In the last chapter we focused on maximum prices, we now look at the economics of price floors where the government intervenes in the market so that prices cannot fall below a certain level.

Definition of a minimum price

A minimum price is a legally imposed price floor below which the normal market price cannot fall. To be effective the minimum price has to be set above the normal equilibrium price. Perhaps the best example of a minimum price is the minimum wage. The national minimum wage was introduced into the UK in 1999. It is an intervention in the labour market designed to increase the pay of lower-paid workers and thereby influence the distribution of income in society. In October 2005, the value of the minimum wage for adults was £5.05 – following a series of small increases over recent years.

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

Adult Rate (for workers aged 22+)		Development Rate (for workers aged 18-21)		16-17 Year Olds Rate
1 Apr 1999	£3.60	1 Apr 1999	£3.00	-	-
1 Oct 2000	£3.70	1 Oct 2000	£3.20	-	-
1 Oct 2001	£4.10	1 Oct 2001	£3.50	-	-
1 Oct 2002	£4.20	1 Oct 2002	£3.60	-	-
1 Oct 2003	£4.50	1 Oct 2003	£3.80	-	-
1 Oct 2004	£4.85	1 Oct 2004	£4.10	1 Oct 2004	£3.00
1 Oct 2005	£5.05	1 Oct 2005	£4.25	1 Oct 2005	£3.00
1 Oct 2006	£5.35	1 Oct 2006	£4.45	1 Oct 2006	To be announced

 

How does a minimum wage work?

The minimum wage is a price floor – employers cannot legally undercut the current minimum wage rate per hour. This applies both to full-time and part-time workers. Labour supply and demand curve analysis can be used to show the effects.

A diagram showing the possible effects of a minimum wage is shown above. The market equilibrium wage for this particular labour market is at W1 (where demand = supply). If the minimum wage is set at Wmin, there will be an excess supply of labour equal to E3 – E2 because the supply of labour will expand (more workers will be willing and able to offer themselves for work at the higher wage than before) but there is a risk that the demand for workers from employers (businesses) will contract if the minimum wage is introduced.

Possible disadvantages of a minimum wage

Although all 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 might damage the international competitiveness of British producers. To the extent that rising unemployment worsens the living standards of those affected it has a negative impact on poverty.
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

1. The Keynesian argument that higher wage rates will increase the real disposable incomes of lower-paid workers many of whom have a high marginal propensity to consume. Thus they will increase their own spending and this will feed through the circular flow of income and spending
2. The efficiency wage argument that raising pay levels for low-paid employees may have a positive effect on their productivity and efficiency. 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 relatively 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: Since the minimum wage was introduced, unemployment in Britain has continued to fall and the level of employment in the British economy is now at a record high. It should be remembered that the National Minimum Wage was introduced in a tight labour market, with employment rising and unemployment falling. The true test of a pay floor is probably when the economy experiences recession.
1. The sectors most directly affected by the minimum wage are in hospitality, leisure, textiles and social care. Even here, the employment effects are small – and they might easily be explained by changes in competition (e.g. from overseas) and from the effects of technological change on labour demand
2. Inflation: There have been negligible adverse effects on wage and price inflation. Other factors affecting inflationary pressure have been broadly favourable for the UK in recent years. In many sectors firms find it hard to pass on higher wage costs to final consumers – again 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 a significant impact on the earnings of part-time female workers.
5. Productivity: It is hard to identify any strong positive effect on labour productivity - but productivity gains have been made in most low-paying industries, a trend which started before the minimum wage was introduced.

Suggestions for further research and reading on the Minimum Wage

Although all of Britain’s major political parties now support the idea of a national minimum wage, the issue remains a controversial one for economists.

You can find out more about the minimum wage in Britain by visiting the Department for Trade and Industry, The Trades Union Congress, the Confederation of British Industry, the Federation of Small Businesses and the Low Pay Commission.