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Semi-conductors are inputs of many other industries which, according to their technology, are affected differently by a price increase of semi-conductors. All of the affected industries will now also switch to a new technology because the price relation of their inputs has changed. They will probably shift to a more labour intensive industry, as for them, capital inputs became more costly. And the story goes on and on. All industries which use semi-conductors will change their prices and their composition of inputs and many more industries will be affected and will change their technology, their input demand and their prices. In the end the complete structure of prices, the composition of inputs and the structure of output will have changed in the economy and it is simply not possible to find out GLU | The Theoretical Debate about Minimum Wages whether the economy will now employ less or more labour. Employment of all types of labour may have increased or decreased.8 Even in more simple cases the prediction of employment effects is difficult to figure out. Let us take the hair-dressing industry and assume that a change in technology is not possible and the output of the industry is not an input of other industries. In this case an increase in minimum wages increases the price of hairdressing services according to the increase in wage costs. Given the price elasticity of demand of hair-dressing services we can calculate how many hairdressers will lose their jobs. However, in this case, too, the story is not over.

The wage sum in the hairdressing industry may increase or decrease. This depends on the price elasticity of hair-dressing services. If the wage sum increases the employed hairdressers create additional demand. Let us assume they go to fitness studios which in this case experience a higher demand and probably employ unemployed hairdressers. However, we have to take into account that an increase in the wage sum in the hairdressing industry reduces the purchasing power of other consumers which now have to pay more for hairdressing services. If the wage sum in the hairdressing industry shrinks, consumers spend more of their income for other goods. Which industry in the end will be affected and how employment in the economy will change in this simpler case, is difficult to predict.

To summarise this point: Minimum wages will change the structure or wages, the structure of prices, the structure of demand for final products and the structure of demand for inputs. How employment is affected is theoretically open and extremely difficult to predict empirically.

Let us come to the second point, the change in distribution. An increase in minimum wages will lead to a change in distribution because low-income earners will benefit most from minimum wage increases. It is also very likely that lowincome households will benefit from higher minimum wages. Because lowincome households have a higher propensity to consume than high-income households, an increase in minimum wages will most likely increase aggregate demand. In a situation of unused capacities and unemployment this will increase output and production.9 This argument adheres to the tradition of Sraffa (1960) and the so-called Cambridge-Cambridge debate.

Already Keynes (1936, p. 321ff.) recommended a more equal income distribution to strengthen aggregate demand.

GLU | The Theoretical Debate about Minimum Wages

–  –  –

Increases in minimum wages change income distribution. First of all higher minimum wages will increase the incomes of workers affected by increasing wages. As far as single households are concerned this may directly push the household above the poverty line. Indirectly, minimum wages also influence the income of bigger households if members of these households benefit from minimum wage increases. If it can be expected that low-income jobs will be destroyed by higher minimum wages this can negatively affect poverty. Overall, the minimum wage must be judged as an important instrument in the fight against poverty. However, it has its limitations because not all poor people work in the formal economy and some of the poor do not work at all (children, old people etc.) (cp. Card/Krueger 1995, p. 305ff.).

GLU | The Theoretical Debate about Minimum Wages

2. 3 What can we learn?

The good news for a policy of minimum wages: Increases in minimum wages do not have systematic employment effects, neither positive, nor negative ones.

Empirically, it also seems extremely difficult to determine whether an increase in minimum wages increases employment or not. However, in the Keynesian paradigm the main driver of employment is aggregate demand. Changes in the structure of relative prices and the resulting change in the allocation of employment and other input factors is of secondary importance for employment.

This also means that Keynesian economists do not recommend changes in the wage structure for the purpose of reducing unemployment. They recommend higher demand, especially investment demand, to fight unemployment. If GDP growth is limited, not possible or not wanted, a reduction of working hours in all its different forms is the only solution left to fight unemployment. Inflationary pressures from minimum wages are usually small and tolerable. There also is no relevant limitation for minimum wage policy.

The bad news for a minimum wage policy: Minimum wages change the wage structure and at the same time the distribution within the working class. This fact makes it a political issue, for the union movement and whole society. Different countries can find different solutions and it is difficult to give a good theoretical answer as to which distribution is the best.


• Firstly, minimum wages should be set at a level which affects a sufficient number of workers. Otherwise it has only symbolic meaning.

• Secondly, in the long run minimum wages should increase at least according to the wage norm. This means that the increase should follow the target inflation rate plus the trend productivity of the economy.

Under this condition minimum wages help to prevent a deflationary development. If the wage level in the economy increases faster than given by the wage norm, minimum wages should increase according to average wages to prevent the wage structure from becoming wider.

• Thirdly, minimum wages can be used to change the wage structure with its distributional effects. If the wage structure should be compressed (the intention is for low-income earners to be privileged) minimum wages should increase faster than average wages until the desired wage structure is reached.

GLU | The Theoretical Debate about Minimum Wages



Firstly, we illustrate the effects of minimum wages according to the standard model. Exceptional cases are discussed in the second subsection.

model 3.1 Effects under the assumption of the standard model For the neoclassical model a dichotomy between the real and monetary spheres is of key importance.

In the long run the monetary sphere does not influence variables like growth, employment or income distribution. Money is neutral and only determines the price level; it is a veil which covers the real sphere. The labour market belongs to the real sphere. It is a market like the market for apples or shoelaces. Thus it is assumed that the labour market can find its equilibrium if the price of labour – the real wage rate – is flexible. Hence, unemployment is always a problem of the labour market and never a problem of a lack of demand. With the absence of market distortions like asymmetric information or transaction costs, the labour market will lead to full employment.10

This model is based on several assumptions:

• Firstly, workers are perfectly informed about the wages in all the firms and are perfectly mobile so they can choose where to offer their labour (no transaction costs).

