The Behavioral Effects of Minimum Wages

Armin Falk (University of Bonn)

Ernst Fehr (University of Zurich

Christian Zehnder (University of Lausanne)

Why studying Minimum Wages?

Minimum wage laws are an important labor market instrument 25 of 29 OECD countries have some form of

minimum wage legislation

The behavioral effects of minimum wages are still not fully understood Anomalously low utilization of opportunities to

pay subminimum wages for certain categories of workers (Katz and Krueger 1991, 1992)

Spillover effect: firms often raise wages of workers who earned less than the new minimum wage above the level of the new minimum wage (Katz and Krueger 1992, Card and Krueger 1994)

Contested employment effects of minimum wages Card (1992), Card & Krueger (1994), Machin & Manning (1994)

Important for policy evaluation Important for the question whether labor markets

are imperfectly competitive or approximate the competitive ideal.

Main Message I

Minimum wages have a direct impact on worker‘s perception of what constitutes a fair wage and thus affect reservation wages Introducing a MW increases reservation

wages Therefore, a sizeable share of workers who

earned less than the MW before the introduction is paid more than the MW after the introduction

Explains the spillover effect

Main Message II

The introduction and the removal of MW has asymmetric effects on reservation wages Introduction: strong rise in reservation wages Removal: Small decrease in reservation wages

Asymmetric effects on actual wages Actual wages strongly increase after introduction

of MW but only weakly decrease after removal of MW

Explains the low utilization of opportunities to pay subminimum wages

Main Message III

Asymmetric effects on employment Actual employment increases after

introduction but does not decrease after removal of the MW

Sheds light on the sources of positive employment effects

Minimum Wage & Reservation Wages

For some time economists speculated that minimum wages might affect reservation wages „The minimum wage becomes a focal point,

representing the going, or acceptable wage. .... workers perceive the minimum as the 'fair‘ wage. In this way the minimum wage might influence workers‘ reservation wages.“ (Card and Krueger 95)

However, reservation wages are difficult to measure in field data

Why a laboratory experiment?

Empirical evidence for zero or positive employment effects highly contested (e.g. Neumark and Wascher).

Measurement errors regarding employment and wages. Important determinants of employment and wages are

unobservable or very difficult to observe. marginal revenue product of labor (labor demand) workers’ reservation wages (labor supply) wage setting mechanism

Information conditions unknown in the field what do firms and workers know about marginal revenue

product, average product, profits and reservations wages. Unknown interactions between MW, labor demand or

supply may occur.

In a Laboratory Experiment

no measurement error with regard to wages and employment

perfect knowledge of marginal revenue product

precise measurement of reservation wages possible

control over information conditions.

Experimental Game

Market Participants 6 Firms 18 Workers

Exogenous Matching At the beginning of a period each firm is randomly

matched with three workers Stage 1 of a period

Firms can offer the same wage to 0, 1, 2 or 3 workers, w [0, 1000]

Stage 2 of a period Workers simultaneously accept or reject the offer they

received

Design continued

Two Treatments: Without minimum wage (NO) With minimum wage (MW) Each treatment lasts 15 periods

Two Treatment Orders: Introduction of MW (NO/MW) [5

Sessions] Elimination of MW (MW/NO) [5

Sessions]

Design continued

Employed Workers Revenue Marginal Revenue Product

0 0 - 1 390 390 2 740 350 3 1000 260

Design continued

Firms’ payoff Revenue – wage employed workers

Workers‘ payoff Wage if employed, zero otherwise

Minimum wage equals 220 < MRP of third employed worker

Information conditions MRP, payoff functions, number of workers and firms

and the matching technology are common knowledge Firms are informed about how many workers accepted

their offer Workers are informed about firms’ profits

Elicitation of reservation wages

Ask workers for their acceptance thresholds r before they know the wage offer

If w > r the offer is accepted, if w < r it is rejected

Supply Schedule observable

Matching technology

If acceptance thresholds are heterogeneous firms face – on average - upwards sloping labor supply schedules

However, with perfectly random matching the distribution of reservation wages a firm faces may not be very representative of the overall labor supply schedule

May generate a lot of randomness at the firm level Needs many periods to converge to whatever the

behavioral equilibrium is in this setting Solution

Each firm gets matched with one worker from each third of the distribution of acceptance thresholds

Standard Predictions

Assumptions Firms and workers are rational and selfish Firms know that workers are selfish

Implications Workers accept every positive wage offer Labor supply is horizontal at a wage of one Firms offer always the smallest acceptable wage to all their

workers NO-Treatment: w = 1 MW-Treatment: w = 220 (Minimum Wage)

There is full employment in both treatments The minimum wage does not change employment but has

strong distributive effects

Predictions with fairness preferences

Workers‘ have heterogenous acceptance thresholds Firms face an upward sloping supply schedule

Wages are much higher than predicted by the self-interest model

Minimum wage may increase employment because more workers accept the wage offer

Example 1 Reservation wages of 0, 10, 100 Marginal cost of hiring 3 instead of 2 workers are

3*100 – 2*10 = 280 > 260 (= MRP of 3rd worker) Third worker is not employed without the MW With the MW law the third worker will be employed

because the marginal cost of the 3rd worker is 220

Example 2 Reservation wages of 30, 80, 130 Marginal cost of hiring 3 instead of 2

workers are3*130 – 2*80 = 230 < 260

Third worker is employed without the MW

MW law has no employment effect

The effect of MW on actual wages(increase and spillover effect)

0

0.1

0.2

0.3

0.4

0.5

0.6

10

20

30

40

50

60

70

80

90

10

0

110

12

01

30

14

0

15

01

60

17

0

18

01

90

20

02

10

22

02

30

24

0

25

02

60

27

0>

=2

80

wage interval

rela

tive

freq

uenc

yffg

NO

MW

MW

Why do firms pay non-minimal wages in NO and more than the minimum in MW?

