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«THE THEORETICAL DEBATE ABOUT MINIMUM WAGES HANSJÖRG HERR MILKA KAZANDZISKA SILKE MAHNKOPF-PRAPROTNIK ISSN 1866-0541 ...»

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GLOBAL LABOUR UNIVERSITY WORKING PAPERS

PAPER NO. 6, FEB 2009

THE THEORETICAL DEBATE

ABOUT MINIMUM WAGES

HANSJÖRG HERR

MILKA KAZANDZISKA

SILKE MAHNKOPF-PRAPROTNIK ISSN 1866-0541

www.global-labour-university.org

Prof. Dr. Hansjörg Herr teaches Economics at the Berlin School of Economics.

He works in the field of Financial Globalisation, Development Economics and European Integration. He teaches in the Global Labour University Master’s Programme, Labour Policies and Globalisation, at the Berlin School of Economics and is member of the Academic Board. He also is a member of the editorial board of the Global Labour University Working Papers.

Milka Kazandziska studied International Economics (M.A.) at the Berlin School of Economics. She teaches Economics at the Berlin School of Economics and is Ph.D.

candidate. She specialises in Economics and Labour Markets with a focus on European Integration.

Silke Mahnkopf- Praprotnik studied International Economics (M.A.) at the Berlin MahnkopfSchool of Economics. She teaches Economics at the Berlin School of Economics.

She specialises in Economics and the German Labour Market.

Editorial Board Sharit K. Bhowmik (Tata Institute of Social Sciences, India) Hansjörg Herr (Berlin School of Economics, Germany) Frank Hoffer (International Labour Organisation) Mariano Laplane (University of Campinas, Brazil) Seeraj Mohamed (University of the Witwatersrand, South Africa) Helen Schwenken (University of Kassel, Germany) Add Contact Add ress Fachhochschule für Wirtschaft Berlin IMB - Prof. Hansjörg Herr Badensche Str. 50-51 D-10825 Berlin Contact: glu.workingpapers@uni-kassel.de Layout: Harald Kröck Global Labour University Working papers ISSN: 1866-0541 © Global Labour University e.V. All rights reserved.

The material in this publication may not be reproduced, stored or transmitted without the prior permission of the copyright holder. Short extracts may be quoted, provided the source is fully acknowledged. The views expressed in this publication are not necessarily the ones of the Global Labour University or of the organisation for which the author works.

First published 02/2009

ABSTRACT

Over the past several decades minimum wages have steadily gained importance.

In many cases this reflects the weakness of unions which have been unable to prevent very low wages compared to the national average wage in some segments of the labour market. Changes in minimum wages can affect employment, income distribution and price level. Empirical investigations in a large number of countries and historical periods show that there is no clear relationship between minimum wages and unemployment. However, there is a broad consensus that minimum wages change income distribution in favour of low-paid workers. Price level effects of minimum wages have not been in the centre of the empirical research.

In principle, for the neoclassical paradigm minimum wages have negative employment effects. These iron law of neoclassical thinking came under discussion after negative employment effects of minimum wage increases in empirical studies were difficult to find. The monopsony case was a way out of the dilemma. However, it seems to lack sufficient relevance to draw general macroeconomic conclusions.

In the Keynesian paradigm nominal wages become the nominal anchor for the price level. Minimum wages compress the wage structure and lead to a change in income distribution first of all within wage earners. Minimum wage policy should be in line with the following principles: a) Minimum wages must affect a sufficient number of employees, b) they should be adjusted frequently, c) they should increase at least according to trend productivity growth plus the target inflation rate of the central bank, d) they should increase at least in line with average wages because this is the only possibility to prevent an increase in the wage gap.

As long as low wages are considered to be too low in comparison to average wages, minimum wages should increase faster than average wages. In a Keynesian perspective no relevant positive or negative employment effects resulting from changes in minimum wages can be expected.

Debate The Theoretical Debate about Minimum Wages

–  –  –

We are grateful for the financial support granted by the Global Labour University and the EU ASIA Link Programme. For his valuable comments we thank Patrick Belser.

