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

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In a closed economy a proportional relationship between changing wage costs and the changes in the price level exists. Or, to put it differently, firms are always able to defend a certain profit mark-up in the medium term (cp. Herr 2008). The profit mark-up may change, but such changes are independent of wage costs. In a market economy and in the game of price setting, firms obviously have the privilege of the last move: They can increase prices after wage costs have gone up.

Unions can only negotiate nominal wages - real wages are then the result of the market. 4 Tarling and Wilkinson (1985, p. 179) ask correctly: “Why should distributional shares change in a system where wages are determined collectively between capital and labour, where prices are determined unilaterally by capitalists and where in time sequence prices follow wages?” In principle Kalecki Implicitly monopolistic competition characterised by product differentiation, different locations and different transportation costs or oligopolistic and monopolistic markets are assumed.

„In assuming that the wage bargain determines the real wage the classical school has slipt in an illicit assumption. (…). There may exist no expedient by which labour as a whole can reduce its real wage to a given figure by making revised money bargains with the entrepreneurs.” (Keynes 1936, p. 13) GLU | The Theoretical Debate about Minimum Wages (1971) followed this argument. However, he states that large increases in wages would intimidate firms into accepting lower profit mark-ups. Here he argues with a behavioural assumption which is not credible. 5 The profit mark-up depends on a number of factors. Keynes assumed that the nominal money interest rate is a kind of external cost the enterprise is confronted with and one which determines the profit rate (cp. Keynes 1936, p. 213 and 222).

Firms can, however, achieve a profit rate above the interest rate. While one possibility is to compensate for risks, a more convincing argument is the power of the financial sector, which pushes firms to achieve higher rates of return. The increasing pressure to earn higher rates of return can be explained by the shift from stakeholder to shareholder capitalism over recent decades, including the increasing role of institutional investors, non-bank financial institutions, etc. Last but not least, monopolies and oligopolies can achieve higher mark-ups than firms in competitive markets.

In a closed economy, nominal wages can be considered the nominal anchor.

While changes to profit rates, natural resources prices, taxes, etc. may lead to changes in the price level, they can not alone create an inflationary or deflationary process. In a closed economy this is only possible if a wage-price spiral starts to turn. However, all kinds of price shocks can trigger such a wageprice spiral. The two oil-price shocks in 1973 and 1979 are instructive examples of this. Increasing oil prices led to an inflationary push. Because of decreasing real wages nominal wage demands increased and triggered an inflationary wave in most Western countries. When central banks started to fight against inflation the economies fell into stagflation and even recession.

The above analysis is modified by taking into account the world market. For smaller countries, particularly developing countries with a high import quota, external cost factors become important. If a country depreciates its currency, import prices, the domestic cost level and the price level increase, whereas real wages decrease. If depreciation triggers a wage-price spiral, a country is caught in a potentially cumulative devaluation-inflation spiral which is combined with a The argument can be made clearer by presenting Keynes’ (1930) fundamental equations of the value of money. National accounting of a closed economy gives us Y = W + Q with Y as nominal domestic income, W as the wage sum and Q as the sum of profits. Profits are equal to the value of the capital stock (P K), the price level multiplied by the real stock of capital, multiplied by the profit rate (q). We get Q = q P K. As nominal income is real income multiplied by the price level (Y = Yr P), it follows that P = W q ⋅ P ⋅ K. This equation gives us a simplified definition of the cost structures in an economy;

+ Yr Yr simplified because factors like the price of natural resources, taxes or a change in import prices are not covered. The term (W/Yr) expresses unit-labour costs, and the term (q P K /Yr) gives us the profit per unit produced. In a closed economy there is a long-run proportional relationship between increases in unit-labour costs and the price level. This is not obvious because unit-labour costs are only part of total average costs. However, an increase in unit-labour costs (W/Yr) increases the price level in the first round; in a second, the price of capital goods in (q P K /Yr) increases. The result is a proportional relationship between unit-labour costs and the price level.

