FRBSF Economic Letter
96-29; October 11, 1996
The Minimum Wage
August 20, 1996, President Clinton signed a bill passed by Congress that
raises the federal hourly minimum wage from $4.25 to $5.15; this is scheduled
to occur through increases of 50 in October 1996 and 40 in September 1997.
Leading up to this increase has been a heated debate within the economics
profession over the past several years regarding the employment and other
economic effects of the minimum wage. This debate has focused largely
on work by David Card and Alan Krueger of Princeton University (1995).
Card and Krueger (henceforth CK) argue that economists' traditional interpretation
of the minimum wage--based on downward-sloping demand curves and consequent
employment reductions--may be mistaken, and they cite quasi-experimental
studies to support this and related controversial claims. Their ideas
have generated substantial resistance from others in the profession. In
this Economic Letter, I discuss the empirical and theoretical
issues surrounding this debate, and also the likely effects of the new
minimum wage.
One of the basic tenets of economics is that, with very limited exceptions,
demand curves slope downwards--i.e., a decrease in the price of a commodity
leads to an increase in the total quantity that market participants wish
to purchase. For many years, there has been no clear reason to disbelieve
the applicability of this "law" to the low-wage market, where
the "commodity" (unskilled workers) is presumed to be relatively
undifferentiated and the corresponding product market is highly competitive.
Consistent with this view, much of the early evidence on the employment
effects of minimum wage increases produced the expected negative effect
on employment (albeit a small one). However, this evidence was based primarily
on time-series regressions of aggregate U.S. employment outcomes on federal
minimum wage changes; given problematic features of these data, it is
surprising that any consistent effect was isolated.
In their book, CK summarize a variety of studies that update this work
using alternative methodologies and that fail to confirm the conventional
wisdom on the subject. CK base their arguments on two key sets of studies.
One set uses published government figures and public use data sources
such as the Current Population Survey (the federal government's monthly
demographic and employment survey) and focus on individuals for whom the
minimum wage is most important (teenagers and low-wage adults). The other
set uses specialized surveys of fast-food restaurants in New Jersey and
Pennsylvania in one case, and Texas in another.
A key difficulty in devising a "quasi-experiment" to assess
the effect of the minimum wage on employment is finding a control group
that is relatively unaffected by the minimum wage, for which employment
growth provides a suitable baseline for comparison. The CK studies do
this in several different ways. For example, they compare employment outcomes
for low-wage workers in states that increased their minimum wage (such
as New Jersey in 1992 and California in 1988) to outcomes for comparable
workers in other states that did not change their minimum wage. Alternatively,
CK identify the effect of the 1990-1991 nationwide increase in the minimum
wage by comparing its employment impact across states that vary in their
share of affected workers, or by comparing the effects of the minimum
wage across high-wage and low-wage establishments (which are differentially
affected by the minimum wage increase). CK make these comparisons over
a short period (1-3 years in general).
Using a variety of such experiments, CK find that the minimum wage increased
wages earned by affected groups, which provides partial validation of
their quasi-experimental design. However, they find no evidence that minimum
wages reduce employment, and they even find evidence suggesting employment
increases. In addition to evidence for the U.S. states, they cite similar
results for Puerto Rico--a locale where the minimum wage is binding for
a large portion of the labor force--and several foreign countries. In
further analysis of U.S. data, CK also find essentially no effects of
minimum wage increases on firms' stock prices, and they find that minimum
wages slightly reduce inequality and poverty in family earnings.
Critics have pointed to a number of potential problems with CK's data
and quasi-experimental design. For example, various researchers have expressed
reservations about the comparison group being used, whether the estimated
effects are biased by employer anticipation of the minimum wage change
prior to the "experimental" period, and also by the possibility
that the long-run employment impact may be larger than the short-run employment
impact. The latter two criticisms--anticipation of the law's impact, and
a larger long-run effect--apply with equal or greater force to CK's finding
that stock prices of low-wage firms were little affected by news of the
1990-91 increase. Also, the survey data collected by CK have some anomalous
features that are highly suggestive of measurement error, including large
employment changes for some establishments. Such measurement error is
likely to bias estimated effects of the minimum wage toward zero, and
in some extreme cases may impart a positive bias to the estimated effects
(particularly given the small sample sizes).
Furthermore, other recent work reports results that directly conflict
with CK. For example, Neumark and Wascher (1992) exploited variation across
states in the timing of state minimum wage changes and the degree to which
the state minimum exceeded the federal minimum, for the period 1973-1989.
By comparing the employment impacts of such changes over time, Neumark
and Wascher (henceforth NW) implemented a test of minimum wage effects
that is similar in design to the CK estimates based on state-specific
changes in minimum wages, but for a longer time period and a larger number
of states than in any of the CK tests. NW conclude that there are small
negative employment effects of the minimum wage, consistent with the previous
generations of time-series evidence. Among other recent work, Deere, et
al. (1995), find particularly large disemployment effects of the 1991-91
increases in the federal minimum wage.
