8University of St. GallenVW 75Spring Semester 2014

Advantages and Disadvantages of the Minimum Wages.Comparing the Neoclassical and Post-Keynesian Perspectives.

Pierre-Louis MarchalMetzgergasse 269000 St. Gallen+ 41 (0)79-562 2983

Term PaperUniversity of St. Gallen Introduction to EconomicsErmira MehmetajGroup 29 April 2014

Abstract:

Since the first minimum wage law was passed in New Zealand in 1984, the debate over the relevance of such legislations has always been around. However, economists, in now more than a century, have never come to a consensus on the matter. Whereas most textbooks have adopted a neoclassical perspective criticizing those laws, others believe this neoclassical model is incoherent and tend to argue in favor of (high) minimum wages. Renowned among them are the post-keynesians.Relying on post-keynesian and neoclassical theoretical findings, as well as many empirical studies, this paper is an attempt at understanding and comparing two prevailing , and radically different, views on an identical topic.

Table of Contents

1 INTRODUCTION4

2. THE NEOCLASSICAL PERSPECTIVE

2.1 Neoclassical Theory5

2.2 Neoclassical Economics on Minimum Wages6

2.3 NeoclassicalEmpirical Studies11

3. THE POST-KEYNESIAN PERSPECTIVE

3.1 Post-Keynesian Theory14

3.2. Post-Keynesian Economics on Minimum Wages16

3.3 Post-Keynesian Empirical Studies20

4. CONCLUSION24

5. DECLARATION OF AUTHORSHIP25

6. BIBLIOGRAPHY26

7. FIGURES28

1 Introduction

Forbidding companies to pay wages inferior to a certain threshold has important effects on the labor market and even on the global economy. Indeed, wage levels influence not only the rates of employment, and the living conditions of part of the payroll, but also a countrys level of education, how much outsourcing is done to countries where (minimum) wages are lower, and even market prices and therefore rates of inflation. Yet, all around the world, and for more than a century now, since the first minimum wage law was passed in New Zealand in 1894 (The Economist, 2001), economists, policymakers, business owners, and many others, have never ceased debating over the varying advantages and disadvantages of minimum wage laws, and like often in economics, there is no consensus among economists.

Indeeed, there is a long-standing tension in economics between belief in the advantages of the market mechanism and awareness of its imperfections. (Solow, 1980, p.1).

Thus, supporters and opponents of market-based economic policies come to very different conclusion when it comes to discussing the impacts of price floors such as minimum wages (abbreviated MW).

In fact, there are many schools of thoughts on the subject and among them, the neoclassical and post-keynesian approaches, basically arguing respectively against and in favor of high MW and tackling the subject in two completely different ways making it particularly interesting for one to confront their point of views.

This paper is organized in two sections. Beginning with the analysis of the neoclassical perspective, this paper will start by formerly defining what neoclassical economics actually is. Then, since effects of MW on the labor market have faced extensive academic attention, this will allow us to continue by pointing out what arguments are brought forward by neoclassical economists regarding the aftermath of MW laws. At last, these arguments will be supported by empirical studies coming to neoclassical conclusions. Symmetrically, in the second part of this work, I will proceed in the exact same way when addressing the post-keynesian perspective, and then conclude on what we have gained from confronting those two very different viewpoints. 2. The Neoclassical Perspective

2.1 Neoclassical Theory

Neoclassical theory is an approach to economics emphasizing the efficiency of the market. Neoclassical economists begin by describing certain distinctive and independent objects: Individuals, firms, supply, demand, quantities, etc and then attempt to draw connections. (Resnick &Wolf, 2012, p.36)The starting point in trying to establish those connections are the actors rational preferences constrained by the information available as well as incomes for individuals and factors of production like the technology availablefor firms. Neoclassical models indicate that the most important influences on those connections, namely prices, can be logically explained as results of shifts in supply and/or demand, and that consequently, actors of the market according to those constraints and influences, will always act in the best possible way. (Resnick &Wolf, 2012, p.37)