GLU | The Theoretical Debate about Minimum Wages wage-price spiral. In many countries the nominal exchange rate can be considered the second nominal anchor of the price level.6 What can we learn from the above analysis for minimum wages? First of all, minimum wages can support or even create a nominal wage anchor which is one of the preconditions for the functioning of capitalist economies. More precisely, minimum wages can prevent a deflationary development in the goods market.





Goods market deflations destabilise the financial system of a country because the combination of nominal debt and falling prices increases the real debt burden and leads to mass bankruptcy and shrinking production. The Great Depression in the 1930s and the deflation in Japan that started in the mid 1990s are examples of the negative effects of deflations (cp. Fisher 1933; Heine/Herr/Kaiser 2006).

To become a nominal anchor minimum wages should increase every year & according to the wage norm. Given the target inflation rate ( PT ) the wage norm & with π as medium-term productivity increases can be stated as wN =π + PT & & & & N the desired increase in nominal wages. Statistically, productivity drops and w during recession because companies cannot immediately dismiss people, and it increases for a while during an upswing as companies use the existing stock of workers to produce more. The wage rule is the desired increase in the nominal wage level and also applies to increases in minimum wages. Thus minimum wage development should follow the medium-term trend of productivity changes plus the target inflation of the central bank. Of course, minimum wage increase above the wage norm can lead to an unwanted high inflation rate. However we have to be cautious here. The conclusions drawn from this depend on the assumption of a uniform wage rate in the economy. In the more realistic case of different wage rates average nominal wages can increase according to the wage norm and minimum wages can develop differently. In the case of a faster increasing minimum wage than given by the wage norm this would imply a change in the wage structure which benefits the low-wage earners.

Distribution effects In the Keynesian approach, changes in nominal wage levels can not ultimately change the distribution of income between wages and profits. This is the result of the fact that firms can roll over higher wage costs and, at in least in the long run, do not have to change the profit mark-up. However, a changing profit mark-up The degree of competition also depends on the openness of a country and on international competition in product markets. In this way profit mark-ups can be influenced by the world market.

For example, it is possible that higher nominal wages-costs go along with a stable exchange rate or an appreciation. The tradable sector in the economy in such a constellation is probably not able to roll over higher wages and must except lower profits, or it realises losses. In the non-tradable sector prices can and will go up. Usually such a constellation is very unfriendly for sustainable economic development. Probably an economic crises, unemployment and lower wage increase will restore the profit-mark up to the old level. A depreciation of the currency can increase the competitiveness of the tradable sector and can leave room for a higher profit-mark up. To sum up, integration into the world market can modify the relationship between wage costs and the price level in special situations;

however, in most countries wages are by far the most important anchor for the price level.

GLU | The Theoretical Debate about Minimum Wages changes labour’s share in national income. Given income distribution real wages change according to productivity development.7 The conclusion for minimum wages is that they are not a suitable instrument to change the distribution between capital and labour. Distributional changes can only be achieved by changing the profit mark-up which seemed to have increased as a result of changes in financial markets. This does not mean that distribution between capital and labour cannot be changed. It only means that minimum wages are not suitable instruments for such an aim.

Employment effects There is no direct relationship between changes in wages and changes in employment because wage costs directly influence the price level. However, there are indirect effects. As mentioned, an extremely low nominal wage increase or even nominal wage cuts lead to deflation, problems in the financial system and a loss of production and employment. Extremely high wage increases lead to inflation which sooner or later will be combated by restrictive monetary policy.

This also leads to losses in production and employment. Minimum wages can support a desirable development of nominal wages and especially help to prevent deflationary developments.

It may be helpful to show these results in a more formal way. Income equals wages plus profits (Y = W + Q). Because profit equals the profit rate multiplied by the stock of capital (Q = q P K) it follows that W/Y = 1 – (q P K/Y). Using the definition of the capital coefficient (k = P K/Y) the wage quota is W/Y = 1 - q k. Taking into account that Y = Yr P we can also write (W/N)/ (Yr P/N) = 1 - q k. Because the nominal wage rate is w = W/N and productivity is π = (Yr/N) we get the following definition of real wages: w/P = π(1 - q k).

