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