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8/6/2019 Economics and Law[1]
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Economic effects of Increases in Minimum Wage
Name: Taimur Khan
UW ID: 20235103
Course: Econ 381
Professor: Anindya Sen
Date: July 27, 2010
Abstract
The purpose of this paper is to discuss the economic effects of increases in minimum wage laws
in Canada. The application of this law leads to several benefits and costs to the society as well as
to certain individuals who are directly affected. To assess the spillover effects of such legislation
the research of numerous economists has been used covering aspects such as employment and
poverty alleviation. Moreover, the application of economic theory and models has been used to
predict further benefits and costs to the society that have not been elaborated upon before. The
results this paper achieves are that the minimum wage increase can create inefficiencies in the
market, reduce consumer surplus hence decreasing societal welfare, but can also lead to benefits
regarding lower student debt and maximization of the social welfare function. As is the case with
most controversial economic policies there is no straight answer of whether minimum wage
increases are beneficial to the society. Although, there seem to be more costs than benefits,
which implies that other laws may be more effective in combating poverty and improving the
standard of living.
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Introduction
Minimum Wage legislation refers to a law that sets a minimum amount that employers must pay
their employees regardless of their level of work. This is used to ensure a certain standard of
living for those who work at the lowest level. In 1912 the first minimum legislation was passed
in the state of Massachusetts which led to British Columbia and Manitoba to enforce this law in
1918 (Prasch 1999).iSince then Canada has ranked amongst the countries with the highest
minimum wage legislations. However, the level of minimum wage differs slightly between
provinces due to differences in cost of living. Currently, the province that has the highest
minimum wage is Ontario, set at $10.25/hour on March 31, 2010 (Ontario Ministry of Labor).
The lowest minimum wage in Canada is in the Prince Edward Island province set at $8.40/hour.
These wages may be slightly lower in certain occupations (or age groups) such as those working
as waiters/waitresses at restaurants as they make majority of their income from service tips.
Over the years this legislation has lead to debates over its effectiveness as a simple demand
supply model would show its inefficiency. Therefore, in the first section of this paper I plan to
review the existing literature analyzing the economic effects to the economy and certain
individuals. The majority of the existing research has been focused on the two main effects,
which are employment effects and poverty alleviation (including redistribution of income
effects) with subtle mentions of further benefits or costs. In the second section I will analyze
further economic effects on the economy and will reach a conclusion on whether or not this law
creates surplus for the society. This section will include detailed analysis of effects that may not
have been discussed in the preceding literature or may have been slightly touched upon. The last
section of this paper will include my results and a summary of the important effects followed by
a bibliography stating my sources.
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Literature Review
As mentioned in the introduction, the Minimum Wage legislation has lead to vast amounts of
research especially in the US and Canada. There will likely be additions to this bank of research
with Canada increasing its minimum wage on March 31, 2010 in Ontario. Most of the work
analyzed in this section is by well known authors and has been published in various economics
journals as well as research specially conducted by the Government of Canada to help in policy
creation and implementation.
From the start of the minimum wage law in the early 1900s economists were against it as
elementary economic theory using simple demand and supply curves suggests that the
implementation of a minimum wage law would definitely lead to unemployment. One of those
who strongly opposed it was Economist J. Lawrence Laughlin of the University of Chicago who
described it as an injurious palliative (Prasch). However, over time economists have not
opposed this legislation as strongly, due to the claims of some economists illustrating the lack of
adverse effects and possible benefits regarding poverty alleviation.
In regard to employment effects the impact of minimum wage on employment has been
controversial in part because of the diversity of the estimates and methodologies.(Campolieti,
Gunderson, Riddell 2006). In the research paper where that excerpt is extracted from, they used
the Neumark (2001) equation, which was used to obtain employment effects for the US and
applied it to the data available for Canada. Equation used was as follows:
Eit = + 1MWit + 2MWit-1 + 3Xit + 4Regioni + 5Yeart + it
Where E= employment ratio, MW= minimum wage (ratio of the minimum wage to the average
wage of workers between the ages of 16-64 in region i and year t. X is a vector of control
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variables, Regional and year sets of regional and year dummy variables. This regression used the
April Labor force survey. This lead to the conclusions that the increase of minimum wages had a
larger impact on the employment levels of lesser skilled workers. Furthermore, it was also found
that the implementation of minimum wages had adverse employment effects on full time
workers (Campolieti, Gunderson, Riddell).ii
Moreover, the same conclusions were reached by Kevin B. Kerr in a paper presented to the
House of Commons in regard to the implications of minimum wages. He stated that a 10%
percent increase in the minimum wage reduces employment between 0 and 3%. This would
mean that the increase from $9.50 to $10.50 in Ontario on March 31 2010 which is 7.89% will
lead to unemployment between 0 and 2.36%. Most economists agree with this range (0-3%) but
the differences arise in whether it is at the lower end or higher end of the scale. (Kerr 2006)iii
In regards to the conclusion of the decrease in part time employment by Campolieti, Gunderson,
and Riddell, the research conducted by McKee and West on part time employment also reaches
the same conclusion stating that in the case of Canada it is clearly evident that minimum wage
increases have caused the proportion of part time work to fall. Thus, the increase in minimum
wage leads to a fall in the part time/full time worker ratio. Other research calculated that the
adverse employment effects for teens were larger at an elasticity of -0.282 than young adults (-
0.155) (Campolieti, Gunderson, Riddell). This can be seen to prove the negative employment
effects as Benjamin accounted that 36% of minimum wage workers were teenagers.