GLU | The Theoretical Debate about Minimum Wages

2.2 Effects under the assumption of heterogeneous labour We now assume heterogeneous labour with different wage rates and analyse the economic effects of minimum wages under this condition.

Price level effects If the wage structure does not change and minimum wages increase according to the wage norm, the target inflation rate is achieved. However, the nominal wage level can increase according to the wage norm and at the same time the wage structure can change. Firstly, the wage structure can become more polarised. An example of this is the development in the United States since the 1980s. The wage level increased more or less according to the wage norm, but driving this development was a strong polarisation of wages (cp. Goldin/Katz 2007). During this period it is obvious that minimum wages in the United States were not used to prevent this polarisation. On the other hand, minimum wages can increase faster than average wages. In this case the wage structure is compressed.

Inflationary effects of minimum wages cannot be excluded from this scenario.

The most extreme case is when minimum wages become the standard to fix all other wages. For example, a semi-skilled worker would earn two times the minimum wage, a skilled worker three times the minimum wage, etc. In such a case increases in minimum wages would not change the wage structure and increases in minimum wages above the wage norm would lead to unwanted inflation. An insufficient increase in minimum wages would lead to deflation.

The above case reflects an extreme assumption which is not very realistic. More realistic, albeit also an extreme case, is a scenario in which all wages increase according to the wage norm except minimum wages which increase faster. In such a constellation the inflation rate will increase a bit faster than the target inflation rate. Firstly, industries which employ workers affected by minimum wages will increase prices more than the target inflation rate. Secondly, as long as these prices are inputs of other industries, these other industries also will increase prices.

The overall conclusion is that changes in minimum wages can affect the price level. However, except in the extreme cases of using minimum wages as the standard for other wages and very strong changes in minimum wages, price level effects of changes in minimum wages can be considered small.

Distribution effects It was argued above that changes in nominal wages are not able to change the distribution between wages and profits. However, minimum wages have distributional effects within the working class. Keynes (1936, p. 14) sees this point clearly: „In other words, the struggle about money-wages primarily affects the distribution of the aggregate real wage between different labour-groups, and not its average amount per unit of employment, which depends... on a different set of forces“. As soon as minimum wages change the structure of wages, which is the normal case, the distribution within the working class will change. An increase

GLU | The Theoretical Debate about Minimum Wages

in minimum wages that compresses the wage structure will increase the wages of low-paid workers at the expense of other workers. For other workers the products produced by workers affected by minimum wage, usually personal services, meals in restaurants, etc., will become more costly and reduce their real income.

Of course, as long as productivity is increasing the living standard of workers not affected by minimum wages must not decrease and will only increase slower than the real wages of the affected workers.

Income distribution is always a political issue as changes in the distribution will unavoidably produce winners and losers. Not all workers may like a flat wage structure, and unions that represent skilled workers may also deny their support for higher minimum wages.

Employment effects We assume here the realistic case that a change in minimum wages will modify the wage structure. In such a case the analysis of employment effects becomes more complicated when compared to a situation of a uniform wage rate. Firstly, a change in the wage structure will automatically lead to a change in relative prices (a change in the structure of prices). Secondly, it will alter the distribution of income. We will discuss one effect after the other.

Let us assume that a uniform increase in minimum wages increases wages in industries in labour incentive branches with mostly low-skilled labour, e.g. in the semi-conductor industry and in the hair-dressing industry. Wages in other industries may not be affected and do not change. As a result of higher wage costs compared to other costs the semi-conductor industry will react in two ways.

It will first search for a new profit maximising technology. Secondly, it will increase the prices of its products because with the new technology prices will be higher, otherwise the technology would have been used before. It is likely that part of the workforce in the semi-conductor industry will become unemployed.

This depends on the degree of change in technology and on the price elasticity of semi-conductors. The new technology involves the reduction of low-skilled workers and an increase of capital inputs (new machines) and/or higher input of skilled workers. How big the net loss of employment will be is difficult to say because the production of a higher capital input also increases employment in the capital-goods producing industry. However, the story is not yet finished.



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