GLU | The Theoretical Debate about Minimum Wages

TABLE OF CONTENTS

1. INTRODUCTION

2. ECONOMIC EFFECTS OF MINIMUM WAGES IN THE KEYNESIAN

PARADIGM

2. 1 Effects under the assumption of homogenous labour

2.2 Effects under the assumption of heterogeneous labour.................. 10 2. 3 What can we learn?

3. ECONOMIC EFFECTS OF MINIMUM WAGES IN THE NEOCLASSICAL

PARADIGM

3.1 Effects under the assumption of the standard model

3.2 Exceptional Cases in the Neoclassical Model

4. CONCLUSIONS





5. REFERENCES

TABLES & DIAGRAMS

Table 1: Empirical Studies of Effects of Minimum Wage Increases..............3 Diagram 1: Employment Effects of Minimum Wages in the

Keynesian Paradigm

Diagram 2: The Neoclassical Standard Model with Homogeneous

Labour

Diagram 3: The Neoclassical Standard Model with Heterogeneous

Labour

Diagram 4: Minimum Wages in the Case of a Monopsony

Diagram 5: The Neoclassical Model with a more Complicated

Labour Supply Function

II GLU | The Theoretical Debate about Minimum Wages

1. INTRODUCTION Minimum wages were first introduced in the early 19th century. Currently about 90 per cent of all countries have statutory minimum wages. However, minimum wages can be set in different ways and can have fundamentally different roles in different countries. They can be set on an hourly or monthly basis for all employees. But minimum wages can also be differentiated according to industry, profession, age, region, etc. They can be set by governments and through the collective bargaining process if the negotiated wages are declared binding for all firms in an industry. They can be set autonomously by the government with or without consultation with trade unions and employers’ associations or automatically following a certain rule of law. While in some instances they may have only a symbolic meaning if they are unrealistically low, they also can be effective and important for a substantial number of employees. Last but not least,

unions may be in favour of minimum wages or against their introduction. In short:

minimum wages must ultimately be judged as part of general labour market institutions which reflect a country’s specific developments and constellations.

Over the past several decades minimum wages have steadily gained importance.

In many cases this reflects the weakness of unions which have been unable to prevent very low wages compared to the national average wage in some segments of the labour market. To a certain extent minimum wages became a substitute for efficient wage bargaining between trade unions and employers’ associations. Germany is a good example for the need to implement minimum wages in some German industries in regions where union density is too low and employers’ associations represent so few firms that wage bargaining is incapable of creating a general level for wages. Some Social Democratic parties which rule in countries with weak unions and very flexible labour markets have been using minimum wages to include a social dimension to their otherwise rather neoliberal policies. Great Britain under Tony Blair is a good example for this case as well as Bill Clinton in the 1990s in the United States. However, there are also countries with more or less symbolic minimum wages because statutory wages are too low to affect a relevant number of employees. For this case Spain is a good example.

Minimum wages constitute a theoretical and political issue in both developing and developed countries. In both groups statutory minimum wages cover the formal sector of the economy; that means the sector in which statutory provisions are at least more or less followed. In both groups of countries an informal sector exists which is beyond the direct reach of statutory provisions. Typically, in developing countries the informal sector is much bigger than the formal sector.

However, minimum wages may also influence wages in the informal sector indirectly.

In this paper we focus on the theoretical economic debate concerning minimum wages. As always in such debates different economic paradigms will come to different conclusions, whereas all paradigms present empirical studies that support their own view. In theoretical debates the neoclassical paradigm

GLU | The Theoretical Debate about Minimum Wages

dominates the stage in almost all countries around the world and its conclusions often seem “natural”, a “common sense” example. This reflects the length of time this paradigm has dominated and how underrepresented other approaches are. It is important for us to show that from a theoretical point of view the neoclassical model is not plausible. In the end it is the struggle between different economic ideas which determine what young economists think, what policy makers believe in and which ideas the majority of people follow.1 Minimum wages can affect income distribution, poverty, inflation and employment. There is a huge body of empirical studies about the effects of minimum wages, the majority of them being dedicated to exploring the effects on employment. Of special importance is the research about employment effects in fast food restaurants in the United States done by Card and Krueger in 1994.

Before their research the dominating view was the one supporting the neoclassical paradigm that minimum wages have negative employment effects (Bazen/Martin 1991; Neumark/Wascher 1992). However, Card and Krueger (1994) found a positive link between minimum wage increases and employment. Their study paved the way for intensive theoretical and empirical debates about the effects of minimum wages. Even the followers of the neoclassical view found for some extraordinary cases (monopsony, see below) a positive impact of minimum wage increases on employment.

As always in a debate between different theoretical approaches, the empirical results are mixed depending on the theory used as a basis for the research. The overall result of the empirical literature is that in many cases a minimum wage increase causes a drop in employment only among certain groups of employees (teenagers, young adults, low-skilled). A negative employment effect on the teenage population or young adults was found for example in Van Soest (1994), Deere et al. (1995), Maloney (1995), Bazen / Marimotou (1997), Burkhauser et al.