As mentioned before the literature on employment effects of minimum wage vary greatly as this
next paper discussed illustrates. An economic security survey report claims that the weight of
the evidence suggests little or no impact on employment from minimum wage increases . Their
research claims that the relationship between employment rates and increases in minimum wage
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are not consistent as sometimes a minimum wage rise decreases employment while in some
cases it increases employment. Further claims stated that the increases in minimum wage did not
play a major role in unemployment as that is more dependent on large scale economic changes,
such as economic booms or recessions (Murray & Mackenzie).iv
On a brief note it is important to mention that there were findings that suggested minimum wage
increases resulted in no effect on job employment and in some cases led to job growth. (Card &
Kreuger).
Before the discussion of the second most discussed effect of increases in minimum wage
(poverty alleviation) it is imperative to discuss some of the other smaller benefits and costs.
Advocates of minimum wage state that increases in the wage will lead to a more productive
workforce as productivity is a function of the wage rate. Furthermore, they state that firms that
would compete by paying low wages would need to become more efficient in their ways which
would not necessarily create unemployment. This would lead to increases in entrepreneurship.
Moreover, increases in minimum wage can result in a) increased bargaining power of the
workers and b) has the potential to generate an independent middle class (Prasch).v Those against
minimum wage increases argue that the fact that such few people work at the minimum wage
and those too are mostly teenagers so it does not matter to the economy. Therefore, it is evident
that the negative employment causes more harm than good. In response to those arguments it
has been said that valuing the work of younger members of the society at a lower amount would
be discrimination on the basis of wage (Murray & Mackenzie).vi
The other main focus of minimum wage increases is the potential they have to alleviate poverty
with redistribution of income in society. Gramlich argued that those who received the minimum
wage were not the poorest but were instead from middle and high income families. Therefore, it
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did not qualify as an effective poverty reduction policy. Although the data presented by Fortin &
Lemieux does show a slight redistribution effect. Strong opposition of the redistributive
properties of such legislation has come due to the belief that those who live at or below the
poverty level are the non-workers and the minimum wage rise can affect only families with
workers.vii This analysis suggests that minimum wage increases can slightly reduce poverty for
a segment of the population that is known as the working poor, which is a term used to
describe individuals and families who maintain regular employment but remain in relative
poverty due to low levels of pay and dependent expenses and leaves out the large portion of self
employed individuals who earn less than the minimum wage
viii
.
However, the consensus as expected seems to be somewhere in between of the two extremes.
The consensus would be that minimum wage increases can help alleviate poverty but cannot be
the only tool used to do so. For the minimum wage to have high redistribution effects the
minimum wage should be increased yearly taking into account inflation as the delays in changes
erode the real value of money. While levels of education and experience have increased and
GDP has grown, real wages remained stagnant from 1981 to 2004. In 2003 only 4.1% of the
workforce or 547,000 people worked at the minimum wage which shows that even there are
positive effects it would not affect too many individuals. One important point from this study
which has not been focused much on is the fact that increases in minimum wage not only
increase those currently at minimum wage but also increase the wages of those who are close to
the minimum wage.ix (Murray & Mackenzie).
Overall, the work of economists on the consequences of minimum wage increases provides great
insight to the effects to the society in regard to employment and redistribution of income.
Moreover, the diversity of conclusions adds further confusion as to whether the increase of
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minimum wage in Canada will lead to favorable or unfavorable results. However, the fact that
much emphasis has been put on these two consequences leaves out other positive and negative
effects of such legislation which affect other individuals in the economy. The different variables
used in their regression analysis leads to these inconsistencies in results. Moreover, there has
been a bias in the literature as at the start of this legislation researchers work was geared towards
proving economic theory correct while those papers that went against economic theory were not
published (Fortin and Lemieux). Therefore, one cannot assert with great confidence on one
certain opinion. Although, some researchers have mentioned other effects, they have not been
assessed in detail. Those consequences will be discussed in the next section with the help of
research on the basis of some underlying assumptions.
