The Minimum Wage and the Importance of Conditional Models

Recently, there were a set of posts arguing for different models of the effects of the minimum wage on employment. Megan McArdle argues that perfect competition models of the effects of minimum wage on the labor market implies that increases in the minimum wage will raise unemployment. Kathy G at Crooked Timber disagrees. She argues that a more accurate model of the minimum wage is a monopsony model. Monopsony is the opposite of monopoly meaning that there is one buyer -- in this case one employer. (Feel free to ignore the very bloggeresque sniping.)

Basically the core disagreement seems to focus on whether a small increase in the minimum wage might cause a small increase in employment and wages. Kathy G points out a theoretical problem with the perfect competition model of labor:

Now, getting back to monopsony: first of all, for readers who are unclear about what the concept means, I suggest that you read this post on my blog, which explains the basics and some of the policy implications. But here, I will just say this: just as monopoly means "one seller," monopsony means literally "one buyer." In the context of labor markets, it suggests one buyer of labor, i.e., one employer.

Except that's confusing, because when economists use the term today and apply it to labor markets, they generally don't mean literally one employer. Rather, they mean that the supply of labor to an individual firm is not infinitely elastic--i.e., if an employer cuts wages by one cent, all the workers at that firm won't immediately quit. The monopsony model holds that because employers set wages, and because of important frictions in labor markets (such workers' heterogeneous preferences, incomplete information, firm-specific human capital, and mobility costs), employers have some degree of monopoly power over their employees. Which means that they can set wages below the levels that would occur in a labor market where there is perfect competition.

The prediction of a perfect competition model would be that even a small change in wages would result in small change in employment. Yet I think it is common sense that if your employer reduced your wages by a small amount, you probably wouldn't leave. The amount of effort that would be required to find a new job would be greater than the benefits that would be gathered by getting higher wage. There are barriers to mobility in the labor market.

McArdle responds that the assumption of the perfect competition assumptions are more or less accurate:

But second, I have trouble arriving at a reasonable model for monopsony in minimum wage markets. The retail and fast food industries that employ most minimum wage workers have extremely low search costs on both sides of the market. The burger joints are all right there, next to the one you're already working at--if you can get to one fast food outlet, you can get to ten. Ditto retail stores. When they're hiring, they put signs right there in your window where you can see them. On the other side, the firms wait for someone to walk through the door, and put a hat on them. They don't spend six weeks calling your references and checking out your scholarly work.

Kathy G. likes heterogenous preferences between workers, which is to say workers liking different kinds of workplaces. This could also explain it. Except . . . in the fast food market? This seems unlikely. It's not like you're taking a lower wage at Wendy's because they have a great dental plan and they let you use the pool. The labor is unskilled, the wages are undifferentiated, and the benefits are nonexistent. Maybe there are some people out there who love Wendy's food, or Gap clothes, so much that they never want to consume anything else, making the employee discount super valuable. But I cannot believe that this group is sufficiently large to be driving the market. Besides, there's empirical evidence against this; most people do not stay in only one industry, much less only one firm.

The two seem to agree that large increases in the minimum wage would cause unemployment to increase. The argument is over small increases.

And what does the empirical evidence suggest. Kathy G summarizes:

There are a number of other reliable scholarly studies on the minimum wage that report similar results...[no increase in unemployment]. There are also quite a few very good studies that show the opposite -- that an increase in the minimum wage does indeed bring about a decrease in employment. A fair characterization of the literature is that the minimum wage's impact on employment is ambiguous. But the fact that the findings are mixed is fairly compelling evidence that there must be something wrong with the standard perfect competition model of employment. And that's because the textbook perfect competition model predicts that an increase in the minimum wage will always and everywhere lead to a decrease in employment, no ifs, ands, or buts about it. (Emphasis mine.)

Now I am not an economist, and I am not qualified to speak to the relative merits of each of these models.

However, I am a scientist, and I do have experience dealing with conditional models. By conditional models, I mean that there are circumstances under which the model applies and explains a lot and circumstances under which it doesn't. I can give you an example. If you work in animal behavior, you learn very quickly that animals -- like people -- respond to incentives. Give the rat a treat, and you can get the rat to do what you want. However, incentive learning does not apply under all circumstances. One example is habitual learning. If you teach a rat that every time it presses a lever that it gets a treat, it will press that lever a lot. However, after the animal has repeatedly done this over and over for a long time, you find that if you remove the reward the animal will just keep on pressing that lever -- even though it gets nothing for it. We say then that the response has become habitual and resistant to reward devaluation. So I could say that incentives matter in learning generally, but there are circumstances where they don't.

This is what I see when I read this debate about the minimum wage. It could be that the perfect competition model functions rather nicely except in the particular circumstance of a small increase in minimum wage. The question then becomes: what is small? Is it 10 cents? Is it a dollar? When scientists create models, we also have to spend a lot of time defining when and where they apply. Under 99% of situations humans deal with, Newtonian mechanics predicts outcomes just fine. It is just situations near the speed of light where relativity becomes important.

From the point of view of models which affect policy -- as minimum wage models clearly do -- elaborating the boundary conditions is especially important. It is also important to realize that all models are in some way conditional. The ambiguity in the empirical studies in this case suggest to me that you are dealing with a complex system. Complex systems often require conditional models to explain all of their behaviors.

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I guess Congress is exempt from these kinds of models, because it seems to encounter no problems when it gives itself substantial raises. Go figure!

By Getting Paid (not verified) on 12 May 2008 #permalink

As long as the minimum wage is set below the market price for unskilled labor then it will have practically no effect. I see fast food restaurants advertising for wages a dollar or two above minimum and a study of immigrant day laborers (mostly illegals) found the average wage to be around $10/hr.

A large hike in the minimum wage (say to $15/hr) would have the eventual effect of dramatically reducing the industries that rely on cheap labor (fast food, lawn service, child care etc). In that case low-skilled workers would suffer as their employment opportunities would be greatly diminished.

I find economics fascinating, but I don't know jack about it. Curious though.

A large hike in the minimum wage (say to $15/hr) would have the eventual effect of dramatically reducing the industries that rely on cheap labor (fast food, lawn service, child care etc). In that case low-skilled workers would suffer as their employment opportunities would be greatly diminished.

Is this accepted and well supported, or just you making stuff up? I could equally say that because you have to mow your lawn, eat (and, apparently, eating implies fast food in america), and pay the baby sitter / daycare so you can work, then the more likely long term effect is that people buy fewer LCD wide screen TVs and ipods, meaning that the losers end up being highly paid engineers that produce non-essential items.

I recently spent some time in Italy, and even though their goods cost more (because their labor costs more), they still had a higher standard of living! People were happy - there was no angst! I think the only way that the US government has gotten away with so much crap is that the people of our country are uneducated on how our European neighbors live. My brother-in-law did the right thing by moving there, and while I could daydream about joining him, I still believe my fellow citizens' rights are worth fighting for.