Causing Unemployment? Or has economic theory got this one wrong? The National Minimum Wage.
This is a hotly contested topic in economics. Classic or traditional economic theory predicts that imposing a wage that is above that which a profit maximising firm is willing to pay, will simply result in unemployment: make something (labour) more expensive will, perhaps obviously, make people (firms) want less of it. As such, a responsible government should stay well clear of making this a legal requirement.
When the National Minimum Wage was introduced in the UK in 1999, businesses were vehemently opposed to it and many predicted that it would be catastrophic in terms of the resulting unemployment. That has clearly not been the case. Not only is the NMW now widely accepted as standard economic policy, it is increased year on year. (https://www.gov.uk/government/publications/the-national-minimum-wage-in-2021).
In the USA Biden has committed to a $15 (~£10.60) wage that must be paid by all government employers (note: not private). In the UK we have a minimum wage of £8.91: this does apply to ALL firms and if employers fail to pay it they will be in breach of the law and can be fined. However the rate varies according to different ages of workers and is lower for those under 21 and under 18.
According to the conventional theory of wage determination, the introduction of and increase in a national minimum wage ought to reduce employment and increase unemployment. This is because a labour market will tend towards equilibrium when the demand for labour equals the supply. If a wage above the equilibrium is introduced, then firms will reduce the amount of labour they wish to hire, while the supply of labour will increase. The result is a rise in unemployment. This is shown in the below diagram.
In this diagram, the supply and demand for labour are in free market equilibrium at E1, with a wage of £X.
Given that the market clearing wage is £X, it is a clear prediction from this analysis that an increase in the wage due to a national minimum set at NMW will reduce the demand for labour and increase unemployment. This is because as the wage rises, firms will find that the wage of labour exceeds its ‘value’ to the firm (it’s Marginal Revenue Product) and they will be making a loss on the last units of labour employed. Firms will respond by reducing employment. At the same time, the higher wage will increase the supply of labour to the industry because more workers will be incentivised to work. The result is unemployment equal to E2 E3. So a national minimum wage above the market equilibrium will increase unemployment.
There are also likely to be further negative effects on employment. For example, increased wage costs of firms will raise costs of production and lead to upward pressure on prices. This might render firms less competitive. Further, firms might seek to avoid the increased labour costs by shifting production to cheaper locations overseas or by replacing more expensive labour with technology. Again therefore a NMW is likely to increase unemployment.
But we know from experience in the UK that this is not the case. As can be seen in the graphic below, in 2017 we had the highest minimum wage and the lowest rate of unemployment.
Furthermore, the introduction of the minimum wage in 1999 caused no increase in unemployment, which only reacted to the 2008 crash and then declined.
So is conventional theory all wrong? Not really: we just need to account for a more complex analysis.
The analysis thus far is static. It assumes that the demand and supply curves of labour don’t change during the period of operation of the NMW. This is unlikely to be true. One reason is that during the period of the NMW the UK economy has been growing and total demand for labour has been increasing. This growth in demand for labour will shift the MRP curve of labour to the right, offsetting the employment effect of the NMW.
The left hand diagram shows how an increase in the wage from W1 to Wm leads to a fall in labour demand to L2 and unemployment of L2L3. However the right hand diagram shows a rightward shift in the demand for labour, due for example to economic growth creating more jobs and raising the value of labour output. As a result, although the wage has increased to Wm there has been an offsetting increase in demand for labour and total employment has increased and there is no increase in unemployment. This has been the experience in the UK since 1999.
Another reason to think that the demand curve for labour might shift to the right is that an increase in wages is likely to raise worker productivity. The fact of receiving higher pay is likely to incentivise workers to work harder as they receive more reward per unit of effort. At the same time employers, having to pay more for labour, are likely to take steps to utilise labour more efficiently. This is the thinking of the Biden Administration: “It would not lead to reduced employment . . . but would enhance worker productivity, and then create higher quality work by boosting workers’ health, morale and effort,” one senior administration official said, noting that the proposal had been studied by the White House council of economic advisers. “It would reduce turnover, allowing employers to retain top talent and lower costs associated with recruitment and training sites.” https://www.ft.com/content/2cc13ecd-7ebb-4e51-8bb5-d86849d11283
Another area of complexity is with respect to the employer: where a labour market is characterised not by competition but by Monopsony, the introduction of a NMW can be expected to reduce not increase unemployment. This possibility is shown in the below diagram.
A monopsony employer is one which dominates the market for a certain kind of labour — e.g. the NHS dominates the market for nurses in the UK. In this situation, if the firm wishes to recruit more labour it must raise the wage for all workers in that industry as it is facing the industry supply curve for that type of labour. If this is the case then the cost of hiring an additional unit of labour is not just the wage of that worker but the increase in wages it must pay to all the labour of that type that it employs. In this case the firm will employ labour until the MRP=MCL, where MCL is the wage of the last unit PLUS the increased wages paid to labour in that industry. In the above diagram the monopsony firm will employ 3 units of labour where MRP=MCL. However while the MCL is £50, the actual wage paid to labour is only £30 and the workers are receiving less than their MRP. If a NMW of £40 is introduced then the gap between MCL and the Wage is abolished since now all labour receives £40. Under this situation it can be seen that the monopsony firm will increase employment to 4, where MRP=NMW. In this case the introduction of the NMW has increased both the wage AND employment. This situation captures many areas of the economy where the employer has much more bargaining power than the worker. For example, there may be local monopsonies such as the local supermarket or the local car factory. Here, the NMW can redress this imbalance and increase wages at no cost to employment.
While the rise in employment during the period since the NMW was introduced might seem to contradict the predictions of conventional wage theory, this is not really the case. This is because the simple prediction of a NMW leading to a surplus supply of labour is based on a static analysis that holds other things constant. In reality an increased minimum wage occurs within a dynamic framework. In particular, raising the wage can coincide with a rightward shift in the labour demand curve due to economic growth and/or rising labour productivity. Further, conventional theory usually applies to competitive and cleared labour markets. In practice actual labour markets are characterised by unemployment even in equilibrium and this may fall due to the increased wage as people are incentivised to actually take jobs. In monopsony markets the introduction of the NMW can redress bargaining inequalities and actually increase employment. For these reasons the rise in employment associated with the NMW does not contradict the theory of labour demand.
However this does not mean that a rising NMW will necessarily be associated with rising employment in the future. If the NMW rises too high, or the growth of the economy slows, or the incentive effects wear off, then an increase in the NMW might still increase unemployment. Note that the Biden administration has not made this a legal requirement for all private sector firms and that the UK government enforces a lower minimum wage for younger workers. These caveats suggest that even politicians know their limits.
Further analysis https://www.youtube.com/watch?v=8H4yp8Fbi-Y&t=32s