Analysis
With the minimum wage increase in Ontario to $10.25, one might argue that this amount is quite
high as some employees work may not add value of $10.25/hour. A lot of the literature
mentioned above covered aspects of employment effects but failed to take into account the value
of the work. It would not make sense for a company to hire someone for a wage, w, when he/she
does not create revenue for the firm in excess of w (MR=MC). This fact, in theory makes sense
but in reality firms spend high amount of revenue on parts of the company that are not a part of
the core business. However, in the case of minimum wage workers this may not apply all the
time.
For e.g. lets look at the case of a firm that produces ribbons. To make this analysis simple let us
assume that this firm has no fixed costs or marginal costs apart from the minimum wage paid to
the employees, w1, further assuming that this wage is not calculated through derived demand but
by the value it adds to the product which is the case in some minimum wage jobs. To justify 0
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marginal costs assume that the owner of the firm inherited an unlimited supply of high quality
fabric. One ribbon can be sold for a price, p. The five employees work is to cut the fabric and
perform some elementary stitching on the sides of the ribbon that adds market value, v, where
p = v and v w1 > 0, which is marginal profit, . The Canadian government announces a
minimum wage increase from w1 to w2. However, this increase leads to v w < 0 (-) and since
this owner cannot afford to buy a machine the owner of the fabric shuts down production and
keeps the fabric unused. Therefore, the minimum wage, w1, increasing to w2 led to the
unemployment of 5 of the employees (unemployment effect) but deprived consumers of high
quality ribbons who had to switch to the same price lower quality ribbons, which reduced their
welfare.
Most of the research on minimum wages has shown its adverse effects, while only a few have
put emphasis on its social benefits. When the government makes policy changes it does not only
take into account the efficiency of the law or how much excess burden it creates but it also takes
into account the social welfare function (SWF). This social welfare function can justify the
promotion of the study of humanities and arts in the countryx. With respect to social welfare
functions it can be understood that although minimum wage increases might lead to inefficiency
it can have welfare maximizing effects. Examples ofSWF are W = Y1 + Y2 + .Yn, where W is
the social welfare function and Yi is the income of individual i among n in the society. Another
example may be W = min (Y1, Y2 ,Yn ). The second welfare function mentioned is different
from the first one as it shows that maximizing welfare in the society would mean maximizing the
income of the poorest whereas the first function aims to maximize total incomexi
. In Canada, the
second SWF seems to be in practice which would show that a minimum wage increase can in
fact lead to welfare maximization as the income of the poorest is increasing.
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Furthermore, the effects of the minimum wage increase in Canada could have the ability to result
in cost push inflation. Simply put, with the increase of the minimum wage those people working
at a wage close to it would also rationally experience an increase in their wage. This would lead
to the variable costs of the firm increasing inevitably leading to a lower profit margin. To
compensate for this drop, the firm might shift the burden of this increase in cost to the consumer
by increasing the price by that amount (assuming relatively inelastic demand), leading to cost
push inflation. Since, proving this with data would be difficult as inflation is a function of many
other economic effects I will present a model that can clearly illustrate this concept.
Assume a firm whose product has relatively inelastic demand and has two sets of employees, one
set earns the minimum wage, MW1, while the other set earns wage, W1, where W1 > MW1 by a
small amount. The profit equation for the firm is 1 = P1Q c(Q, L) where p = price, Q =
quantiy, c = cost, L {Set of MW and W employees}. However, the increase in minimum wage
(MW2) makes W1 = MW2 and therefore, to stop the workers in the second set to quit working,
the firm has to increase their wages to W2, where W2 > MW2. Assuming that in the short run (SR)
quantity is fixed, which makes the profit 2 = P1Q c(Q,L) , (2 < 1). Since the demand for this
product is relatively inelastic the producer can shift this increase in cost to the consumer by
charging P2 (p2 > p1) which makes 2 = 1.This price increase would lead to lower consumer
surplus as individuals will now be
paying a higher price.
Red = consumer surplus
Grey + Blue = loss of consumer surplus
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Blue = Excess Burden (deadweight loss)
*note: L is fixed due to a trade union, or the amount of L is still profit max.
The labor market effects discussed earlier spoke mostly about the direct effect of minimum wage
increases to unemployment. However, apart from that I predict a high possibility of distortion
created in the labor market which can lead to severely complicated results which would create
ambiguity in the final consequences. A minimum wage high enough can cause several effects
simultaneously, such as new entrants into the labor market as well as the closing down of several
small businesses in search of higher income. Labor economics introduces a term known as
reservation wage which is basically the lowest wage a person will work for. If the wage is
lower than his reservation wage he/she will exit the labor market. While, if the wage is higher
than the reservation wage he/she will find it satisfying to work. Therefore, when the minimum
wage increased from $9.50/hour to $10.25 all those individuals whose reservation wage was >10
would enter the market and look for employment. Apart from these entrants, a segment of the
working poor who are self employed people (265,000 in 2001) earning less than $20,000/year
might find it easier to shut down and enter the labor force working at the minimum wagexii. This
would further increase the labor supply, while the increase in wage would further reduce the
demand for labor. Keeping these scenarios in mind, people might become discouraged workers,
who are left out of most unemployment statistics. Therefore, the increase of minimum wage can
have a larger impact than what is reported by economists.
