdressing. As can be seen the upper few occupations employment rates such as retail (+0.5%), Hospitality (+0.3%) and social care (+0.2%) have increased. The other sectors that have decreased are part of a declining industry but nevertheless the rate of employment has stuck to approximately 26% showing little change, further proving the theory that the minimum wage does not hinder employment. It also may link to the application of margin framework that to cut costs employers would rather cut hours than the actual labour force. Possible reasons for the minimal change in the employment rate is the depiction of models over time. The textbook neo-classical theory applies to employers adjusting in the Long run. However in the short run it is apparent that labour could be more costly for the employer to adjust due to rules about unfair dismissal and redundancy payments. These costly short run adjustments are not likely to respond immediately these changes will take place in the long run as “some firms exit the industry, others gradually downsize and potential entrants are deterred from starting new firms.” (Card & Kreuger p367) Metcalf also focuses on the actual mobility out of minimum wage employment. “For 2/5 of workers a minimum wage job in one year is a stepping stone to a higher paid one the next year” (Metcalf p24). As Metcalf suggests a large amount of the population tend to base their jobs on career prospects and the necessary experience they will have to obtain in order to access these. When looking at evidence such as that in Figure 7 it can be said that a large proportion of the population is only within minimum wage for one year and that 40% of the workers that were in work set at the minimum wage for 1 year and progressed onto a higher paid job. Even though 44% remain below or at the level of the minimum wage approximately half of the people will move on to higher paid jobs where the probability of leaving employment is low. This demonstrates a positive correlation between the wage rate and employment as if the wage rate is higher it provides more incentive for workers to stay in employment which could link to the theory of efficiency wages. According to the neo classical competitive model of labour, firms would pay workers of equal productivity the same wage which would be the market clearing price. However in a more realistic context equal productivity could get paid at different rates as firms could offer differing wages for similar jobs which does not adhere to the market clearing price. The efficiency wage theory assumes that firms will pay employees above the market clearing price explaining why the market may not clear in accordance with neo classical prediction. If firms were to pay wages above the market clearing price it could lead to a positive correlation between wage and productivity as workers would contribute and supply more effort raising their marginal product. There are four models that could explain the reluctance to reduce wages for firms one of which being the ‘Shirking’ model. This model assumes that workers are likely to shirk when marginal benefits exceed marginal costs. Therefore a payment above the market clearing price can act as an incentive to work, this resembling theories of a monopsonistic market. The labour turnover model explains that the probability of quitting a job is relative to the rate of pay. A wage above the market clearing price will therefore reduce the number of quits and labour turnover. The adverse selection model assumes that workers productivity is associated with their level of reservation wage. Higher wages could then be offered to stimulate a higher level of productivity, this coincides with Metcalf’s theory of productivity and effort. Metcalf proposes that the minimum wage could increase productivity as employees are motivated to work harder and the labour quantity per head could rise through an intensification of effort. If higher wages raise effort this will be passed on to the quantity and quality of goods and services supplied which could reduce labour turnover. Also a rise in a workers productivity could mean less time and cost will be spent on hiring new workers in terms of inductions and training. If employers were to pay more attention to work organisation and training of its existing staff then they are more likely to achieve extra output per unit of labour. Metcalf strengthens this point as if employers substitute their labour for capital then employment would be reduced, “whereas greater effort, better organisation and more investment in human capital will tend to moderate any employment effects of the minimum wage,” and this could also raise the level of employment. There are models that focus of the wage rates of individuals in groups one of which being the Gift Exchange model. As individuals tend to work within the parameters of a group effort the implication of the minimum wage could raise the intensification of effort of the group’s norm. Therefore it is probable that the imposition of the minimum wage is unlikely to reduce employment. Theories applied by card and Kreuger complement Metcalf’s line of thought. They compose a survey focused on the fast food industry between two states to provide indications on how the minimum wage may affect employment. The use of fast food restaurants in this model is very important as these conceived lower level occupations are more likely to be affected by the minimum wage and also labour and training is roughly homogenous which resembles a perfectly competitive market. They present a wide variety of alternative explanations to explain that the minimum wage will not affect unemployment. Monopsony markets, the reduction of hours rather than actual jobs and productivity in relation to wage increase are all examples of complementing ideas between Metcalf and Card and Kreuger. Card and Kreuger also look upon the effect of the minimum wage in terms of the opening of new store outlets which is not fully covered in Metcalf’s work. As an important potential effect of minimum wage is a deterrent to the opening of new business’ due to higher labour costs Card and Kreuger analyse the level of newly opened outlet restaurants(in this case Mcdonalds). Card and Kreuger then state that the results “provide no evidence that higher minimum wage rates exert a negative effect on either the net number of restaurants or the rate of new openings,”(Card & Kreuger p789) this little effect proves that of supply of jobs is not obstructed by the minimum wage. Since the introduction of the minimum wage in the UK in 1999, evidence suggests that this has little effect on employment and in some cases even caused it to increase. This does not follow the critique of a neo-classical model of labour in a perfectly competitive market that a rise in wage is likely to reduce employment. However, realistically, labour markets could resemble that of a monopsonistic market where labour is heterogenous. Here employers would have to raise the pay rate above the minimum wage in order to establish incentive to attract workers. Even though neoclassical theory suggests that the National Minimum Wage will increase direct costs in terms of an employer it could also encourage productivity and an employer would rather cut down the number of hours an employee works rather than employment itself. As there is a positive correlation between wage and productivity the level of satisfaction in a workplace will be higher and will therefore reduce the number of quitting in an industry. If employers concentrate focus on training and work organisation they could probably achieve a greater returns to investment from each worker reducing labour turn over. Therefore it can be said that contrary to neo classical models the minimum wage will probably have little or no negative impact on employment.

