Ebook Optimal Minimum Wage Policy in Competitive Labor Markets
The minimum wage is a widely used but controversial policy tool. A minimum wage can increase low-skilled workers’ wages at the expense of other factors of production such as higher skilled workers or capital and hence can be potentially useful for redistribution. However, it may also lead to involuntary unemployment, thereby worsening the welfare of workers who lose their jobs. A large empirical literature has studied the extent to which the minimum wage affects the wages and employment of low-skilled workers (see e.g., Card and Krueger (1995), Brown (1999), or Neumark and Wascher (2006) for extensive surveys). The normative literature on the minimum wage, however, is much less extensive.
This paper provides a normative analysis of optimal minimum wage policy in a conventional competitive labor market model, using the standard social welfare framework adopted in the optimal tax theory literature. Our goal is to use this framework to illuminate the trade-offs involved when a government sets a minimum wage, and to shed light on the appropriateness of a minimum wage in the presence of optimal taxes and transfers.
The first part of the paper considers a competitive labor market with no taxes/transfers. Although simple, this analysis does not seem to have been formally derived in the previous literature. We show that a binding minimum wage is desirable as long as the government values redistribution from high-to low-wage workers, the demand elasticity of low-skilled labor is finite, the supply elasticity of low-skilled labor is positive, and most importantly, that the unemployment induced by the minimum wage is efficient, i.e. unemployment hits workers with the lowest surplus first. The intuition is extremely simple: starting from the competitive equilibrium, a small binding minimum wage has a first order effect on distribution but only a second order effect on efficiency as only marginal workers initially lose their job.
The second part of the paper considers the more realistic case where the government also uses taxes and transfers for redistribution. In our model, we abstract from the hours of work decision and focus only on the job choice and work participation decisions. Such a model can capture both participation decisions (the extensive margin) as well as decisions whereby individuals can choose higher paying occupations by exerting more effort (the intensive margin). In that context, the government observes only earnings, but not the utility work costs incurred by individuals. In such a model, we show that a minimum wage is desirable if unemployment induced by the minimum wage is efficient and the government values redistribution toward low-skilled workers.
The intuition for this result is the following. A binding minimum wage enhances the effectiveness of transfers to low-skilled workers as it prevents low-skilled wages from falling through incidence effects. Theoretically, the minimum wage under efficient rationing sorts individuals into employment and unemployment based on their unobservable cost of work. Thus, the minimum wage partially reveals costs of work in a way that the tax system cannot. Unsurprisingly, if rationing is uniform (i.e., unemployment hits randomly and independently of surplus), then the minimum wage does not reveal anything on costs of work and it cannot improve upon the optimal tax/transfer allocation.
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