The minimum wage can harm workers by reducing unemployment

The Minimum Wage Can Harm Workers by Reducing Unemployment

DWIGHT R. LEE*

University o f Georgia, Athens, Georgia 30302

Economists may disagree over how much raising the minimum wage increases unemployment, though few argue that the unemployment effect is zero. According to the standard model, the less the unemployment caused by a minimum wage increase, the less the harm (or greater the good) that results. But by recognizing that minimum wage workers receive fringe benefits, I show that increasing the minimum wage may not cause any unemployment and harms workers because it doesn't. Furthermore, when there is lumpiness in providing fringe benefits, a minimum wage increase may harm workers by reducing unemployment.

I. Introduction

Economists almost unanimously accept the argument that increasing the minimum wage above the lowest market wage will increase unemployment, but improve the welfare of those who remain employed. This argument seems to be an inescapable implication of downward sloping demand curves and upward sloping supply curves for labor. So the debate over minimum wage increases has focused on the magnitude of employment and unemployment effects of the increases, with opponents claiming that the effects are sufficiently large and concentrated on the least advantaged to be troubling, and proponents claiming that they are too small to offset the benefits. Many studies suggest that the effects are indeed quite small, with a ten percent increase in the minimum wage causing far less than a ten percent decrease in employment, with little increase in unemployment. Proponents see these studies as providing strong support for minimum wage increases, since they suggest an increase in the average earnings of minimum wage workers. 1

As far as I know, no one has argued that increasing the minimum wage can reduce unemployment, and by doing so reduce the welfare of the workers who remain employed at the higher wage. Plausible arguments have been made that an increase in the minimum wage can increase employment, or at least leave it unaffected. For exam- ple, when employers have some monopsony power, it is possible to increase employment by imposing a minimum wage. This possibility is mentioned, though rejected, by Card and Krueger (1994) as an explanation for their controversial empirical finding that a higher minimum wage has no negative (and possibly a small positive) effect on employment. Also, a higher minimum wage could conceivably increase worker productivity (either by allowing employers to exert more control over workers, or by moti-

J O U R N A L OF LABOR R E S E A R C H

Volume XXV, Number 4 Fall 2004

658 JOURNAL OF LABOR RESEARCH

vating workers to improve their skills) enough to offset the negative employment effect of the higher wage. 2 But increasing employment is not the same as reducing unemployment, and so even if a higher minimum wage did increase employment because of monopsony and increased productivity effects, it does not follow that unemployment would be reduced.

I shall argue that increasing the minimum wage can reduce unemployment, and employed workers are harmed when this occurs. The crucial consideration behind this result is that employers can respond to a minimum wage increase by making adjustments on more than one margin. The standard story is that employers respond only on the employment margin. But employers can also, either wholly or partially, offset the effect of a minimum wage increase by reducing employee fringe benefits. This offset can explain why the employment effect is not nearly as great as is indicated by the standard demand and supply model of the labor market. In Section II, I incorporate fringe benefits into a standard demand and supply model and show how increasing the minimum wage can harm all workers because it doesn't cause unemployment. In Section III, I adjust the model to consider the lumpiness commonly found in the provision of fringe benefits, and show that a minimum wage increase can reduce unemployment and do the greatest harm to workers when it does. I offer some concluding comments in Section IV.

II. The Minimum Wage, Fringe Benefits, and Incremental Adjustments When analyzing the minimum wage, few economists consider the possibility that increasing the minimum wage may do little to increase the cost of hiring workers. Yet this is clearly the case when it is possible, as it often is, for employers to partially or completely offset the minimum wage increase by reducing fringe benefits. The most complete analysis of that possibility has been done by Wessels (1980a, 1980b), who has shown that (1) the unemployment effect of a minimum wage increase will generally be less than the standard analysis predicts, and (2) the increase can harm even those workers who remain employed.

