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Economics: Minimum Wages in Labor Markets


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About this Lesson

  • Type: Video Tutorial
  • Length: 14:48
  • Media: Video/mp4
  • Use: Watch Online & Download
  • Access Period: Unrestricted
  • Download: MP4 (iPod compatible)
  • Size: 157 MB
  • Posted: 03/29/2010

This lesson is part of the following series:

Economics: Full Course (269 lessons, $198.00)
Economics: Understanding Markets (22 lessons, $35.64)
Economics: Interfering with Markets (3 lessons, $5.94)

In this video lesson, we will discuss the impacts that minimum wage has on a labor market. Taught by Professor Tomlinson, this video lesson was selected from a broader, comprehensive course, Economics. This course and others are available from Thinkwell, Inc. The full course can be found at The full course covers economic thinking, markets, consumer choice, household behavior, production, costs, perfect competition, market models, resource markets, market failures, market outcomes, macroeconomics, macroeconomic measurements, economic fluctuations, unemployment, inflation, the aggregate expenditures model, banking, spending, saving, investing, aggregate demand and aggregate supply model, monetary policy, fiscal policy, productivity and growth, and international examples.

Steven Tomlinson teaches economics at the Acton School of Business in Austin, Texas. He graduated with highest honors from the University of Oklahoma and earned a Ph.D. in economics at Stanford University. Prof. Tomlinson's academic awards include the prestigious Texas Excellence Teaching Award given by the University of Texas Alumni Association and being named "Outstanding Core Faculty in the MBA Program" several times. He has developed several instructional guides and computerized educational programs for economics.