The increase in minimum wage can have a positive outcome with respect to the government
funding of education. The research showed that in 2003 57% of the minimum wage workers
were between the ages of 15-19 and 19% were between the ages 20-24 (Murray & Mackenzie).
Assuming that this proportion does not differ greatly with the minimum wage work in Ontario
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this could lead to considerable saving by the government of OSAP funds, which could be
diverted to other welfare increasing activities. Those teenagers and young adults working can
save a portion of their income which can help reduce the burden of debt on themselves. This
would mean that they would ask for lower OSAP loans from the government which as
mentioned earlier could divert the governments funding to another cause. Since OSAP loans are
interest free for the duration of the school program lesser amounts given would benefit the
government and society. The literature above suggested the redistributive effects would be
minimal in terms of poverty alleviation but in the case of students it might lead to positive
results. In this case there are positive redistributive effects from owners of capital to students. It
may not have the positive impact that poverty alleviation would but this benefit to society cannot
be ignored. Although the trend
of
Ontario spending does not prove
the point (Ontario Ministry of
Training) that has been
conveyed it may be true later on.
The demand for education is still
on the rise but when it reaches
its long run equilibrium it could
be evident that the provincial
government is spending less after minimum wage increases.
Numerically, my point can be illustrated as follows: 76% of minimum wage earners are
teenagers and young adults in Canada so we assume Ontario follows the same proportion. In
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2004 Ontario had the highest number of minimum wage workers at 283,000 peoplexiii.76% of
283,000 = 215,080. Since those under the age of 18 earn a minimum wage of $9.60 as compared
to the general minimum wage $10.25, lets set an average minimum wage rate of $9.90/hour. If
these individuals work 15 hours per week for the year they earn $7,128. Even if a portion of this
(say $1000) is allocated towards their education the total reduction in OSAP costs would be
215,080 * 1000 = $215,080,000. If they allocated this amount for all the years before university
and during university their debts would be greatly reduced along with the governments funding.
On a brief note, the increase in minimum wage in Canada could be motivation for current
students to want to drop out of school and begin earning money. Although, this might be the
thinking of certain individuals a rational economic agent would quantify benefits of education
against the opportunity cost of spending time in school. Even with a change from $9.50 to
$10.25, it would not justify individuals to drop out of school. Furthermore, the government of
Canada has taken an initiative to reduce high school dropouts. In Toronto, they have spent $19
Million to reduce dropout rates by providing their four pillars which are academic support
provided by volunteer tutors, social support through a mentoring program, counselling, and
financial assistance, which ranges from bus tickets and lunch vouchers to bursaries for post-
secondary studies.xiv
Conclusion
Economic theory from the outset claimed minimum wage legislation would have negative effects
to the economy. Therefore, it is not surprising to see most economists not considering it an
efficient way to increase the standard of living or to alleviate poverty. Although, this paper does
emphasise benefits arising from this legislation as it can lead to positive socio-economic impacts.
With regard to unemployment the research has varied greatly which is due to major economic
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changes that affect it. It cannot be clearly stated that the increase in minimum wage will increase
unemployment as other forces intervene, which cloud the analysis.
Moreover, my analysis comprised of some benefits and costs to the society which were not
discussed in great detail by economists. The model introduced regarding added value, showed
that by increasing the minimum wage the economy could be inefficient leading to welfare losses.
The second model introduced showed how increases in minimum wage could lead to higher
prices reducing the consumer surplus of employees. If that model assumed a one firm economy
its effects could be even more significant as the employees of that firm would buy its own
product at a higher price making the wage increase useless. Moreover, since the number of
minimum wage workers are mostly under the age of 24 it can lead to lower debts for the students
which would decrease provincial spending on education. Those funds could then be diverted to
other welfare increasing policies. The Government of Canada does not only look at the economic
effects of such policies but tries to maximize its social welfare function which could be
represented as W = min (Y1, Y2, Yn). Overall, as is the case with most economic policies there
is no straight answer whether the minimum wage increase in Canada will lead to a surplus in the
society as there are opposing forces, although there seem to be more costs than benefits which
suggest that the results achieved by minimum wage legislation could also be achieved by a
more effective broad-based approach for raising the incomes of Canadas working poor (which)
might be found in earnings supplementation schemes such as the recently introduced Working
Income Tax Benefit (WITB)xv(Kerr 2008).
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