One reason fringe benefits are typically ignored in analyses of minimum wages may be a belief that few minimum wage workers receive fringe benefits. This is mis- taken, however, particularly if fringe benefits are defined broadly. True, most minimum wage jobs do not come with expensive health insurance programs, limousine service, or country club memberships. Such benefits cost employers more than they are worth to minimum wage workers. But minimum wage workers are commonly allowed flexible working hours to accommodate class schedules; provided meals if they work in a fast-food eatery; given laundry service for required uniforms; allowed some relaxation on the job; provided pleasant working conditions; given training through varied job assignments; as well as other things that minimum wage workers favor by more than it cost the employer to provide. Of course, the menu of fringe benefits will vary over firms depending on employer cost and worker preferences, often varying over workers in the same firm when not too costly to give workers some choice in their fringe benefit packages. Only by providing fringe benefits worth more than

DWIGHT R. LEE 659

they cost can a firm profit by lowering wages by more than the cost of the benefits, but by less than they are worth to its workers. This allows a firm to attract better workers by increasing the value of their compensation packages while reducing the cost of those packages. Competition applies constant pressure on firms to search out and provide cost-effective fringe benefits at all pay levels.

Government mandates requiring firms to provide certain benefits (such as fam- ily leave) or a certain level of benefits if they are provided (such as minimum levels of health insurance) are almost guaranteed to harm workers. Without government mandates, firms will probably provide any benefit, and level of benefit, that workers value by more than they will have to pay for it. I emphasize "probably" to indicate that I am not claiming market infallibility. With worker preferences and technologies changing constantly, there will likely be some fringe benefits not being providing that are worth more than they cost. But the chances that politicians are more informed about these benefits and more motivated to provide only those that are cost effective are extremely small. Since politicians have such limited information on the situation facing each of the multitude of firms and their workers, government mandates are typically imposed generally, with little attempt to adjust them to individual circumstances except in clumsy ways (e.g., exempting firms with fewer than 50 employees). Such broad mandates are inappropriate in most cases, requiring that most workers pay more for benefits with lower wages than they are worth.

So workers, including minimum wage workers, receive fringe benefits without government mandates. Furthermore, the type and quantity of the benefits provided are more likely to promote the interests of both employers and employees when provided in response to market incentives than when mandated by government. These two considerations are sufficient to establish a strong presumption that increasing the minimum wage above the market wage for low-income workers can leave all affected parties worse off, particularly workers, without increasing unemployment.

Consider the situation represented in Figure 1, with the number of workers hired shown on the horizontal axis and money wages on the vertical. Without fringe benefits, the demand curve for labor is given by D and the supply curve is given by S, with W and L the equilibrium wage and employment level, respectively. Next assume that there is a fringe benefit provided for which employers are the cheapest providers, and that is worth more to workers than its cost. The cost is assumed to be a constant amount per worker, which increases in proportion to level of the benefit provided. The level of benefit provided to each worker is such that its cost per worker is given by the vertical distance between curves D and D', with the latter curve becoming the relevant demand curve since the wage employers are willing to pay at each employment level is reduced by the benefit's per-worker cost. I also assume that each worker realizes the same value from the fringe benefit provided, with that value given by the vertical distance between curves S and S' at the level of benefit associated with demand curve D'. This means that S' becomes the relevant supply curve, because the reservation wage for each worker will decline by the amount the benefit is worth. It is assumed that the


Figure 1

$

Wage l

W . . . . . . . . . . . . . . . . . . . . . . . , . . . . a S S. D "D WM

W'

L D L M L ' Labor L s

level of the fringe benefit associated with S' and D' is the efficient level - - where the marginal cost per worker is equal to the marginal value provided each worker.

As drawn, the efficient level of the fringe benefit is worth twice what it cost, and so we would expect the new equilibrium (given by wage W' and employment level L') to find both employers and employees better off. This is easily seen to be true from Figure 1. The fringe-benefit cost for each of the original L workers hired is given by the distance ab, but providing the benefit allowed the money wage to be lower by the amount given by the distance ac > ab. On the other hand, in return for giving up ac in money wages, each of these L workers received a benefit worth ad > ac. Furthermore, by hiring an extra L ' - L workers, employers realize an additional net gain given by the area bce in Figure 1, and the extra workers realize a net gain of cde. Employers are alert to the gains workers realize when fringe benefits are provided because those benefits that provide the greatest gain to workers also provide the greatest gain to employers.

