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

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Governments should not introduce minimum wages to avoid this affect. Let us remember that in the Keynesian paradigm the employment effects were open and considered secondary. There is also another difference between the paradigms. In all of its versions the neoclassical standard model deducts that minimum wages reduce profits. Both paradigms suggest that minimum wages change the structure of prices.13 The macroeconomic version of the neoclassical model presented above is burdened with many problems. It has to make extreme assumptions to come to its conclusion. Let us start with the macroeconomic production function which is behind the demand function for labour. Firstly, constant returns to scale have to be assumed. In the case of economies of scale the sum of wages and profits determined in the model is bigger than the income determined in the same model. Economies of scale can also lead to a situation in which the demand for labour increases with increasing real wages. This would of course mean the end of the model. In the case of diseconomies of scale the wages and profit do not add up to income. Looking at the empirical situation most industries are characterised by economies of scale. Secondly, even a production function with constant returns to scale does not exist. The theoretical destruction of the macroeconomic production function started when John Robinson (1953) asked how to measure capital. The Cambridge-Cambridge debate of the 1960s revealed that, due to “reversed capital deepening“ and “re-switching”, a neoclassical labour demand function simply does not exist. The only possible “solution” to make the neoclassical macroeconomic model consistent is to assume the existence of only one capital good in the whole economy. Under this assumption capital can be aggregated in physical units. Abstractions are intended as a simplification of a complex world which can facilitate analysis. But it is unsustainable to simplify the real world of many capital goods into a world with one capital good that operates in a completely different manner, simply because economists do not like the consequences of their own model.14 Indeed, it is a disgrace that the results of the Cambridge-Cambridge debate are suppressed or simply ignored. The ideological costs of accepting that a macroeconomic production function does not exist seem too high!15 Card/Krueger (1995, p.355ff.) analyse all standard neoclassical models. In the case of heterogeneous labour, they distinguish between two or more discrete types of labour and labour with a continuum of perfect substitutes. In all versions unemployment increases and profits decrease after the introduction of minimum wages.

After Sraffa‘s (1960) publication neoclassical economists tried to prove that the “simple parables” based on a macroeconomic production function could also be told in a world with more than one capital good. The attempt failed (for an overview of the debate cp. Harcourt/Laing (1971).

What is left from the neoclassical model if there are many capital goods? Neoclassical economists must build their models on the basis of the General Equilibrium Model. Although this model is consistent it is not able to come to strong macroeconomic conclusions (cp. Bliss 1975; Hahn 1981). For example, in a situation of disequilibrium with unemployment the model cannot recommend that a reduction in real wages is the way to full employment.

GLU | The Theoretical Debate about Minimum Wages

Of course, the neoclassical paradigm can be criticised from a Keynesian point of view. It can be argued, among other points, that nominal and not real wages are negotiated. Most people in capitalist societies believe that money is important.

Neoclassical economists tell them that they are wrong and that in the end, money is unimportant. In Keynesian thinking employment is determined first of all by aggregate demand which determines production and employment. It seems to be far from real world development that output is always supply-determined and never depends on demand. And last but not least, a partial analysis which cuts away the labour market from the rest of the economy seems to be insufficient from a methodological point of view.