(1997), Abowd et al. (1997), Baker et al. (1997). General positive employment effects of increases in minimum wages were detected, for example, by Card/Krüger (1994) und (1995), Machin/Manning (1994), König/Möller (2007).

Many studies have found insignificant or no employment effects after the increase in minimum wages, for example Card (1992), Benhayoun (1994), Card/Krüger (1995, 1998 and 2000), Bell (1995), Lang/Kahn (1998), Dolado et al.

(1996 and 2000), Steward (2004), Dickens /Draca (2005) and Draca et al. (2006).

Again, other studies support the neoclassical belief that increases in minimum wages lead to negative employment effects, for example Bazen/Martin (1991), Currie/Fallick (1996), Chapple (1997), Orazem/Mattila (1998), Burghauser et al.

(2000), Neumark/Wascher (2000), Machin/Wilson (2004). Obviously, there is no clear and no quantitatively relevant relationship between minimum wage development and employment.

„For in the field of economic and political philosophy there are not many who are influenced by new theories after they are twenty-five or thirty years of age, so that the ideas which civil servants and politicians and even agitators apply to current events are not likely to be the newest. But, sooner or later, it is ideas, not vested interests, which are dangerous for good and evil.“ (Keynes 1936, p. 283f.) GLU | The Theoretical Debate about Minimum Wages

–  –  –

GLU | The Theoretical Debate about Minimum Wages There is also literature on the distribution effects of minimum wages. Nearly all empirical studies found that higher minimum wages compress the wage structure and change the income distribution. Low-paid and low-skilled and especially women benefit from minimum wage increases. To a certain extent minimum wage increases can reduce poverty, cp. for example Dickens et al.

(1994b), Card/Krüger (1995), Bernstein et al. (1995), Sutherland (1995), Gosling (1996), Burkhauser et al. (1996), Neumark/Wascher (1997), Dolado et al. (2000), Machin/Wilson (2004), König/Möller (2007).

Empirical research has not come to a clear and definitive conclusion about the effects of minimum wages. At the same time the theoretical debate is mainly based on neoclassical thinking. In most cases a macroeconomic approach is missing. This state of affairs motivated us to write this paper. In Section 2 we discuss the Keynesian approach to minimum wages. Section 3 is reserved for the analysis of the neoclassical approach and their consequence for minimum wages.2 Firstly, minimum wages in both paradigms are discussed under the assumption of homogenous labour with only one wage rate for the whole economy. This is an oversimplification, but it allows us to illustrate the fundamental differences between the different approaches. In the part that follows thereafter, minimum wages are then introduced under the assumption of heterogeneous labour and different wage rates.

There is a different version of the neoclassical and the Keynesian paradigm. For the neoclassical paradigm we take the macroeconomic model which dominates the theoretical and political debate.

For the Keynesian paradigm we base our analysis on Keynes (1930 and 1936).

GLU | The Theoretical Debate about Minimum Wages

2. ECONOMIC EFFECTS OF MINIMUM WAGES IN

THE KEYNESIAN PARADIGM

2. 1 Effects under the assumption of homogenous labour We start with the analysis of price level effects of minimum wages and continue with the analyses of distribution and employment effects.

Price level effects The basic Keynesian idea is that in a closed economy costs determine the price level in equilibrium. The model assumes mark-up pricing and the power of enterprises to increase prices. If costs decrease it is assumed that competition will lead to falling prices.3 This means the assumption of a direct price-price effect when wage costs (and other costs) change. Thus Keynes did not subscribe to the idea that in a situation of low capacity utilisation higher nominal wages lead to higher real demand and higher production. A direct price-price effect reflects, as mentioned, equilibrium conditions. The dynamic process after a cost shock is more complicated, needs some time and depends on the historical circumstances.

Cost increases and cost decreases seem to follow a different typical adjustment path. If all firms in an industry are confronted with higher costs, all have an incentive to increase prices and will do so, at least in a closed economy. Good examples of this mechanism are higher oil prices or an increase in value-added tax. When wage costs increase, higher costs will also be rolled over. If costs decrease, firms will cut prices. However, the process of falling prices typically requires a longer period of time. Even in a situation of shrinking demand and production increasing costs lead to inflation. This is called stagflation. Good examples of stagflation are the 1970s and the period after 2007, as both periods suffered from the combination of increasing prices of natural resources, inflation and economic stagnation.



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