Now consider the effect of imposing a minimum wage of W M which is greater than the market wage W', as shown in Figure 1. Employers are unwilling to hire L' workers at wage W~t while continuing to provide the efficient level of the fringe benefit. If it is impossible to reduce the amount of fringe benefit provided, D' and S' would remain the relevant demand and supply curves and the unemployment rate will increase

DWIGHT R. LEE 661

from zero to L s - L D. But assuming that the fringe benefit can be adjusted incrementally, employers will respond to the minimum wage by reducing the fringe benefit until the unemployment is eliminated. The reduction in fringe benefits saves employers money on each worker (shifting the demand curve above D' and shifting the supply curve above S3 while still allowing them to hire more workers than they want at W M.

Employers continue to gain by reducing the fringe benefit as long as unemployment remains, i.e., as long as they can hire all the workers they want at the minimum wage W M. As Figure 1 is constructed, this remains the case until the fringe benefit reduction results in the demand curve given by D" and the supply curve by S", with L M workers being hired. Although there are now fewer workers employed, the number willing to work at minimum wage W M is exactly the number employers are willing to hire.

It is obvious from Figure 1 that, given the imposition of the minimum wage, employers are better off by reducing the fringe benefit, increasing the labor demand curve to D", and hiring L M workers, than they were providing the efficient level of the fringe benefit. But employers are not as well off in the post minimum wage equilibrium as they were in the pre-minimum wage equilibrium. And neither are the workers. The L M workers who keep their jobs at W M, receive a wage increase of L M - W ' ,

but they lose fringe benefits that each values by an amount given by gf > WM--W'.

And the L ' - - L M workers who quit are obviously worse off, since the net gain they had received from employment has been eliminated.

One way of explaining this lose-lose situation is that the minimum wage creates an externality. Without the minimum wage the value of the fringe benefit to workers is effectively internalized into the calculus of employers, who take that value into consideration because they can profit by doing so. A minimum wage in excess of the market wage externalizes the value workers realize from a fringe benefit by making it illegal for workers to compensate employers for additional units of the benefit with a lower monetary wage, even though the units are worth more than they cost.

It is also obvious that imposing a minimum wage greater than the prevailing wage, W', does not cause any unemployment, at least up to a point. The minimum wage can be increased above W' until it equals the wage W in Figure 1 (the equilibrium wage without any of the fringe benefit being provided) without causing any unemployment. Up to wage W, the response to a minimum wage increase is a sufficient reduction in the fringe benefit to maintain a zero unemployment equilibrium by increasing the money-wage demand for workers and reducing the money-wage supply of workers. But any increase above W begins causing unemployment, since at W no fringe benefit is left to eliminate.

So increasing the minimum wage above the market wage does not increase unemployment, although it reduces employment and harms all affected workers, even those who remain employed at the higher wage. But nothing in the analysis so far suggests that increasing the minimum wage can reduce unemployment. But by making a sim- ple, and realistic, change in an assumption on how fringe benefits are provided, we can establish the possibility that increasing the minimum wage will decrease unemployment, but do so by harming workers.


Figure 2

Wage

wM

w,

W'

a

c

S

,e i

0 L L' L s Labor

S'

IH. The Minimum Wage and Lumpy Fringe Benefits

The assumption that the fringe benefit can be adjusted incrementally is crucial to the result that an increase in the minimum wage will not cause unemployment. I now consider a situation where the fringe benefit is lumpy, i.e., not subject to incremental change. Lumpiness can result from the nature of the benefit, cost considerations, public policy restrictions, or some combination of these factors. Health club memberships are generally available in only a few standardized packages, as are medical insurance programs. Fine gradations in the level of these benefits may be possible, but impractical due to the cost of designing or monitoring them. Laundering work uniforms is typically either provided at some specified frequency, or not provided at all. Public policy sometimes allows a firm discretion to provide or not provide a fringe benefit, but, as with medical insurance, if the benefit is provided, some minimum level of benefit is legally specified. Also, some benefits are required of firms with more than a specified number of workers, with 50 being a common number, but optional for firms with fewer workers. This can result in a firm's deciding to reduce employment below the critical level and discontinuing the fringe benefit entirely.