NO-MW sequence

The effect of MW on reservation wages

(heterogeneity, fairness, increase)

0

0.1

0.2

0.3

0.4

0.5

0.6

0 10

20

30

40

50

60

70

80

90

10

011

012

013

014

015

016

017

018

019

020

021

022

023

024

025

026

027

028

029

0>

=30

0

reservation wages

rela

tiv

e fr

equ

encysd

NO

MW

NO_MW sequence

Employment effectsWithout MW employment is inefficiently

low?

Average Employment per Firm

1.4

1.8

2.2

2.6

3.0

1 2 3 4 5 Average

Session Number

NO

MW have the chance to raise employment

If reservation wages were constant across conditions average employment per firm should approximate 3 in the MW treatment

However, the MW increases reservation wages

Minimum wage leads to a small but significant increase in employment

0.0

0.5

1.0

1.5

2.0

2.5

3.0

1 2 3 4 5 Total average

Session

Em

ploy

men

tdf

NO

MW

Do firms chose profit maximizing wages?

NO condition MW condition S1 S2 S3 S4 S5 1-5 S1 S2 S3 S4 S5 1-5 Optimal wage

177 183 151 189 184 177 233 227 237 238 232 233

Actual wage

165 172 154 189 200 176 234 228 237 238 243 236

Employment effect is the result of profit maximizing firm behavior

A temporary MW has permanent effects – pre- and post-MW economy exhibit

different wages

140

160

180

200

220

240

260

period

mean

wag

e NO_MW

MW_NO

Distribution of wages in the pre- and the post-MW economy

0

0.05

0.1

0.15

0.2

0.25

0.3

0.35

0.4

10

20

30

40

50

60

70

80

90

10

0

110

12

0

13

0

14

0

15

0

16

0

17

0

18

0

19

0

20

0

21

0

22

0

23

0

24

0

25

0

26

0

27

0

>=

28

0

wage interval

rela

tiv

e fr

equ

encyff

g NO_MW

MW_NO

Why are wages in the post-MW economy so high?

Why do employers‘ not take more advantage of the elimination of the

MW?

Related to the underutilization of subminimum wage opportunities in the field

In Katz & Krueger 92, 62% of restaurant managers believed that they could not „attract qualified teenage workers at the subminimum wage“ Suggests that employers are labor supply

constrained But why could they fill their ranks before the

increase in the MW?

Reservation wages in the pre- and the post-MW

economy

0

0.05

0.1

0.15

0.2

0.25

0 10

20

30

40

50

60

70

80

90

100

110

120

130

140

150

160

170

180

190

200

210

220

230

240

250

260

270

280

290

>=

30

0

reservation wages

rela

tive

freq

uen

cysd NO_MW

MW_NO

Pre-MW median = 150

Post-MW median = 200

Given these distributions, was it optimal to pay higher wages in the post-MW economy?

Distribution of profit maximizing wages in the No condition across sequences

0

0.05

0.1

0.15

0.2

0.25

0.3

0.35

0.4

0.45

0 10

20

30

40

50

60

70

80

90

100

11

0

120

130

140

150

160

170

180

190

200

210

220

230

240

250

260

270

280

290

300

profit-maximizing wage offer

rela

tiv

e fr

equ

encysss

NO_MW

MW_NO

Difference in reservation wages between pre and post-MW economy

is significant

Table 8: Effects of introduction versus removal of minimum wage on reservation wages

Reservation wage

MW-dummy (Impact of MW in NO-MW sequence)

85.74*** (5.44)

MW_NO-dummy (impact of treatment order on NO-treatment)

12.46** (4.70)

MW-dummy*MW_NO-dummy -12.47 (9.41)

Constant (omitted category is NO-treatment in NO-MW sequence)

144.51*** (2.72)

Number of obs. 5400

Prob > F .0000

R-squared . 345 Note: The regression controls for session fixed effects. Robust standard errors clustered on sessions in parentheses, *** indicates significance at the 1-percent level., ** indicates significance at the 5-percent level.

Removal of MW has no employment effect

0

0.5

1

1.5

2

2.5

3

1 2 3 4 5 Total average

Session

Em

ploy

men

tdf

NO

MW

Summary

Economists focus on how economic policy changes the incentives for private agents

Economic policies have effects that go far beyond changing incentives Results suggest that minimum wages affect

the perception of what constitutes a fair wage Minimum wage increases reservation wages

Results suggest that minimum wage creates a kind of entitlement effect that is not fully reversible

Explains asymmetric response of reservation wages

This effect on reservation wages gives rise to important wage & employment effects

Firms pay on average more than the minimum wage after the introduction of the MW

Wages in the pre-MW economy are much lower than in a post-MW economy

Employment rises less after the introduction compared to a situation with stable reservation wages

Employment does not fall after the removal of the MW Our results lend support to the idea that the

spillover effect and the under utilization of opportunities to pay subminimum wages in field data are driven by the impact of minimum wages on reservation wages