p38-43 Vol4-4 Minimum wage

Imagine you had some free time this December holiday and wanted to find a part-time job, such as working as a barista at Starbucks or serving tables at a small family restaurant with wages

paid by the hour. In Singapore you would get paid around S$6 or S$7 an hour—a decent sum. However, you soon realize that some of your international counterparts get paid significantly more. The French would get 9.22 Euros (S$14.73) an hour, the Japanese around 650 Yen (S$10.43) an hour and the Americans at least US$7.25 (S$9.21), with many states actually offering more. The reason? A minimum wage policy.

THE TEXTBOOK EXPLANATIONThe most simplistic method to model the

minimum wage policy is to view it as the implementation of a price floor in the labour market. There are limitations with this, but it provides the foundation for us to build our analysis.

Assume first that we have the labour market as shown in Figure 1, where Labour Demand is shown by LD and Labour Supply is shown by LS. In a non-interventionist market, the equilibrium

wage and employment levels are given by W and Q respectively. A minimum wage policy would thus legally mandate a wage W*, where the minimum wage is higher than the current equilibrium wage.

Here we can immediately see how the minimum wage distorts the labour market. At the new wage W*, the quantity of labour supplied (QS) exceeds the quantity of labour demanded (QD) and we have structural unemployment,

MINIMUM WAGEFIGURE 1

38 THE UNEMPLOYMENT ISSUE THE UNEMPLOYMENT ISSUE 39

SKILLS CONTENTBUSTER ESSAYS ARTICLES

Why are minimum wages bad for the economy?

Are minimum wages necessarily bad for the economy?

KEY POINTS OF QUERYdenoted by QS–QD. In other words, having a minimum wage policy distorts price incentives in the labour market, where more people are willing to work due to

the higher wages, but the higher cost of labour means that firms are hiring fewer workers. This results in an increase in unemployment levels—and that’s not all.

MISSING THE TARGET AUDIENCEProminent monetarist Milton Friedman classes the minimum wage as a group of policies that, in his words, despite being labeled as for the poor and for the needy; almost

always have effects exactly the opposite of those of which their well-intentioned sponsors intended. The reason is this: Having a minimum wage means that

MINIMUM WAGEFIGURE 2

A minimum wage policy is legislated as a policy to reduce income inequality in a country as measured by the Gini Coefficient. In recent times, increased income inequality due to globalisation has led to more and more economies looking to a minimum wage as a solution to a widening income gap. Countries such as Hong Kong and Malaysia have recently announced or started enforcing plans for a minimum wage.


MACROECONOMICS

inflationary situation. This often makes governments reluctant to start the ball of a minimum wage rolling. As can easily happen where a push for a minimum wage leads to a rise in prices and if prices rise more than wages, real income falls and there comes a need to adjust the

minimum wage to keep up with prices, which triggers a wage-price spiral.

people who do not have the skills or productivity to justify that minimum wage will become unemployed. To understand this, we can look at the simple hiring decisions of a firm.

The process of hiring an individual can be simplified to a simple cost-benefit analysis. The cost to a firm for hiring a worker is simply the real wage, while the benefit to a firm is the amount of output that worker can produce for the company, which in turn is dependent on the worker’s skill set, education level, and productivity. Workers with low skills or low productivity are paid lower wages, since firms are unlikely to offer them a high wage for their work as the corresponding value obtained from the worker’s output is not high.

The implementation of a minimum wage thus, as argued by Friedman, backfires on its initial intentions, which is to help raise the income level of low-wage workers. By legally enforcing the wage that firms have to pay, firms will choose not to hire workers whose skill set isn’t sufficient to earn that minimum wage, putting low-skilled, low-income workers out of jobs. The minimum wage thus, in effect, results in those low-income workers becoming no-income workers.

HIGHER WAGES, BUT HIGHER PRICES, TOOTaking a bird’s eye view on the matter, labour is like any other factor of production, and the implementation of a minimum wage law raises the cost of production of firms in the market. Daniel Aaronson and Eric French, writing in a paper published by the EPI in 2006, explicitly found that prices rise about 0.4 to 1.5 percent with a 10% minimum wage hike. From a microeconomic standpoint, firms faced with higher cost of production will seek to raise prices in a bid to maintain profits. When firms do that nationwide, it translates into an economy-wide effect felt from a macroeconomic standpoint and the minimum wage policy is equivalent to a rise in the short-run Aggregate Supply, similar to other supply shocks. This leads to a case of cost-push inflation with a fall in national income and employment.

The combination of a rise in wages and a rise in prices sets up a potentially

What worries countries more in this age of globalisation is a loss of competitiveness in exports and attracting investment into the country.

THE FLIP SIDE OF THE COINWe have established that from basic economic modeling of supply and demand, the distortionary effects of a minimum wage seem devastating, yet 192 member states of the United Nations maintain an effective minimum wage. That list includes countries that are performing well economically, such as Hong Kong,

This problem is made worse, since there is now increased competition for jobs. As seen from Figure 2, the higher wages enforced by the minimum wage will attract workers to enter the labour force. Together with a fall in demand for workers, a persistent surplus of workers will remain in the market. The labour market is unable to clear, and hence employers will have the ability to hire only the best and the most highly skilled.

Another common reason for a minimum wage is when the poor can’t keep up with the rising cost of living. In order to help them have a decent ‘living’ wage to afford the basic necessities, a minimum wage is set.