I now proceed by assuming that the fringe benefit being considered is completely lumpy - - it is either provided or not. The labor supply and demand curves from Fig- ure 1 are carried over into Figure 2, where S and D, respectively, represent the labor

DWIGHT R. LEE 663

supply and demand curves when the fringe benefit is not being provided, and S' and D' represent the labor supply curves when it is. As before, without a minimum wage both the firm and its employees are better off when the benefit is being provided, with the equilibrium wage and employment given by W' and L' respectively. But now, the firm cannot respond to the imposition of a minimum wage above W' by reducing the fringe benefit incrementally. Since it is faced with either maintaining the existing level of the fringe benefit, or eliminating it entirely, there are some minimum wages in excess of the market wages that will not motivate any change in the provision of the benefit, and this will cause some unemployment. This is true of any minimum wage up to W/ in Figure 2.

As can be seen, if a minimum wage of W/is imposed, the firm will be indiffer- ent between keeping the fringe benefit, or eliminating it. If the fringe benefit is con- tinued, the labor supply and demand curves remain S' and D', the firm will hire L workers and will realize a surplus given by the area c d W I in Figure 2. If the fringe benefit is discontinued, the relevant labor supply and demand curves are S and D, the firm still hires L workers and realizes a surplus given by the area a b W M. As constructed, the vertical distance between demand curves D and D ' is exactly the same as the distance between W M and W 1, so areas c d W I and a b W M are the same. So as long as the minimum wage is less than W 1, it will pay the firm to provide the fringe benefit. But any minimum wage below W 1 (as long as it is greater than W3 will cause unemployment, and that unemployment will increase toward L S - L as the minimum wage

approaches W 1.

But as soon as the minimum wage exceeds W 1 it no longer pays the firm to provide the fringe benefit, since it is illegal to reduce wages enough to cover its cost. As soon as the fringe benefit is eliminated, the relevant labor demand and supply curves shift to S and D, the equilibrium wage immediately becomes W M, and the unemployment employment fails to zero. The increase in the minimum wage has reduced unem-

ployment. Further increases in the minimum wage leave the full employment equilibrium unaffected until it exceeds the market wage W M and once again becomes binding, at which point the standard textbook analysis applies since there are no fringe benefits to reduce.

The reduction in unemployment that occurs when the minimum wage goes above W t comes at the expense of both the firm and the workers, but the harm done to the workers is of greatest interest. The effect on the welfare of all workers, including those who lose their jobs, as the minimum wage is increased between W' and W t depends on the relevant elasticities, and cannot be determined a priori. But we do know that any increase toward W 1 clearly benefits the workers who remain employed - - their wage is increased and they continue to receive the fringe benefit. However, as soon as the minimum wage inches above W 1, the L employed workers suffer a significant loss as they lose the fringe benefit entirely for a wage increase that is worth less than the benefit. From Figure 2 we see that the L workers receive a surplus given by the area OfdW t when the minimum wage is at or slightly below W 1, which is larger than the surplus of W 1 b W M they receive at wage W M by an amount give by the area h f d W r


All workers were better off with no minimum wage than they are at any minimum above W 1. While the L workers who keep their jobs at a minimum wage above W I are better off with a minimum wage just slightly below W 1 than with no minimum at all, they are better off with no minimum wage than they are with one slightly above W 1. They receive a surplus of OfeW' without a minimum wage, which exceeds by hfeW'

the surplus of WrbW m when the minimum wage is above W r In addition, the loss of surplus to those workers who lose their jobs when the minimum wage increases to W 1 is given byfeg. Of course any minimum wage above W' is harmful once the welfare of both workers and the employer is considered.