Of course, such results also are open to criticism. For example, the
NW results hinge critically on whether school enrollment is accounted
for in the estimation. In fact, NW find results consistent with CK when
the school enrollment variable is included. Because this variable is related
to teenage employment and minimum wages in a complicated fashion, deciding
how to treat it in the estimation is a challenging problem. Also, although
NW's analysis of a newly collected Pennsylvania/New Jersey data set produced
results that contradict CK's findings, the NW data and findings have not
yet been subject to widespread scrutiny, due to pre-publication restrictions
on the use of these data. Among examples of other studies that conflict
with CK, the Deere, et al., results may be affected by the time period
studied, which encompasses the 1990-91 recession. Because data from other
recessions are not included in their sample, their results may be biased
by failure to account for business cycle effects on employment probabilities
that differ across low-wage and high-wage workers.
Many economists do not believe the CK results because they fly so directly
in the face of conventional theories of low-wage labor market operations.
On the other hand, some economists are more willing to accept the assumptions
needed to produce the CK results. The class of models that produce this
result are "monopsony" models. In the standard competitive setting,
individual firms can hire additional qualified low-wage workers at a constant
wage rate which is equal to the wage rate paid to similar workers at other
firms. In contrast, a firm has monopsony power in the low-wage labor market
if, as CK put it, it must "pay a higher wage in order to maintain
and motivate a larger [low-wage] work force." In economic parlance,
monopsony implies that labor supply curves to individual firms slope upwards,
rather than being completely flat--i.e., firms are price-setters, rather
than price-takers, in the labor market.
Many economists regard this model as a curiosity that applied historically
to "company towns," in which a single firm faced the entire
local market supply curve of labor. Such economists feel that the model
certainly does not characterize the constraints facing the small retail
and other establishments that dominate low-wage labor markets today. However,
the "dynamic monopsony" model described by CK embodies monopsony
power in the relationship between the wage and turnover rates. In particular,
CK note that as long as either the quit rate or the hiring/application
rate varies with the wage, a positive wage/employment relationship exists
for individual firms, at least in the short run. This reasoning may be
particularly applicable to low-wage labor markets, in which high rates
of employee turnover are a particular concern. Of course, the assumption
that turnover rates respond to wages in ways that individual firms can
control cannot be accepted a priori, and the empirical evidence
that CK cite on this point is weak. They cite statistically imprecise
results from an earlier study and results using their specialized data
sets that do not confirm the precise predictions of dynamic monopsony
models.
Several existing models with a more complex structure, in which monopsony
power arises from informational imperfections in labor markets, also predict
ambiguous employment effects of minimum wages. Some of these models account
for the complexities of the job search and matching process for firms
and workers, which produce equilibrium wage variation (akin to monopsony
power) across firms. Other models account for the possibility that worker
effort varies with the wage, and that firms' costs of monitoring their
workers decrease as wages rise but increase as employment rises. At this
point, however, empirical testing of such models is limited at best, and
their applicability to estimated minimum wage effects on employment and
wages is speculative.
Given the theoretical ambiguities and the unavailability of high quality
experimental data, disagreements over the effects of minimum wages on
the level of employment are unlikely to be resolved soon. However, economists
(including CK) can at least agree that such increases raise wages for
low-wage workers who remain employed, and that the wage effects "spill
over" to workers above and below the new minimum wage. This raises
concern about the impact of the forthcoming minimum wage increase on wage
and ultimately price inflation.
The estimated effect of the higher minimum wage on product prices depends
on observable factors, such as the number of minimum wage workers and
labor's share of output, and also on the size of the "spillover effect."
Using the best available estimate of the law's coverage (90 percent of
the work force), data from the 1995 Current Population Surveys reveal
that the $5.15 minimum wage will directly raise the hourly wage of approximately
9 million workers currently earning between $4.25 and $5.15 per hour,
out of 110 million employed (excluding the self-employed). Assuming that
the wages of those currently earning less than $4.25 are raised to preserve
their relative distance from the minimum and that wages of those currently
in the $5.15-$6.00 range also increase somewhat, this implies an increase
in average economy-wide wage earnings of 0.40 percent. Assuming that labor's
share of output and costs is 0.70, the wage increase implies a price increase
over the implementation period of 0.28 percentage points. Although this
should lead to an approximately equivalent increase in inflation over
the implementation period, the longer-run effect on inflation depends
on whether the price increase is incorporated into workers' and firms'
price expectations.
As for the employment effects of the new minimum wage, it is likely that
they will be sufficiently small as to be difficult or impossible to observe.
First, although the impending minimum wage increase is large (21 percent),
in historical terms the new minimum wage will not be high relative to
average wages in the economy. Second, despite disagreement over the exact
employment effects of the minimum wage, evidence suggests that this effect
always has been relatively small in the aggregate and that it may have
declined over time. Whether the economy stays strong or weakens, any disemployment
effects arising from the minimum wage will be difficult to disentangle
from the prevailing employment trends. Ironically, the impact of the minimum
wage increase may not be clear enough to help us measure the effects of
the decision.
Robert Valletta
Economist
References
Card, David, and Alan B. Krueger. 1995. Myth and Measurement: The
New Economics of the Minimum Wage. Princeton, NJ: Princeton University
Press.
Deere, Donald, Kevin M. Murphy, and Finis Welch. 1995. "Employment
and the 1990-91 Minimum-Wage Hike." American Economic Review
85 (2, May), pp. 232-237.
Neumark, David, and William Wascher. 1992. "Employment Effects of
Minimum and Subminimum Wages: Panel Data on State Minimum Wage Laws."
Industrial and Labor Relations Review 46 (October), pp. 55-81.
Opinions expressed in this newsletter do not necessarily reflect
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