Unit 1 Micro: Economics of a Minimum Wage

This revision blog looks at some of the economic issues surrounding the minimum wage. A pay floor is an important government intervention in the labour market and it was first introduced into the UK in April 1999 at a rate of £3.60 per hour for adult workers. The adult rate of the National Minimum Wage will be increased by 11 pence to £6.19 an hour from 1 October 2012

Over the years the rate for the national minimum wage has been raised each year - the current rate is £6.08 for adult workers, £4.98 is the Development Rate
(for workers aged 18-20) and £3.68 is the 16-17 Year Olds Rate.

The Low Pay Commission reported in 2012 that “the adult rate of the NMW has now increased by nearly 69 per cent since its introduction. That is faster than both average earnings and prices. Since October 2006, however, the increases in the minimum wage have broadly been in line with average earnings, though below inflation.”

A key point is that the minimum wage rate is not set at an especially high level relative to other wages rates in the economy. The UK minimum wage as a proportion of median earnings) increased from 45.7 per cent in 1999 to 51.0 per cent in 2007 but then remained just under this level between 2007 and 2010.

The main aims of the minimum wage

1. The equity justification: That every job should offer a fair rate of pay commensurate with the skills and experience of an employee. There are many low-paid jobs in the UK. Low-paying sectors include care services and housing; fast food, pubs and restaurants; hotels; leisure; retail.

2. Labour market incentives: The NMW is designed to improve incentives for people to start looking for work – thereby boosting the economy’s labour supply.

3. Labour market discrimination: The NMW is a tool designed to offset some of the effects of persistent discrimination of many low-paid female workers and younger employees.

Possible disadvantages of a minimum wage

Although all of Britain’s major political parties are now committed to keeping the minimum wage, there are still plenty of economists who believe that setting a pay floor represents a distortion to the way the labour market works because it reduces the flexibility of the labour market

1. Competitiveness and Jobs: Firstly a minimum wage may cost jobs because a rise in labour costs makes it more expensive to employ people and higher labour costs. It will be interesting to observe whether the minimum wage is said to have caused extra unemployment during the current economic downturn. Studies of the effects of the National Minimum Wage (NMW) carried out before the recent recession found almost no evidence of significant adverse impacts on employment and only little evidence of a negative impact on hours worked

2. Effect on relative poverty: Is the minimum wage the most effective policy to reduce relative poverty? There is evidence that it tends to boost the incomes of middle-income households where more than one household member is already in work whereas the greatest risk of relative poverty is among the unemployed, elderly and single parent families where the parent is not employed.

Can a minimum wage actually increase employment?

The answer is yes – depending on the circumstances in the labour market when a pay floor is introduced and also on what happens to the productivity of labour when a high (statutory) rate of pay is introduced. There are two main explanations for the possibility of higher employment

The Keynesian argument that higher wage rates will increase the disposable incomes of lower-paid workers many of whom have a high propensity to consume. Thus they will increase their spending and this will feed through the circular flow of income and spending

The efficiency wage argument that raising pay levels for low-paid employees may have a positive effect on their productivity. In addition to the psychological benefits of being paid more, businesses may take steps to improve production processes, workplace training etc if they know that they must pay at least the statutory pay floor.

The importance of elasticity of demand and supply of labour

The impact of a minimum wage on employment levels depends in part on the elasticity of demand and elasticity of supply of labour in different industries. If labour demand is inelastic then the contraction in employment is likely to be less severe than if employers’ demand for labour is elastic with respect to changes in the wage level.

In the next diagram we see the possible effects of a minimum wage when both labour demand and labour supply are elastic in response to a change in the market wage rate. The excess supply created is much higher than in the previous diagram.

Evidence on the minimum wage – has it worked?

1. Employment: For most of the years since the NMW was launched, unemployment has been falling. The jobless total is now increasing at a rapid rate but the main cause has been the domestic and global economic recession.

2. Inflation: In many sectors firms find it hard to pass on higher wage costs to final consumers – limiting the inflationary effect of the minimum wage

3. Wage costs: The minimum wage affects only a small proportion of workers and the effects on the wage bills of most businesses is not a significant factor in their employment decisions. In the short term, the demand for labour tends to be inelastic with respect to changes in wages

4. Discrimination: The minimum wage has had an impact on the earnings of part-time female workers.

5. Productivity: It is hard to identify any strong positive effect on labour productivity - but efficiency gains have been made in most low-paying industries, a trend which started before the minimum wage was introduced.

There is now a growing campaign in the UK to consider moving beyond a minimum wage and look to introduce a living wage. The living wage is calculated by academics at £7.20 an hour, as a minimum level of pay to ensure an acceptable standard of living.

Newsbeat (BBC news, April 2012) - is the minimum wage enough? Click here


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