The result that an increase in the minimum wage can reduce unemployment clearly depends on the assumption of some lumpiness in the provision of fringe benefits. This is a reasonable assumption when considering a few firms which respond pretty much in unison to increases in the minimum wage, as I have been implicitly doing. But the effect of lumpiness in fringe benefits obviously diminishes as we consider a larger number of firms. In the limiting case, the number of firms is so large that one might assume that the total provision of fringe benefits can respond incrementally to minimum wage increases, as was assumed in Section II, with the possibility of a minimum wage increase causing a reduction in unemployment being eliminated. But this assumes that the fringe-benefit response to minimum wage increases is randomly distributed. Such a distribution seems less likely, however, than a situation in which the fringe-benefit response is more uniform across firms as the minimum wage is increased. One can rea- sonably expect very little reduction in fringe benefits in response to small increases in the minimum wage above the market wage (although some firms would no doubt be on the margin with respect to fringe-benefit decisions), with such increases causing some unemployment. As the minimum wage increases, more firms can be expected to begin eliminating fringe benefits, with further increases in unemployment being moderated, and eventually reversed with a reduction in unemployment. As long as there is some unemployment over some initial increase in the minimum wage above the market wage, a minimum wage likely exists beyond which a further increase causes a sufficient reduction in fringe benefits to reduce unemployment (at least unemployment caused by the minimum wage). There will unlikely be a monotonic increase and then a decrease in unemployment, as in the graphical analysis, but the fact that the lumpiness in providing fringe benefits is smoothed out somewhat when we consider a large number of firms does not eliminate the possibility of our result, at least qualitatively. Increasing the minimum wage can reduce unemployment, and harm workers in the process.

Fundamental to the possibility that a minimum wage increase will reduce unemployment by harming workers is the assumption that a higher minimum wage makes available jobs less attractive. This assumption is based on the plausible argument that, as money wages are increased by minimum wage legislation, employers remove fringe benefits from the compensation package that the workers value more than the additional wage, which is reflected in the upward shift in the labor supply curve in response to a higher minimum wage as shown in Figures 1 and 2. Put another way, increasing the minimum wage reduces the labor force participation of affected workers, prima-

DWIGHT R. LEE 665

rily teenagers. The empirical studies that bear on this issue yield mixed results, with the minimum wage having a negative effect on the labor force participation of some categories of workers and having positive effects on the participation of others. But there is rather convincing evidence that minimum wage workers lose fringe benefits when the minimum wage is increased, and that they value those benefits by more than the wage increase. 3 The result is that a higher minimum wage negatively affects their labor force participation. Considering just teenage workers as a whole, Brown (1988, p. 139) discusses studies that, taken together, indicate "a reduction in the [teenage] labor force participation due to the imposition of a minimum wage. If one accepts the idea that labor force participation is an increasing function of the average rewards from participating in the labor force, it appears these rewards are reduced for teenagers by the minimum wage" (emphasis added). Brown expresses some puzzlement over this conclusion since he does not consider fringe benefits and the possibility that those benefits are reduced by the minimum wage.

IV. Conclusion

Card and Krueger (1994) excepted, it is difficult to find economists who argue that increasing the minimum wage will increase employment among those workers directly affected. 4 Most economists accept the implications of downward sloping demand curves and upward sloping supply curves and accept the view that increasing the minimum wage above the market wage will reduce employment and increase unemployment, at least to some degree. But some economists support minimum wage legislation as an effective way to help low-paid workers. Advocates of the minimum wage point to studies that indicate the unemployment effect is small (as many studies do), so the benefit from the higher wage received by those who keep their jobs is seen as greater than the costs to those who become unemployed.

This argument for the minimum wage can be challenged on general efficiency grounds by extending consideration beyond those workers directly affected. But in this paper I have challenged the case for the minimum wage by concentrating on the welfare of workers and by recognizing that their compensation includes fringe benefits that can be reduced in response to minimum wage increases. The implication is that increasing the minimum wage harms even those workers who keep their jobs precisely because the unemployment effect is small - - the employer reduces fringe benefits to offset the cost of the higher wage even though the lost benefits are worth more to workers than the additional wage. Furthermore, because there is commonly some lumpiness in the provision of fringe benefits, increasing the minimum wage may decrease unemployment. But this can hardly be considered an advantage of the minimum wage, since workers are harmed the most by a minimum wage increase when it does reduce unemployment, because that is when it is also causing the largest loss in fringe benefits.

