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Basic Minimum Wage Model. Basic economic model of minimum wage impact. wage. S. Wm W1. D. employment. Ebar E1 Es. Basic model.

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Basic Minimum Wage Model

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basic economic model of minimum wage impact
Basic economic model of minimum wage impact







Ebar E1 Es

basic model
Basic model

Assumptions - all firms comply with the law and all workers in the economy are covered by the law, meaning their wage can be no lower than the legal minimum.

In the graph W1 is too low and thus a minimum is enacted. Wm is an example of an effective minimum wage because the market price can not occur. (is a wage lower than W1 an effective minimum?)

At Wm the Qs = Es and the Qd = Ebar and thus

Es - Ebar = surplus or unemployment.


Now, since Es - Ebar = surplus or unemployment, we have

Es - Ebar = (Es -E1) + (E1 - Ebar). The unemployment created by the minimum wage is made up of two components: Es - E1 is the unemployment that results because a higher wage attracts more workers, even though firms do not want to hire them; E1 - Ebar is the unemployment from those who actually had work before the minimum, but lose their job due to the minimum wage.

Now, those that still work, Ebar, get the higher wage and make more income.

non compliance

All firms do not comply with the law. If and when they get caught the “guilty” firms typically have to pay workers the money they did not originally pay them.

So in a way you could say non-compliant firms are getting an interest free loan from the employees they are with-holding from.

what if all workers are not covered by law
what if all workers are not covered by law?

In the real world all workers are not covered by the law. In other words, some types of jobs do not require a minimum be paid. We will want to explore what can happen in the sectors that are covered by the law and the sectors that are NOT covered by the law.

But let’s digress for a minute. Say if I flip a coin and it comes up heads I will give you a dollar, but if it comes up tails you will give me a dollar. (By the way, if you are ever offered this bet, please only accept it if you can use your coin and you flip the coin.) The expected win is .5(1) + .5(-1) = 0, or in general the probability of an outcome times its outcome, summed across all outcomes.

covered sector
covered sector

Look back at the graph I had at the beginning of this section. But, now consider it only the sector that is covered by the minimum wage. Say p is the probability you still have a job after the minimum wage is legislated. Thus (1- p) is the probability you do not have a job. The expected wage is then

p(Wm) + (1 - p)(0) = pWm.

uncovered sector
uncovered sector

If a worker goes to the uncovered sector then the wage is certain. Call this wage Wu. Then the expected wage in the uncovered sector is the certain wage Wu.

Next let’s explore what might happen if the expected wage in each sector is not the same. As we do this consider the following two ideas.

1) Displaced workers in the covered can leave the covered market and enter the uncovered market, pushing the uncovered market wage down.

2) Workers in the uncovered market may leave for the covered market in hopes of getting a job there, pushing the uncovered wage up.

say pwm wu
Say pWm > Wu

This condition means people expect to make more in the covered market than in the uncovered market. Workers move toward the covered market, lowering p and raising Wu. So, the inequality can not last.

say pwm wu10
Say pWm < Wu

This condition means people expect to make more in the uncovered market than in the covered market. Workers would move toward the uncovered market, raising p and lowering Wu. So again, the inequality can not last.

So what is the moral of this story? The expected wage is the same in each market.