Unit 6 The firm and its employees

6.13 Application: The minimum wage

Governments in many countries set a legal minimum hourly wage, in order to protect the living standards of low-paid workers. In some cases, the same minimum wage applies to all workers; elsewhere it may vary according to the type of work. In India, minimum wages vary by state and industry. In the United States, many individual states set their own minimum wage above the federal minimum, according to local conditions and preferences.

minimum wage
A minimum level of pay laid down by law or regulation, for workers in general or of some specified type. The intention of a minimum wage is to guarantee living standards for the low-paid. Many countries, including the UK and the US, enforce this with legislation.

It is often argued that if employers have to pay higher wages, they will employ fewer workers—which leads to unemployment of low-skilled workers. So while some will benefit from higher pay, others will be unable to find jobs. But economists who have studied the effect of rises in the minimum wage have found that the effect on wages is much bigger than the effect on jobs. Some studies have found a modest decrease in employment; others estimate that the number of jobs has increased. In our video, Arin Dube explains how he and his co-authors measured the effects of the minimum wage, and what they found.

Question 6.12 Choose the correct answer(s)

Watch the video of Arin Dube’s study on the minimum wage in the US, read the following statements, and choose the correct option(s).

  • To examine the effect of a minimum wage increase, Arin Dube’s study compared bordering areas where one side experienced a change in the minimum wage while the other did not.
  • Worker turnover increased after a rise in the minimum wage.
  • Increasing the minimum wage reduced income inequality.
  • Raising the minimum wage had a minimal negative effect on employment.
  • This method is known as a natural experiment—the side of the border that did not experience a minimum wage increase was the ‘control’ group; the side that did experience a minimum wage increase was the ‘treatment’ group.
  • The study found the opposite—that the minimum wage could improve the functioning of the labour market by reducing labour turnover.
  • Inequality decreased because the minimum wage benefitted low-wage workers especially, raising their overall take-home pay.
  • The study found that employers passed on the increase in wage costs to the consumers, so there was a minimal negative impact on employment.

We can use our wage-setting model to show that when employers have labour market power, a minimum wage can lead the firm to raise both employment and wages. This happens because the minimum wage limits the firm’s ability to hold wages down by keeping employment low.

Figure 6.19 shows the no-shirking wage curve for a firm that maximizes profit by employing 50 workers at a wage, w0. Work through the steps to analyse the effect of a minimum wage.

In this diagram, the horizontal axis shows employment N. The vertical axis shows wage w. Coordinates are (employment, wage). The zero-profit line consists of a vertical segment between (0, 0) and a relatively high wage, and a horizontal line starting from that level of wage. A series of upward-sloping, concave lines starting from the horizontal axis are isoprofit curves for increasing profits the further away from the origin. An upward-sloping, convex line labelled no-shirking wage curve is tangential to a isoprofit curve at point E (50, w_0). The area above the no-shirking wage curve is the feasible set. A horizontal line starts from min_w on the vertical axis and connects the vertical axis with the no-shirking wage curve at point F, which lies on a isoprofit which is higher than the one passing through point E. Min_w is higher than w_0.
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Figure 6.19 The effect of a minimum wage on wages and employment.

Maximizing profit: In this diagram, the horizontal axis shows employment N. The vertical axis shows wage w. Coordinates are (employment, wage). The zero-profit line consists of a vertical segment between (0, 0) and a relatively high wage, and a horizontal line starting from that level of wage. A series of upward-sloping, concave lines starting from the horizontal axis are isoprofit curves for increasing profits the further away from the origin. An upward-sloping, convex line labelled no-shirking wage curve is tangential to a isoprofit curve at point E (50, w_0). The area above the no-shirking wage curve is the feasible set.
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Maximizing profit

The firm maximizes profit within its feasible set at point E. It employs 50 workers, at a wage w0. What happens if the government introduces a minimum wage?

A low minimum wage: In this diagram, the horizontal axis shows employment N. The vertical axis shows wage w. Coordinates are (employment, wage). The zero-profit line consists of a vertical segment between (0, 0) and a relatively high wage, and a horizontal line starting from that level of wage. A series of upward-sloping, concave lines starting from the horizontal axis are isoprofit curves for increasing profits the further away from the origin. An upward-sloping, convex line labelled no-shirking wage curve is tangential to a isoprofit curve at point E (50, w_0). The area above the no-shirking wage curve is the feasible set. A horizontal line starts from min_w on the vertical axis and connects the vertical axis with the no-shirking wage curve. Min_w is lower than w_0.
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A low minimum wage

The minimum wage shrinks the firm’s feasible set: it can no longer set very low wages. But if the minimum wage is below w0, it has no effect on this firm. The firm maximizes profit at E as before, employing 50 workers at wage w0.

A higher minimum wage: In this diagram, the horizontal axis shows employment N. The vertical axis shows wage w. Coordinates are (employment, wage). The zero-profit line consists of a vertical segment between (0, 0) and a relatively high wage, and a horizontal line starting from that level of wage. A series of upward-sloping, concave lines starting from the horizontal axis are isoprofit curves for increasing profits the further away from the origin. An upward-sloping, convex line labelled no-shirking wage curve is tangential to a isoprofit curve at point E (50, w_0). The area above the no-shirking wage curve is the feasible set. A horizontal line starts from min_w on the vertical axis and connects the vertical axis with the no-shirking wage curve at point F, which lies on a isoprofit which is higher than the one passing through point E. Min_w is higher than w_0.
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A higher minimum wage

If the minimum wage is above w0, point E is no longer feasible. The highest profit the firm can achieve is at point F. It employs 70 workers at the minimum wage.

The minimum wage alters the firm’s feasible set. If N is low, the lower boundary of the feasible set is horizontal at the minimum wage. As N rises, this remains true until it hits the reservation wage curve.

If the introduction of a minimum wage makes the firm’s previous profit-maximizing point infeasible, its choices of wage and employment will change, from E to F in the figure. Make sure you understand why it maximizes profit at point F, by imagining yourself moving along the lower edge of the feasible set (as in Section 6.10), and using the isoprofit curves to determine whether profit is rising or falling.

This analysis shows that a minimum wage can benefit workers in this firm. If it is high enough to affect the firm’s decision, then more workers are employed—and at a higher wage than before. But the firm makes less profit: profit is lower at F than at E.

  • Barbara Ehrenreich worked undercover for minimum wage in motels and restaurants to see how America’s poor live.1
  • Polly Toynbee, a British journalist, had previously done the same in the UK in 2003, working in a call centre, a care home, and other low-wage jobs.2

This model shows how minimum wages could have positive effects on both wages and employment, consistent with evidence from several studies of how it works in practice. But be careful how you interpret this: if the minimum wage were raised further, it could exceed the workers’ productivity. Then the firm would make negative profits and have to shut down or fire workers. For this reason, policymakers tend to be cautious in setting the level of the minimum wage, and in many countries the standard of living of those in minimum wage jobs remains low.

  1. Barbara Ehrenreich. 2011. Nickel and Dimed: On (Not) Getting By in America. New York: St. Martin’s Press. 

  2. Polly Toynbee. 2003. Hard Work: Life in Low-Pay Britain. London: Bloomsbury Publishing.