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Section 3: The Economic Impact of Minimum Wages

  • Issued: January 27, 2014
  • Content last reviewed: January 2014

3.1 What is the Economic Impact of Minimum Wages? Theory and Evidence

Theoretical Concepts

Basic economic theory suggests that setting a minimum wage above the market equilibrium wage would result in a reduction in the demand for low-wage labour on the part of firms. This would occur as they substitute other inputs for the higher priced low-wage workers, and as they reduce their output because of the higher labour cost. Hence, all else being equal, an increase in minimum wages can be expected to have an adverse effect on employment (Benjamin et. al, 2012). Workers at the lower end of the wage distribution would be most affected. Workers at or near the minimum wage may lose their jobs because of employers' reduced demand for labour. In a growing economy, however, this is more likely to occur in the form of reduced new job opportunities rather than outright layoffs. The priced-out jobs clearly distinguish winners and losers under the new higher minimum wage level. Workers who remain employed will benefit from the wage increase, while workers who become unemployed will be the losers under the new wage regime.

Other factors, however, may mitigate this disemployment effect of a minimum wage hike. For example, the adverse employment effect will be more likely to show up in the form of reduced employment opportunities rather than outright layoffs if aggregate labour demand increases at the same time. Also, if there is an economic expansion, fewer workers are likely to be at or below the minimum wage (and hence affected by the minimum wage increase) as employers are more likely to increase wages to meet their growing labour demand. Employee turnover can be lower as a higher minimum wage increases the incentive for employed workers to remain at their organization given their higher wage. Workers may also feel more committed to their organization and increase their effort in response to their higher wage — what economists term an "efficiency wage" effect. The minimum wage increase may also "shock" employers into doing other more efficient managerial and other practices including reducing excess wages to other higher paid workers. They may also be able to attract higher-quality and hence more productive labour because of higher wages for the same jobs. While these various adjustments suggest that minimum wage increases in part may "pay for themselves", the offset is not likely to be substantial, otherwise employers would have voluntarily increased those wages without the legislative prompt.

Employers may absorb higher wage costs without large reductions in employment by reducing other costs (Hirsh, Kaufman and Zelenska, 2011; Schmitt, 2013). They could reduce non-wage labour costs such as fringe benefits or hours worked or expenditures on on-the-job training and development opportunities for minimum wage workers. While these may be alternatives to reducing employment, they still have negative ramifications for employees. The increasingly popular usage of precarious employment and variable hours can be seen, in part, as evidence of firms compensating for higher wages.

Firms can also pass on the cost increases to their customers by raising the product price. This outcome is more likely in industries where demand for the product or service is relatively insensitive to price increases. Such price insensitivity is less likely to be prominent, however, under competitive market forces induced in part by global competition.

It is also argued that the higher earnings for minimum wage workers would enhance their consumer spending thereby generating additional demand for goods and services. This could create a positive feedback loop for further economic growth that can mitigate any adverse employment effect. This could be offset, however, by any reduction in demand from those who are unemployed because of the minimum wage increase, or from employers whose spending power for new investments is reduced because of the higher cost of minimum wages.

Lastly, in local labour markets employers may be reluctant to raise their wages to attract new recruits if they have to also pay those higher wages to their incumbent workforce for reasons of internal equity. A minimum wage may actually alleviate that constraint because they have to pay that fixed wage to all workers — potential new recruits and the incumbent workforce. In such circumstances — termed monopsony by economists — employers may actually increase their employment in response to minimum wages. This can occur because they are no longer inhibited from expanding their employment by the possibility of having to pay higher wages to attract new recruits.

In sum, economic theory generally predicts an adverse impact on employment of an increase in minimum wages. However, other factors could mitigate or nullify this effect: reductions in labour turnover; improvements in organizational efficiency; reductions in wages of higher earners; and small price increases. Schmitt (2013) in his review points to these factors that may in part explain why some studies found no disemployment effects of a hike in the minimum wage.

Evidence from Past Research

In the sections below, evidence from research on minimum wage impacts is summarized. Some areas of research are controversial while there is a general consensus on other aspects.

Impact of minimum wages on employment of low-wage workers

Will an increase in minimum wages reduce employment for these workers? There is no consensus on this question in the existing empirical research. Early studies in the U.S. over the 1950s, 1960s and 1970s (based on approximately 26 studies reviewed in Brown, Gilroy and Kohen 1982; 28 in Brown 1999; and 29 in Card and Krueger (1995, p. 180-82) find that minimum wages reduce employment for teenage workers. The "consensus range" at that time was that a 10% increase in the minimum wage led to a 1% to 3% reduction in the employment of teens.