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Suppose you are concerned about the plight of low wage workers in the economy. You want to make sure that people who are working hard make enough money to take care of their basic needs or feed their family and therefore, you are lead to support a minimum wage. Now, frequently in Economics we study unanticipated consequences of economic policy. That is, we enact the policy for one reason, but the policy has unanticipated consequences that may actually work against the policy's intention. Economists like to make this argument about the minimum wage. That in fact minimum wage laws may in many cases hurt the very people that they are designed to help.
Now, there's a lot of controversy these days about the minimum wage, whether it actually helps or hurts low wage workers. But what we'll do in this lecture is look at the standard economic argument using supply and demand analysis for why the minimum wage has unanticipated consequences that may in fact harm low wage workers. We're going to look at this story in our supply and demand diagram that we're so familiar with. I want to make sure that we're clear on what all of the curves represent. Let's suppose now, that we have price and quantity, and since this is the market for labor, the price will be the wage. This will be the hourly wage or the amount of money that must be paid per hour for labor services.
On the horizontal axis we'll have the quantity of labor and this will be the quantity supplied by workers or demanded by employers. Now, putting these two together, we create a graph in which we can represent the market for labor. Let's begin with the demand curve for labor. The demand curve for labor is downward sloping representing the fact that as labor gets less expensive, firms will hire more workers. Firms will hire more workers for two reasons. The first is, as the wage falls, the cost of doing business in declining and therefore the business may be inclined to expand its operations. Remember, when costs fall at the margin, businesses find it profitable to produce more of their output for sale on the market. So, as the wage falls, the business may actually be expanding and hiring more workers.
A second reason why lower wages lead to an increased quantity of labor demanded is the substitution between labor and other factors of production. That is, when labor gets less expensive, employers are inclined to use more labor and less capital to produce a given quantity of output. So lower wages result in a substitution in the direction of labor. The less expensive or the output that is declining in relative price. So, for two reasons, the costs of doing business are lower and labor is now relatively less expensive, lead to an increased quantity of labor demanded as the hourly wage falls.
Let's look now at the other side of the market, that is, the supply curve for labor. And the supply curve for labor is a controversial graph. How do we know how workers are going to respond when the wage goes up. There are two things that workers might do. As the wage increases, we might expect first of all what we call in Economics a substitution effect. That is, with higher wages now, workers are inclined to work more hours, because the cost of leisure has increased. That is, if I have to choose between spending an hour sitting in the park reading a book and an hour working at the factory, well, I'm going to be considering the quantity of goods and services that I could purchase with the wage that I earn from that hour's worth of work.
If the wage goes up now, then I'm giving up more goods and services to enjoy the hour sitting in the park. The cost of leisure to me, the opportunity cost of leisure, is rising. Therefore, I'm inclined to consume less leisure and enjoy more of the goods and services that I can purchase from that hour of work in the factory. Therefore, the substitution effect leads workers to work more hours when the hourly wage increases. On the other side of the argument, there is what we call the income effect. The income effect is the effect on the worker's behavior when the worker becomes richer.
After all, if the wage rises then you can now afford to pay your bills by working fewer hours. If I have to pay $500 worth of bills every week, then if I can earn $500 from 20 hours worth of work instead of 40, then I'll work my 20 hours and spend the rest of the time having fun. That's because at a higher wage, I'm now wealthier, I'm now richer for a given amount of work and I'm inclined to purchase more leisure. That is, as my wealth increases, as my income rises, as I get richer, I'm going to want more of all goods, including leisure, and therefore I will cut back my hours at work. Ask yourself this question. What would you do if your boss at work doubled your wage? Would you work more hours or fewer hours?
Well, it depends on whether the substitution effect is stronger for you or whether the income effect is stronger for you. If the income effect is stronger, then you would cut back your hours and enjoy more leisure or study time. If the substitution effect is stronger, you would work longer hours so that you can afford to buy more toys and goods and services and other things that you enjoy that money can buy. So, the effect of a higher wage on household behavior is ambiguous. It depends on whether the substitution effect is stronger or whether the income effect is stronger. But for the sake of our argument, we're going to draw the supply curve for labor as if it is upward sloping. That is, I'm going to draw this picture as if the substitution effect were stronger. That is, as if higher wages lead workers to work longer hours.
So, here I go, I'll make sure this line is real clear. There's my substitution effect dominating. There's my supply curve for labor. So, the demand curve represents the behavior of firms. They demand a larger quantity of labor when the wage falls and the supply curve represents the behavior of households. They supply more labor hours as the wage rises. Suppose we have an unregulated market. In a free market, equilibrium would be established where the quantity supplied and the quantity demanded are equal. That is, at the intersection of the blue and the red curves. If we drop our line down here, we'll see this is the quantity of labor that would be supplied and demanded in the labor market at equilibrium and the wage at which the market clears would be W star.
So this might be something like $5.00 an hour and this might be 100 hours a week, in a particular labor market. Well, suppose we decide, as a society, that $5.00 an hour is too little for a worker to be paid. That in order to make a living wage, workers have to earn at least $6.00 an hour and we calculate that through studies and logical reasoning and looking at the prices of food and housing and medical care. And we want to establish then a minimum wage that's higher than the equilibrium wage. Now, the minimum wage is a floor below which the wage is not legally permitted to fall. That is, if a minimum wage is established, then all businesses have to pay a wage that is at least as great as the minimum wage.
So, we'll put the minimum wage up here. We'll call this W[m] for minimum wage. And it's important that the minimum wage is above the equilibrium. After all, if it's below the equilibrium, then it's irrelevant, because market forces are going to bid the wage up to at least $5.00 an hour. It's only if your minimum wage is greater than $5.00 an hour that it makes any sense at all. So, suppose now that we have legislated a minimum wage. That is, all workers can expect to receive this wage if they have a job and all employers are required by law to pay it. What would the consequence of a minimum wage be? Well, if we follow the minimum wage over to check on the behavior of the players in this competitive market, we see first of all that the prospect of earning $6.00 an hour draws a lot more households into the labor market.
The quantity of labor supplied increases with the minimum wage. That is, the amount of labor that households want to supply at this higher wage is greater than it was before. So, we'll call this QS[m]. That's the quantity of labor supplied under a minimum wage. On the other hand, firms are less interested in hiring workers when they have to pay this higher wage. Therefore, the quantity of labor demanded is reduced. And it's reduced for two reasons in this story. The same two reasons that the demand curve for labor is downward sloping. The first is that the minimum wage raises the overall cost to the firm of doing business and therefore, inclines the firm to cut back its output. Therefore, it needs fewer workers. The second problem for the workers is that the higher wage leads firms to substitute away from labor in the direction of capital or other factors of production.
With the higher wage and less labor being demanded, or a smaller quantity of labor demanded, then we have Q equals the quantity of labor demanded under the minimum wage being less than the quantity supplied. Ah, here's the unintended consequence. With the minimum wage above the equilibrium, the quantity of labor supplied exceeds the quantity of labor demanded. We have therefore, an excess supply of labor and that has a special name. We call that unemployment. There are a lot of people who want jobs at the minimum wage who are not going to have the opportunity to get them because firms want hire the workers. That is, the quantity of labor supplied exceeds the quantity of labor demanded and the distance between these two points constitutes unemployment. Workers who are willing and able to work at the going wage, but cannot find jobs because the firms are not hiring. This is the unintended consequence.
Well, what's going to happen then? Who's going to actually get these jobs? If there are only 50 jobs being offered but 150 applicants, how are we going to sort out which workers actually get them? Well, all kinds of things could happen. First of all, notice that we've got 50 workers who are willing to work for a much lower wage down here. If we look at the actual supply curve, we can get 50 workers for a wage down here of maybe $3.00 an hour. Now, legally we have to pay those workers $6.00 an hour, but we could ask those workers to do other things. We could make sure that they wash their uniforms themselves. We can make sure that they get transportation to and from work, perhaps riding with their parents or other workers or whatever. So, ultimately firms might be able to pass costs on to workers that lower their effective return from the job down to something like $3.00.
These workers wouldn't apply in those circumstances, because they couldn't make enough money to cover their opportunity cost. They'd rather work at home or be out of the labor force, perhaps taking care of children or some kind of self-employment. But these workers down here would work for the equivalent of $3.00 an hour and therefore even though they're being paid $6.00 an hour, the firm is able to impose extra duties on them that reduce their effective pay down to $3.00 an hour. The economist has been concerned because look, all of these jobs that should be created where the benefit to firms is greater than the cost to the workers, all of these jobs are shut down by the minimum wage. The price regulation creates a deadweight loss and a kind of non-price competition. Those workers who are willing to stand in line the longest, wash their uniforms the cleanest, make sure they get transportation to work, or any other arbitrary conditions that the employer might like to impose, they're ones who get the jobs. And their effective return is lower than the minimum wage.
So, to summarize. The minimum wage was adopted in order to help low income workers or low wage workers, but in fact there are two unintended consequences that work against the very people that the policy is designed to help. The first is that with a minimum wage, employers may reduce their demand for labor and when the quantity demanded of labor falls, unemployment is created as there is an excess supply. The workers want to work at the higher wage, but the jobs aren't available. The second consequence is that there may be some kind of non-price competition. Employers imposing extra burden on workers so as to lower their effective wage down to somewhere even below the equilibrium wage that we started with, due to extra duties. Like cleaning uniforms or providing transportation or other things.
So, in summary, the minimum wage is an example that economists like to use to show how policies that are well meaning may actually have unintended consequences that actually hurt the very people they are designed to help. So, why then, are labor unions often in favor of minimum wages? We'll see this in the next unit when we consider the relationship between wages and productivity.
Understanding Markets
Interfering With Markets
Understanding the Problem of Minimum Wages in Labor Markets Page [3 of 3]

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