3.2 Exceptional Cases in the Neoclassical Model In the debate about minimum wages several so-called exceptional cases which are based on the neoclassical labour market model have become prominent. The most famous one and widely discussed is the so-called monopsony. 16 In a monopsony a firm is confronted by perfect competition in the market of the product it produces. The output price is given. However, the firm has an influence on input prices since it is the only buyer in the market. More precisely, the firm is confronted with the usual neoclassical aggregate supply function of labour. The higher the wage the firm offers, the higher the supply of labour. In the standard model, the price for wages would be given for the firm and it could employ as many workers it wants for the market price, however, it would not be able to change the price of labour. We denote that the case of monopsony is to some extent similar to a monopoly whereby a single seller has the power to set the prices of products which are demanded by many buyers by limiting the quantity of output it intends to produce. In the situation of monopsony, the one buyer can reduce the price of labour by decreasing the quantity it demands. According to Pigou (1924) the exploitation of workers is a state in which the workers are paid less than the value of their marginal product in the company they work for and this is exactly the situation a monopsony can create. A monopsony can exist in a region with only one employer in combination with a limited mobility of the regional workforce. The latter can exist because of transaction costs (costs to drive with the car to the next city, costs to move to the next city, etc.), lack of information or other market imperfections. Even small firms can be in a monopsony constellation when market imperfections lead to a situation in which a firm is confronted with a labour supply function that increases with increasing wages. A typical example is a company-town with only one employer (e.g. mining company) that employs almost everyone in the town and faces an upward-sloped curve of the labour supply, i.e. it will have to offer a higher wage for all workers to increase employment.





The monopsony model is presented in Diagram 4. The labour supply function the firm is confronted with increases with increasing wages. Given fixed costs the The monopsony case was first discussed by Stigler (1946), also compare the debate in Card/Krueger (1995).

GLU | The Theoretical Debate about Minimum Wages total cost function without minimum wages reflects the shape of the labour supply function. The total revenue function is a straight line as the price of the produced product is given. A profit maximising firm will look for the output where the difference between total revenue minus total costs is biggest. In the diagram this is shown by the lower equilibrium A. Now let us introduce minimum wages. In this case the total cost curve is a straight line until the employment reaches the level from which the firm has to pay more to get additional workers.

From this point onwards the total cost curve is again determined by the labour supply function. In the diagram a minimum wage is chosen which maximises employment and at the same time destroys all extra profits of the firm.17 The old level of employment would produce a loss as total costs are higher than total revenue. To maximise profits, to earn at least normal profits, the firm must and will increase its employment until output B.

–  –  –

By setting an official minimum wage, a government limits the “exploitation” power of employers, obliging them to pay a higher wage. According to this model, the optimal level of minimum wage, i.e. the wage level which allows the maximum positive employment effect, is the one which would be paid under perfect competition. Such a minimum wage would completely destroy the monopsonist’s power. This would also be the level at which the real wage equals the marginal product of labour. In Diagram 4 this would be the wage leading to Normal profits are included in costs.

GLU | The Theoretical Debate about Minimum Wages output B. If the minimum wage is higher than the optimal level, the profit maximising firm will reduce employment again.

Many economists who argue that minimum wage increases will not lead to unemployment and that, on the contrary, moderate minimum wage increases can even increase employment use the monopsony model. It offers the possibility of harmonising empirical findings of the absence of negative employment effects of minimum wages with arguments based on the neoclassical model. There is no doubt that the monopsony case can be found in reality, typically in the sector of small- and medium-sized businesses, for example restaurants, craftsmen, laundries, etc. The monopsony model can also be used for certain industries.

However, the model lacks a macroeconomic dimension and, like all neoclassical models of the labour market, is but a partial model and explains output completely by supply-side factors. We accept the fact that monopsony can exist under specific circumstances and can be used as an argument in favour of minimum wages. However, we believe that the case of monopsony is theoretically as well as empirically of limited importance.

There are two other approaches which can explain increasing employment of minimum wages within the neoclassical paradigm (cp. Hagen 2008). The first one argues that the intensity of searching for a new job by unemployed people depends on the wage they expect to earn. Thus, higher minimum wages can stimulate research activities of the low-paid workers and reduce unemployment.

If this effect is bigger than the usual negative effect of higher minimum wages, employment can increase.18 The second argument is based on training and other costs which are unavoidable when new workers are taken on board. Because it is assumed that better paid workers do not leave the job as frequently as very low paid workers, minimum wages may reduce overall costs and lead to higher employment. Compared to the monopsony case these arguments are even less plausible as a basis for analysis of the effects of changes in minimum wages.