References:

Card, D & Kreuger, A , ‘Minimum Wages and Employmen’t: A Case Study of the Fast-Food Industry in New Jersey and Pennsylvania, The American Economic Review, Vol. 84, No. 4. (Sep., 1994), pp. 772-793.

Forth, J & O’Mahoney, M, The Impact of the National Minimum wage on Labour productivity and unit labour costs, National Institute of Economic and Social Research, January 2003

Jones,P, The Impact of Minimum Wage Legislation in Developing Countries where Coverage is Incomplete, National Institute of Economic and Social Research, December 1997

Metcalf, D, Why Has the British National Minimum Wage Had Little or No Impact on Employment? Centre for Economic Performance Discussion Paper No 781, April 2007

Ormerod, C, Labour Force Survey low pay estimates: method of dealing with second jobs, Social Economic Micro Analysis and Reporting Division, Office for National Statistics,

Stuart, M.(2006) The Impact of the introduction of the UK minimum wage on the employment probabilities of low wage workers
Sutherland, J., (2007) 'Personnel Economics '. ‘The module handbook’. Leeds Metropolitan Business School

Websites:

(http://www.businesslink.gov.uk/bdotg/action/layer?topicId=1074402393)

http://www.is4profit.com/business-advice/employment/minimum-wage-and-statutory-pay-obligations_2.html

Riley, G http://www.wdcweb.info/clydebank/documents/NMW.pdf

Office for National Statistics: http://www.statistics.gov.uk/CCI/nugget.asp?ID=1426&Pos=1&ColRank=2&Rank=896 http://www.statistics.gov.uk/CCI/nugget.asp?ID=591&Pos=1&ColRank=2&Rank=1000)

References: Stuart, M.(2006) The Impact of the introduction of the UK minimum wage on the employment probabilities of low wage workers Sutherland, J., (2007) 'Personnel Economics ' Websites: (http://www.businesslink.gov.uk/bdotg/action/layer?topicId=1074402393) http://www.statistics.gov.uk/CCI/nugget.asp?ID=591&Pos=1&ColRank=2&Rank=1000)