• Secondly, as mentioned before, the labour market functions in the same way as any other market,

• Thirdly, nominal wage change leads to real wage change,

• Fourthly, there is perfect substitutability between labour and capital.

In the neoclassical world workers and employers negotiate the real wage rate;

that means the basket of goods and services workers earn. Effectively, the neoclassical world is a barter economy – workers exchange a certain quantity of goods against a certain quantity of time they have to work. Of course neoclassical economists know that in the real world only money wages are determined. But they believe that changes in money wages will lead to changes in real wages.

Following the quantity theory of money the price level is given by the quantity of money, whereby the latter is exogenously determined by the central bank.11 Following the neoclassical approach the central bank is responsible for inflation and deflation and the labour market for employment or unemployment.

We start with the assumption of homogenous labour and the assumption of perfect competition. Perfect competition means that the output price and all input prices for firms are given. Diagram 2 shows such a market under the condition of perfect competition. Labour demand and labour supply depend on real wages (wr). Flexible real wages lead to an equilibrium wage rate wr* and an For a detailed explanation of the neoclassical paradigm cp. Heine/Herr (2003).

The quantity theory of money has a long tradition. For modern versions of the quantity theory cp.

Irving Fisher, Milton Friedman (Monetarism I) or Robert Lucas (Monetarism II).

GLU | The Theoretical Debate about Minimum Wages equilibrium employment N*. This model is based on the works of John Bates Clark (1899) which became the mainstream thinking at the beginning of the 20th century, enduring until today.

The basis for explaining labour demand in the neoclassical paradigm is the socalled macroeconomic production function. For a single firm it is trivial to say that the physical output depends on physical inputs including labour. The current key argument is that any additional unit of labour employed will reduce the additional unit of output. Thus, firms can only employ more workers if real wages decrease.12 Usually a labour supply function is assumed which shows an increase in labour supply when real wages increase. The explanation is that higher real wages lead to higher consumption opportunities and stimulates utility maximising households to sacrifice some leisure time to work and consume more.

Labour Diagram 2: The Neoclassical Standard Model with Homogeneous La bour Let us assume a very simple production process, for example picking apples from small apple trees and selling them. To carry out the production process only trees as capital goods (K) and labour (N) is used. Capital is calculated in number of trees, labour in number of working hours. Output (Yr) is calculated in number of apples. Apples can be consumed or used as seeds to increase the number of trees and produce more apples. Put in an equation, output is a function of the two inputs, that means Yr = f (K, N). It is assumed that an ever-increasing labour input per unit capital reduces the marginal product of labour. Given a fixed labour input an increase of the number of trees reduces the marginal product of capital. The price of labour is the wage per hour; the price for capital is the interest rate. It can be shown that under the conditions of perfect competition a firm maximises profits if the real wage rate is identical with the marginal product of labour and the interest rate identical with the marginal product of capital. If P is the price for 100 apples and also the price for one apple tree, w the nominal wage rate and i the interest rate, then the profit Z of a firm is defined as: Z = PYr – wN – iPK.

Using the production function Yr = f(K,N) we get Z = Pf (K, N) – wN – iPK. A firm maximises its profit if labour input (N) is adjusted to the point when dYr/dN = w/P, the marginal product of labour is identical with the real wage rate, and capital input (K) is adjusted to the point dYr/dK = i, the marginal product of capital is identical with the interest rate. Thus a profit maximising firm will increase labour demand when real wages decrease, and it will increase demand for capital if the interest rates goes down.

GLU | The Theoretical Debate about Minimum Wages

Minimum wages which would have to be defined as minimum real wages have no place in this model. If they are below the equilibrium wage rate they are ineffective as the market wage is higher. If they are above the market wage they are dangerous because they create unemployment. In Diagram 2 a minimum wage above the market equilibrium rate is shown. The outcome of this minimum wage is unemployment. At the minimum wage level firms’ labour demand is N1, households’ labour supply is N2 and unemployment is N2 - N1. In conclusion, if there is an increase of minimum wages above the market clearance wage rate, the firms will make workers redundant.

In many markets we find oligopolistic and monopolistic markets. In these cases if we assume that firms have the price setting power for their own product and if at the same time input prices for them are given, minimum wages will have the same negative effects as under perfect competition.

Let us come to the case of heterogeneous labour. In Diagram 3 two labour market segments are shown, one with skilled workers and one with unskilled workers.

Both segments have labour demand and labour supply functions similar to the case of homogenous labour. Without minimum wages both of these labour market segments are in equilibrium and the economy is in a state of full employment. Equilibrium wages in the market of skilled workers (wr*) are higher than in the market of unskilled workers (wr**) reflecting the lower (marginal) productivity of unskilled workers. If minimum wages are introduced to increase the wages of unskilled workers and to depress the wage structure, unemployment is created. In Diagram 3, unemployment of unskilled workers jumps from zero to N2 – N1.

–  –  –

GLU | The Theoretical Debate about Minimum Wages To summarise, the standard neoclassical model comes to the clear conclusion that increasing minimum wages reduce employment and increase unemployment. This is based on deep neoclassical thinking that supply-side conditions determine employment and output. The conclusion is clear.

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