There is one additional case which is not discussed in the literature and which is also compatible with the neoclassical macroeconomic labour market model. The “normal” shape of the supply curve of labour is not deduced from a strict microeconomic analysis. From a microeconomic foundation many different types of macroeconomic supply functions of labour are possible (cp. Bliss 1975). When real wages become very low, any further reduction in real wages typically increases the supply of labour as people have to work more to survive. Historically, this phenomenon was demonstrated during the industrial revolution (cp. Engels 1845). In today’s developing and even developed countries we also see this phenomenon as people with low income need two or three jobs to meet their subsistence needs (cp. Shipler 2004). At very high real wage rates labour supply for utility maximising households can decrease as the opportunity cost of leisure increases. Deducted on the basis of the neoclassical paradigm a more complicated supply function of labour can lead to several equilibrium This argument was used by the German Counsel of Economic Advisers in its report in 2006 (cp.

Hagen 2008).

GLU | The Theoretical Debate about Minimum Wages combinations between real wages and employment. Such a case is shown in Diagram 5.

–  –  –

The existence of a more-than-one-equilibrium is well known from the General Equilibrium Model and leads to path-dependence of economic development. On purely theoretical grounds, it is not possible to say which equilibrium is optimal, given that utility comparisons between different individuals are not possible, and therefore it is not possible to develop a macroeconomic utility function. However, politically and socially it is arguable that a situation of very low real wages in combination with very long working hours is not preferable for a society.

Minimum wages, for example, are therefore one available tool which helps to avoid undesirable equilibriums with very low real wages and long working hours (wr1 with employment N3). In addition, it is questionable whether labour supply depends on real wages. On the contrary, labour markets are institutionally highly regulated, representing socially accepted norms of working times.

GLU | The Theoretical Debate about Minimum Wages

4. CONCLUSIONS 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. In the case of homogenous labour, minimum wages above the market-clearing wage lead to unemployment. In the case of heterogeneous labour, minimum wages above the market-clearing wage for low-skilled workers will create unemployment for low-skilled workers. These iron laws of neoclassical thinking came under discussion after negative employment effects of minimum wage increases in empirical studies were difficult to find. The monopsony case known for a long time but considered a contradictory and completely unimportant case – was a way out of the dilemma. A monopsony has the monopolistic power to push real wages of workers below the equilibrium wage in a competitive labour market. It can do this as workers depend on jobs provided by the monopsony due to regional immobility and transaction costs. The monopsony reduces output and labour demand, pushes wages below the equilibrium wage level under pure competition and in this way can achieve a monopolistic profit. This leaves room for wage policy to increase minimum wages to a level that prevents the monopsony from exploiting its demand power.

However, if minimum wages are increased further unemployment will be the result. We accept the existence of monopsonies, especially in the sector of smalland medium sized enterprises. However, the monopsony approach seems to lack sufficient relevance to draw general macroeconomic conclusions and explain why empirical findings do not support the neoclassical standard model.

An alternative to the neoclassical approach is given by the Keynesian paradigm.

Here a minimum wage policy has two important functions.

First: In this paradigm nominal wages become the nominal anchor for the price level.19 Desirable nominal wage increases in this approach are equal to the trend productivity increase plus the target inflation rate of the central bank. If nominal wages increase according to this norm, wage inflation is identical to the target inflation rate. This makes the central bank happy as it does not have to fight against both inflation and deflation. The problem of deflation is not a historical phenomenon of the 1930s. In Japan after the end of the stock market and real estate market bubble in the early 1990s, wages started to decrease and deflation came back. Germany is another example where, after the start of the European Monetary Union in 1999 nominal wage increases were much too low and the country was in danger of following Japan. After the start of the subprime financial The second important nominal anchor especially in small open countries and developing countries is the nominal exchange rate.

GLU | The Theoretical Debate about Minimum Wages

crisis in 2007 and its escalation in 2008, the resulting sharp recession in many countries around the world may trigger insufficient wage increases and even falling nominal wages. After three decades of dominant neoclassical thinking and neoliberal policies, labour market institutions in many countries and wage negotiation mechanisms have eroded and weakened the nominal wage anchor.



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