Because of its very causal, scientific, nature, this methodology is often described as determinist and reductionist in the sense that, regardless of political and sociological variables,once one or a few determining, essential causes have been found, then every event can potentially be explained. (Resnick & Wolf, 2012, p.38)

Nevertheless, as reductionist as it may be, worldwide, the neoclassical model is very popular and even considered to be the dominant economics model of our lifetime. Therefore many neoclassical economics is often referred to as mainstream, orthodox, or conventional economics. (Keita, 1992, p.6)

This mainstream model suggests, that the private, decentralized, competitive market is self-correcting, and will thus correct any kind of occasional, temporary, market imperfection. (Palley, 2004, p.1) Therefore neoclassical theory clearly points in the direction that the economy will best manage itself when markets, solution to agents maximization problems, are not interfered with.

Hence, no matter how good the states intentions are, external intervention aiming at controlling the market economy (in our case regulating the labor market and setting MW) will only undermine the markets otherwise successful properties. Moreover, neoclassical economists actually argue that economic inefficiencies are due to an interventionist state trying to regulate markets (Resnick & Wolf, 2012, p.3). For instance, according to neoclassical economists, huge state deficits occur because governments borrow money to rescue collapsed markets whereas private borrowers should be taking care of it instead. In fact, private decisions of individuals and businesses reacting to and taking advantage of the market power will always be considered as better means to solve economic issues. Consequently institutions are completely de-emphasized and thus the starting point of all neoclassical thinking is microeconomics.In other words an efficient economy and social welfare can only be obtained via deregulated markets. From this basic assumption comes a wide range of neoclassical theories about various areas of economic activity. Therefore it is not surprising to see that neoclassical administrations like republicans argue in favor of less government interventionand therefore no MW as they believe that free markets will not let valuable factors of production, including labor, go to waste. Instead, prices will adjust to ensure that demand for labor is forthcoming and that all factors are employed. (Palley, 2004, p.1)

2.2 Neoclassical Economics on Minimum Wages

It has just been highlighted that the neoclassical theory is extremely easy to understand. Applied to the labor market framework; it could be summed up in one sentence. State intervention will only lead to an inefficient labor market.Indeed, the neoclassical model demonstrates that flexible wage rates are key for supply and demand for labor to coincide, thus eliminating shortages and surpluses in the labor market while determining appropriate real wages. Therefore, the neoclassical theory gives the impression that market forces alone tend to establish full employment. Consequently, government policies attempting to reduce involuntary unemployment appear to be absolutely unnecessary.

Indeed, exogenous shocks such as MW laws can only lead to price distortions and consequently inefficiencies in the market. (Asia monitor, 2010, p.6). Thus, since the market ensures that factors of production are paid what they are worth, price floors preventing downward adjustment of salaries, as well as other obstacles like social protection institutions and strong trade unions for instance, actually lower social well-being and cause unemployment by interfering with the market process. (Palley, 2004, p.4)

In fact, for neoclassical economists, the reasons why MW not only do not help but actually disserve the ones they were supposed to help in the first place (i.e. the unskilled workers) are pretty straightforward.

As always, neoclassical economists base their reasoning on the elementary demand and supply model. Of course, this model can produce results that some will not like as low demand for labor may lead to very low wages (especially for unskilled workers). Even though governments cant simply ignore the distress caused by extremely low wages, neoclassical economists believe that relying on MW to artificially increase the incomes of low skilled workers; in other words, to fight against the market rather than to make use if its power to address those who suffer from the outcome of supply and demand, is perilous and unlikely to be effective since its based on two errors.(Stiglitz &Walsch, 2006, p. 91)

The first error is to assign the responsibility to someone (or a group): in our case, the employer. Neoclassical economists insist that it is anonymous market forces that determine equilibriums. Therefore, the reasons for changes in equilibriums lie in the market itself and not in a particular actor of this market, namely the employer. (Stiglitz &Walsch, 2006, p. 91)

The second mistake is that no matter how powerful one is, one cant interfere with the laws of supply and demand (no more than it can, for instance, interfere with the law of gravity.) By attempting to, the result will be a market out of balance with either excess supply or excess demand. Stiglitz &Walsch (2006) summarize it in a small sentence one ignores the workings of the law of supply and demand only at ones peril (p.94).

