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Wage and employment effects of non-binding minimum wages

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Wage and employment effects of non-binding minimum wages

Marcus Dittrich Andreas Knabe

TU Chemnitz & CESifo FU Berlin & CESifo

Social Choice and Welfare

Moscow, July 2010

- “The effects of the minimum wage on employment and the distribution of income have been hotly debated policy question for over 50 years.“ (Brown 1999)
- Pro: raising the wages of the lowest-paid would help fighting poverty
- Contra: introducing such rigidities impedes allocative role of flexible wages, causing more unemployment and possibly even more poverty

- Oneissuethatmostproponentsandopponentsagree on: MW have to be binding to have any effect!

- But: Many studies report that raising the MW has spillover effects (Katz/Krueger 1992, ILLR; Manning 2003, Neumark et al. 2004, JHR).
- Two important stylized facts:
- Firms raise the wages of workers that used to earn less than the new MW above the minimum level required.
- Workers already earning wages above the new MW receive wage raises as well.
- Possible explanation: Employers attempt to maintain their internal wage hierarchy.

match if firm‘s offer ≥ res. wage

Experimental evidence (Falk et al. 2006, QJE)

- excludes wage hierarchy effects or effort considerations
- similar to “ultimatum game”
- firm proposes a wage
- worker sets reservation wage

- main finding: introduction of MW increases wages above the new minimum, because it drives up reservation wages

- Motivation: spillover effects of MW
- Model economy
- Nash wage bargaining
- Kalai-Smorodinsky wage bargaining
- Conclusion

- economy with large number of sectors
- bargaining over wages (w ) between unions and firms
- representative firm’s profit:
- representative union’s utility:
- alternative income:

Nash bargainingsolutionfollowsfromfouraxioms (Nash 1950,Econometrica):

- Pareto efficiency
- Invariance to equivalent utility representations
- Symmetry
- Independence of irrelevant alternatives

- Nash bargaining solution:
where = player i ’s utility, = conflict utility, S = utility possibility set

- applied to wage bargaining problem:

What do non-binding MW do?

1. sectoral level

- w0 exogenous
Sectoral MW has no effect on bargained wage.

What do non-binding MW do?

1. sectoral level

- w0 exogenous
Sectoral MW has no effect on bargained wage if it is non-binding.

2. national level

- no change in any wages
- hence, w0 unchanged
National MW has no effect on bargained wage if it is non-binding.

alternative axiomatic solution (Kalai/Smorodinsky 1975, Econometrica)

maintain first three axioms of Nash solution

replaces IIA with “individual monotonicity” axiom

a player must not suffer from an enlargement of the bargaining set that leaves the maximum utility attainable by the other player unchanged

- both bargaining parties agree to a solution that equalizes the relative utility gains ( ratio of the actual gains to the maximum feasible gains)
- maximum feasible gain is determined by the payoff one can secure by pushing the other party to the minimum payoff it would just be willing to accept
- could be interpreted as “fairness” (McDonald / Solow 1981, AER) if a player could have more (without hurting the other player), he should have more

- general KS solution: both parties make equal proportional concessions from their respective favored points KS curve:
- applied to wage bargaining problem:

- “utopia points”:
- bargained wage:

What do non-binding MW do?

- change in utopia point:
- KS curve:
- bargained wage:

What do non-binding MW do?

1. sectoral level

- w0 exogenous
- bargained wage raises to a level above the former wage
- implication: MW is non-binding, but effective!
Sectoral MW reduces the firm‘s utopia payoff and hence drives up the wage.

What do non-binding MW do?

1. sectoral level

- w0 exogenous
Sectoral MWreduces the firm‘s utopia payoff and hence drives up the wage.

2. national level

- direct effect in each sector if
- plus: changes in w0 affect wages in other sectors
National MW does not have to be binding, but is effective

- Empirical evidence suggests that MW have real effects even if they are not binding.
- Implications for economic theory:
KS solution is able to describe these effects, Nash solution is not.

- Implications for public policy:
Even relatively low MW might have negative employment effects policy implications depend on whether union-firm-bargaining follows Nash or KS solution.

Thank you very much!

Empiricalevidence

- Katz and Krueger (1992, ILRR): Texan fast-food restaurants
- one-third “maintained their wage hierarchy” (workers who earned more than the old MW will also earn more than the new minimum)
- 60% of restaurants who had starting wages already above new minimum still increased their wages
- Manning (2003): US data 1979-2000
- spillovers for wages up to 150% of the MW

- Neumark et al. (2004, JHR): US data 1979-1997
- spillovers for wages up to twice the MW

- Three popular theoretical explanations
- Substitution effects (Pettengill 1981)
- increase in demand for above-minimum wage workers raises their wages, too

- Monopsonistic firm behavior (Manning 2003)
- some firms pay high wages to attract workers from low-wage firms
- if low-wage firms pay more, also high-wage firms have to raise their wages

- Efficiency wages (Grossman 1983, JHR)
- smaller wage differential between skilled and unskilled workers has to be compensated to keep up effort of skilled workers

- Substitution effects (Pettengill 1981)

- Falk, Fehr & Zehnder (2006, QJE) conduct a laboratory experiment in which a rent is distributed between “workers” and a “firm”.
- In the experiment’s first step, workers state their reservation wages, which are not observed by the firm.
- Then, the firm makes a wage offer and workers with reservation wages below this wage offer are hired.

- The introduction of a minimum wage raises workers’ reservation wages: Before its introduction, 91% of workers stated a reservation wage below the later minimum wage.
- After it had been introduced, 59% reported that their reservation wage was equal to the new minimum wage, and the other 41% said that their reservation wage was even larger than the new minimum wage.
- Result: minimum wages affect the wage level that people are willing to accept even if they are not directly affected by the new minimum wage.

- reference scenario: monopolistic union sets the wage, firms set employment
- monopoly union behavior:

What do non-binding MW do?

1. sectoral level

- w0 exogenous
Sectoral MW has no effect on monopoly union‘s desired wage.

What do non-binding MW do?

1. sectoral level

- w0 exogenous
Sectoral MW has no effect on monopoly union‘s desired wage.

2. national level

- no change in wages
- w0 unchanged
National MW has no effect on monopoly union‘s desired wage if it is non-binding.

Find a bargaining solution that satisfies the following four axioms:

- Pareto efficiency(PAR)
- Invariance to equivalent utility representations (INV)
- Symmetry (SYM): symmetric utility functions should ensure symmetric payoffs
- Independence of irrelevant alternatives (IIA):
If S is the Nash bargaining solution for a bargaining set X, then for any subset Y of X containing S, S continues to be the Nash bargaining solution.

Find a bargaining solution that satisfies the following four axioms:

- Pareto efficiency (PAR)
- Invariance to equivalent utility representations (INV)
- Symmetry (SYM): symmetric utility functions should ensuresymmetricpayoffs
- Individual monotonicity (MON):
If the bargaining set is enlarged such that the maximum utilities of the players remain unchanged, then neither of the players must not suffer from it.