NOTES

*I thank the Earhart Foundation for providing financial support during the preparation of this paper. Any errors are solely my responsibility.

666 J O U R N A L O F L A B O R R E S E A R C H

IAs related by Deere et al. (1996, p. 33 in footnote), "In the 1996 [American Economic Association] ses- sion [on the minimum wage] Richard B. F r e e m a n . . . stated that one of the things you would want to know before supporting an increased minimum was whether the minimum wage rose by a greater percentage than the drop in teenage employment. Citing the result [that it did], he then stated his support for an increased minimum�9 Similarly, Card (1992, p. 36) concludes, "Comparisons of grouped and individual state data con- firm that the rise in the minimum wage raised average teenage wages," since "there is no evidence that the rise in the minimum wage significantly lowered teenage employment rates."

2I heard University of California labor economist Richard Sutch argue at a conference we both attended in Tucson in the early 1990s that increasing the minimum wage above the market level could encourage low- skilled workers to become more productive to maintain their employability. One would think that the higher pay that comes from more productivity without a minimum wage would be adequate motivation to improve productivity, but maybe the fear of losing a job because of a minimum wage increase adds to that motivation, though 1 know of no empirical support for this argument. The argument that the negative employment effects of a higher minimum wage will be offset by allowing employers to impose more control over workers is also suspect. If this were true, employers would be strongly motivated to pay a higher wage to achieve that control without a minimum wage. Also, efficiency wage models suggest that the advantages (including productivity increases) a firm realizes by paying higher wages does not prevent those wages from causing some unemployment�9 See the introductory chapter in Akerlof and Yellen (1986).

3For a discussion of some of these studies, see Wessels ( 1980b, pp. 75-84). Despite the mixed results, there is enough evidence for a negative effect of the minimum wage on labor force participation for Wessels (1980b, p. 84) to conclude that this evidence "correspond[s] with the expanded model (the one including fringe benefits) and not with those of the standard model."

4For a careful and damaging critique of the Card and Krueger result, see Neumark and Wascher (2000), followed with a reply by Card and Krueger (2000).

R E F E R E N C E S

Akerlof, George A. and Janet L. Yellen, eds. Efficient Wage Models of the Labor Market�9 Cambridge: Cam- bridge University Press, 1986.

Brown, Charles. "Minimum Wage Laws: Are They Overrated?" Journal o f Economic Perspectives 2 (Sum- mer 1988): 133-45.

Card, David. "Using RegionaJ Variations in Wages to Measure the Effects of the Federal Minimum Wage." Industrial and Labor Relations Review 46 (October 1992): 22-37.

- - and Alan B�9 Krueger. "Minimum Wages and Employment: A Case Study of the Fast-Food Industry in New Jersey and Pennsylvania: Reply�9 American Economic Review 90 (December 2000): 1397420.

�9 "Minimum Wages and Employment: A Case Study of the Fast-Food Industry in New Jersey and Pennsylvania." American Economic Review 84 (September 1994): 772-93.

Deere, Donald R., Kevin M. Murphy, and Finis R. Welch. "Examining the Evidence on Minimum Wages and Employment." In Marvin H. Kosters, ed. The Effect of the Minimum Wage on Employment�9 W~ish- ington, D.C.: American Enterprise Institute, 1996, pp. 26-54.

Neumark, David and William Wascher. "Minimum Wages and Employment: A Case Study of the Fast- Food Industry in New Jersey and Pennsylvania: Comment" American Economic Review 90 (Decem- ber 2000): 1362-96.

Wessels, Walter J. "The Effect of Minimum Wages in the Presence of Fringe Benefits: An Expanded Model." Economic Inquiry 18 (April 1980a): 293-313�9

�9 Minimum Wages, Fringe Benefits, and Working Conditions. Washington, D.C.: American Enter- prise Institute, 1980b.

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The minimum wage can harm workers by reducing unemployment