Based on more recent studies using US data from the 1980s and into the 1990s, the results tend to be conflicting. Some find effects within the former consensus range whereby a minimum wage increase of 10% would lead to an employment reduction of 1-3% (Neumark and Wascher 1992, 1994, 2000, Williams 1993, Williams and Mills 1998). Some find even larger negative effects (Burkhauser, Couch and Wittenburg 2000, Deere, Murphy and Welch 1995, Kim and Taylor 1995). Others find adverse employment effects that are close to zero or statistically insignificant (Card 1992a, 1992b, Card, Katz and Krueger 1994, Card and Krueger 1994, 1995 and 2000, Katz and Krueger 1992, Klerman 1992, Solon 1990, and Wellington 1991). Studies that use panel data to estimate the employment transitions of persons affected by minimum wage increases tend to find adverse employment effects that range from small (Currie and Fallick 1996, Zavodny 2000) to substantial (Abowd, Kramarz, Lemieux and Margolis 2000 and Linneman 1982).

Other studies (e.g., Neumark 2001 based on 1995-98 data) find that the effects are sensitive to the specification of the empirical models and to the group being analysed. No adverse employment effect is consistently found for teens 16-19 years of age and all youths 16-24 years of age although adverse employment effects tend to be found for high-school dropouts.

Meta-analyses, i.e., an analysis of many analytical studies, have reported an insignificant impact of increases in minimum wages on employment (Doucouliagos & Stanley, 2009; Wolfson & Belman, forthcoming). Findings in a spate of recent studies also support Card and Kruger's finding that minimum wages do not have a discernible effect on employment (Dube, Lester & Reich, 2010; Allegretto, Dube & Reich, 2011; Hirsch, Kaufman & Zelenska, 2011; Addison, Blackburn & Cotti, 2012). In contrast, Sabia, Burkhauser, and Hansen (2012) used a research methodology similar to Card and Kruger's but found significant adverse employment effects on less-skilled, less-educated workers.

In the Canadian context, researchers have generally found an adverse employment effect of raising minimum wages especially for young workers. Studies from the 1980s suggest that a 10% increase in minimum wages would result in 1%-3% reduction in employment (Swidinsky, 1980; Schaafsma & Walsh, 1983). More recent studies find larger adverse employment effects (Baker, Benjamin & Stanger, 1999; Yeun, 2003; Baker, 2005; Campolieti, Fang and Gunderson, 2005a.b.; Campolieti, Gunderson & Riddell, 2006; Sen, Rybczynski and Van De Waal, 2011). Typically those studies find that teen employment would drop by 3% - 6% if the minimum wage is raised by 10%.

In a recent study, adverse employment effects were found to be declining over time and disemployment effects were substantially larger for workers who have been in minimum wage jobs for a long period of time (i.e., permanent minimum wage workers) compared to temporary minimum wage workers who are only in minimum wage jobs for a short period of time; in fact the adverse employment effects fall almost exclusively on permanent minimum wage workers (Campolieti, Gunderson and Lee, 2012).

Campolieti, Fang and Gunderson (2005a) found that the disemployment impacts in Canada were not sensitive to whether the minimum wage increases were pre-announced and made in a regular fashion or were periodically made in an ad hoc and unanticipated fashion. However, the adverse employment effects were substantially larger when they involved a large minimum wage increase compared to a cumulative series of smaller increases of the same magnitude.

On the positive side, Fang and Gunderson (2009) found that minimum wage increases have positive impacts on the employment of older workers in Canada. It is likely that employers faced with a higher wage would substitute older workers for younger workers since older workers may bring additional qualities to the job such as reliability and work experience.

British econometric evidence suggests no adverse employment effect for the economy as a whole from the small minimum wage increases that occurred in an expanding economy (Stewart 2004) but an adverse employment effect for the low-wage home-care sector where minimum wages are more prelavent (Machin & Wilson 2004).

International evidence for nine OECDOECD, 1998a, p. 45-48).

Overall, the U.S. evidence remains inconclusive while the Canadian and OECD evidence tends to find a negative employment effect of minimum wages increase. New labour market entrants (e.g. teens, recent immigrants) are more likely to experience the disemployment effect of rising minimum wages.

Impact of minimum wages on hours worked

Minimum wages increase the labour cost on an hourly basis. It is possible that employers would reduce the hours worked instead of, or in addition to, cutting employment under higher minimum wages. The limited evidence (Gramlich 1976; Brown, Gilroy and Kohen 1983; and Dube, Lester and Reich 2010 but not Zavodny 2000) indicates that minimum wage increases also lead to a slight reduction in hours of work, suggesting that the focus on employment tends to underestimate the total effect if the reduction in hours were not considered. Hungerford (1997) also found that minimum wage increases lead to higher involuntary part-time employment, suggesting that employers may have reduced hours of work for both part-time and full-time workers even when workers preferred to work longer hours.

Impact of minimum wages on the wage distribution

The increase in minimum wages can affect not only the workers at the minimum wage but also workers who earn higher hourly wages. The limited empirical evidence suggests small spillover effects, raising the wages of those slightly above the minimum wage (Card and Krueger 1995, p. 160-66; Cox and Oaxaca 1981; Gramlich 1976; Grossman 1983; and Katz and Krueger 1992). It is likely that the immediate effect originates from a hike in the minimum wage which then "ripples" through other wages just above the minimum wage. Over a longer run, an increase in the average or median wages can then trigger a call for a subsequent increase in the minimum wage, which could lead to a "ratcheting" up cycle.