Thats why conventional wisdom in economics states that by forcing up MW above the equilibrium wage, supply for labor will excess demand for the latter and the surpluses created will, inexorably, lead to unemployment, or underemployment at least. Moreover, quite logically, the bigger the difference between the equilibrium wage and the MW, the bigger the surplus. Therefore, labor markets, either with low equilibrium wages (reflecting low productivity) or where MW are set at a high level, will be particularly exposed to job losses. On another hand, if the difference between the MW and the market equilibrium is minimal, then the distortion will be insignificant and in that case, neoclassical economists wont consider MW to be a problem anymore.

When the difference is significant however, setting arbitrary MW above the equilibrium wage prevents a market from moving toward its natural equilibrium price, leading to shortages in demand for labor.

Figure 1. Supply Surplus From Price Floors. This figure illustrates that in a competitive market employment will fall if the wage is exogenously raised. At W1>W0, quantity of labor demanded has decreased from L0 to L2 while the supply of labor has increased from L0 to L1. Therefore the surplus caused by the instauration of a MW, in other words the unemployment, is the difference between L1 and L2.

Moreover, MW laws are often the first step of a cycle making all wages rise. Namely, after workers with lower skills are raised to the MW, more qualified workers who used to earn the amount now corresponding to the MW will in turn seek higher wages thus intensifying the distortions in the market.To fully understand the neoclassical perspective however, one also has to understand why firms decide to hire or not to hire in the first place. To simplify things, we consider a model in which labor is the only factor of production. Therefore decision to produce is equivalent to decision to hire. Hence, once the market price of a good (or service) is known to a firm (regardless of whether the firm acts as a price taker, or price setter), depending on its marginal cost curve, it will see how much units if this good it can produce. Logically the higher the price, the more a company will decide to produce and consequently hire. (Stiglitz &Walsch, 2006, p. 182)

Fig. 2, The Demand for Labor. These two graphs illustrate what labor input L1 is required in order to produce a certain level of output Q1. Graph A: Looking at price p1, the firm will know what output Q1 to produce. Graph B: Looking at output Q1, the firm will know how much labor L1 to hire in order to produce Q1.

Sticking with the conventional analysis, while keeping in mind that firms are always considered to be price-takers in the market for labor, there is another way of looking at firms decision to hire. It is pretty simple, they "hire labor up to the point at which the value of the output produced by the last worker employed equals the money wage which he or she must be paid. (Appelbaum, 1979, p.40)

As a consequence, the lower the equilibrium wage, the lower the value of a marginal worker, and the more workers firms can hire. Thus neoclassical analysis insists on the fact that once MW are instituted, the ones who manage to get a job might be better off; but because the model suggests that high MW lead to unemployment, most of the unskilled workers are likely to loose their jobs and be driven into driven into extreme poverty instead. In fact, MW make it impossible to share the pie in more but smaller pieces. In this way, MW, by forbidding basic work to be poorly compensated penalize the less skilled fraction of the payroll as it is excluded from the labor market. Therefore, in the simplest, as in the more sophisticated, neoclassical models of employment, unemployment is essentially caused by excessive real wages. (Lavoie, 1998, p.17) Thus, if the objective of MW laws is to eradicate poverty, then, the MW, from this perspective, seems counterproductive.

Fig. 3, The Demand Curve for Labor. This figure describes how an increase in wages leads to unemployment. Since demand for labor cant exceed the value of a marginal worker, at wage w1>w2, employment is L1w1, employment is L2