Since minimum wages increase wages at the bottom of the wage distribution, and likely those just above the minimum wage through spillover effects, increases in minimum wages are likely to result in lower wage inequality. This is enhanced by the fact that minimum wages may eliminate some low-wage jobs. Empirical evidence for the U.S. suggests that higher minimum wages reduce wage inequality (Card and DiNardo, 2002; Card and Krueger, 1995; DiNardo, Fortin and Lemieux, 1997; Lee, 1999; Lemieux, 2005; Meyer and Wise 1983a, b; and Tuelings, 2000).

Impact of minimum wages on income distribution

The reduction in wage inequality outlined above should also contribute to a reduction in family income inequality and poverty. However, this can be offset somewhat by the possible adverse effect on employment and hours of work. In terms of the distribution of family earnings, the U.S. evidence suggests that minimum wages can bump up the income level for lower wage families. Card and Krueger (1995) suggest that more than 35 percent of the earnings gains generated by the 1990 and 1991 federal minimum wage hikes were concentrated among families in the bottom 10 percent of the family-earning distribution in U.S.

Impact of minimum wages on poverty

The link between poverty and low wages is weak for a variety of reasons. Many poor families have no employed workers in the household or they work only a few hours, and many others work at wages above the minimum wage. Many minimum wage workers are youth who live in non-poor families, or are persons in multiple earner families where the combined earnings takes them out of poverty. Moreover, minimum wage jobs are often taken as temporary stepping-stones to higher paying jobs.

Empirical findings provide support for these arguments for both the US (Burkhauser and Finnegan, 1989; Card & Kruger, 1995; Burhauser, Couch & Glenn, 1996; Burkhauser, Couch & Wittenberg, 2000; Vedder and Gallaway, 2001, 2002; Neumark and Wascher, 2002; Neumark Schweitzer and Wascher, 2005; Burkhauser and Sabia, 2007; although not in Mincy, 1990 or Addison and Blackburn, 1999;) and Canada (Shannon & Beach, 1995; Goldberg & Green, 1999; Benjamin, 2001; Campolieti, Gunderson and Lee, 2012). Surprisingly, some studies even find that a higher minimum wage leads to an increase in poverty. Sen, Rybczynski and Van De Wall (2011) found a small but statistically significant increase in poverty due to higher minimum wages: a 10% minimum wage increase was found to be significantly associated with a 4%-6% increase in the percentage of families living under Low Income Cut Offs (LICO) in Canada between 1981 and 2004. The higher minimum wages trigger higher unemployment, which results in more poverty as household incomes drop among low-income families.

Given what we know about the demographic profile of people working at minimum wages, it is not surprising that the overlap between working at the minimum wage and being under the poverty line is small. Only about 12.5% of minimum wage workers lived in poor households in 2011 according to Statistics Canada's Low Income Measure (LIM). The vast majority (i.e., 87.5%) lived in households with incomes above the LIM. (Estimates provided by the Ontario Ministry of Finance based on the Labour Force Survey). Thus, although raising the minimum wage would reduce poverty for some, its overall impact on poverty as a whole would be limited.

Impact of minimum wages on training

Minimum wages can inhibit training by inhibiting the ability to accept low-wages in return for training. If there is an adverse employment effect, they can also reduce the on-the-job training that goes with employment. Training could increase, however, to facilitate enhancing productivity to qualify for or retain the higher wage jobs.

The US evidence tends to suggest that minimum wages do have a negative effect on training but the effect is very small (Grossberg and Sicilican, 1999; Hashimoto, 1982; Leighton and Mincer, 1981; Neumark and Wascher, 2001; and Neumark and Sicilian, 2001). But no effect on training was found in Acemoglu and Pischke (2001) or Converse, Coe, Corcoran, Kallick and Morgan (1981).

Impact of minimum wages on education

Minimum wages may encourage youths to drop out of school to try to obtain the higher paying minimum wage jobs. To the extent that there are adverse employment effects, however, minimum wages may encourage students to remain in school because of the fewer jobs. As well, they may remain in school so as to enhance their productivity to be able to get the higher paying jobs.

The evidence on the effect on schooling is mixed, although generally suggesting that higher minimum wages induce youths to leave school for the higher-paying minimum wage jobs. For the US, this is the case in Neumark and Wascher (1995a, 1995b, 1996) and Cunningham (1981) and for teenagers in low-income families in Ehrenberg and Marcus (1980, 1982). Card (1992a), however, finds no effect on schooling and Mattila (1981) finds that minimum wage increases induce youths to remain in school because of the reduced employment opportunities. For Canada, Campolieti, Fang and Gunderson (2005) find no effect of minimum wages on schooling.

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