Besides the loss of competitiveness caused by a minimum wage, economists are wary of introducing rigidities into labour markets when globalisation and trade favours markets that are flexible. Imposing a minimum wage thus prevents market forces from operating freely and introduces rigidities. This is a potential cause of structural unemployment, since wages aren’t allowed to fall below the floor to encourage more workers to switch to skills in demand as the wage difference is not reflective of the differences in demand due to the minimum wage.



South Korea, Demark, and Germany (the latter two countries are slight outliers and the distinction will be discussed later).

Academically, it is interesting to see how studies by the International Labour Organization have shown that a minimum wage cannot be directly linked to unemployment and job losses in countries. The Fiscal Policy Institute in the US even went a step further and a study of US states showed that the minimum wage was correlated with higher employment growth and faster growth in business profits.

As such, it is clear that there are additional dimensions to the minimum wage that have to be considered in order to explain the overall effectiveness of

such a policy. Hence, before you decide to use the classical textbook minimum wage explanation as the be-all and end-all of the minimum wage debate, carefully scrutinize the assumed preconditions and decide if they are relevant to the real world. We’ll offer you four alternative viewpoints on the minimum wage that may derail the classical hypothesis.

1. THE LABOUR MARKET IS NEVER AT EQUILIBRIUMClassical analysis relies on the critical assumption that markets are efficient, with perfect information, perfect competition, and the absence of market failures or distortions. What we find in the real world, however, is that this is never true. The labour market in particular is plagued with market failures and inefficiencies. Asymmetric information

exists due to the inability for employers to accurately screen the skills and capabilities of potential workers. Time constraints, search costs, and even relationships or personal recommendations affecting hiring decisions are all examples of inefficiencies in the market.

Thus, it could well be a case that market failures result in low-income workers being paid below the real equilibrium rate, and a minimum wage is a form of government intervention to raise wages up to the real equilibrium. Of course, one could make an argument against the effectiveness of the government in making such decisions or the inability to accurately pinpoint the exact equilibrium wage, but you cannot deny that a minimum wage might have a chance of improving a labour market with market failure.

Another commonly cited criticism of the textbook explanation comes from the fact that the labour market, in reality, is much more segregated, with varying labour demands and supplies for different industries and workers of different skill sets. Lower-paying industries will inevitably be affected more by a minimum wage than the banking sector, for example,

where most workers are paid well above the minimum wage. There are even industries that are completely excluded from the policy—the self-employed and farm owners, for example. The presence of such ‘non-covered groups’, as argued by labour economist Gary Fields of Cornell University, renders the textbook model obsolete and calls for more empirical studies. If that is the case, the effects of a minimum wage as shown in Figure 2 need not be that severe, as it may only affect a small portion of the labour market, since many job profiles with wages well above the minimum wage would in fact end up with the legislation being ineffective, as it was set below the market clearing wage

In the case of Malaysia, a wage floor of RM800 to RM900 has been announced for certain states. Though this might cause a one-off increase in cost of production, if we compare the minimum wage imposed in Asia with the levels in the US or Euro regions, the fact that the rates are lower than those in other countries may lessen this danger.

A market failure when low- skilled workers don’t know the market rates of wages and hence accept wages that are too low. By setting a minimum wage, government data on wages helps workers make informed decisions as to what wage rate to offer their labour.

This means that we should not be looking at the labour market as one aggregated whole. We should be looking at the labour market being segregated into different types of labour markets, such as demand and supply of teachers, demand and supply of pilots, etc.

For a minimum wage to be effective, it must be set above the market equilibrium.

MACROECONOMICS


for that particular type of skill.

2. A PRICE INELASTIC DEMAND FOR GOODSThe textbook model hinges on the assumption that a rise in the real wage will lead to a fall in the demand for labour—an overarching generalization that has some exceptions. In a market for goods with a highly price inelastic demand, for example, a firm can simply pass on the higher costs of labour as higher prices, and due to the inelastic demand, this may actually lead to higher revenues. If this increase in revenue offsets the rising cost of wages, firms have no incentive to lay off workers since profits are rising. In this scenario, the minimum wage might actually increase employment.

3. ENCOURAGES EMPLOYMENT AND PRODUCTIVITY GROWTHIt is not all gloom and doom with the minimum wage, and over the years economists have derived potential positive spillovers from a minimum wage policy in a bid to explain discrepancies in the empirical data, especially with many studies having inconclusive results concerning the link between a minimum wage and employment.

First, and most obviously, the prospect of a higher wage encourages employment, increasing the labour supply of a country as more people who were previously unwilling to work step out and find jobs. In a study of Hong Kong, it was found that the employment rate increased from 77.6% to 81.3% after the Hong Kong Minimum Wage Ordinance took effect on May 1, 2011. Arguably the country is still limited by its labour demand, but increase labour force participation rates does increase the productive capacity of a country.

Second, offering a higher wage may increase labour productivity, due to efforts from both the employee and employer. Being able to earn a significantly higher wage as compared to the past and the knowledge that there is a high demand

for jobs (and hence uncooperative and unproductive workers can be easily replaced), a minimum wage may lead to a lowering of turnover rates and employee absenteeism. On the part of firms, the higher costs of labour encourages firms to improve the productivity of its workers through further training and education to ensure that their output is able to justify the minimum wage. It also encourages research and innovation to develop more cost-effective methods of production that rely less on labour. Either way, this leads to increased productivity in the economy—a benefit, no doubt.

4. AN EFFECTIVE REDISTRIBUTION TOOLFinally, even if we accept the various positive and negative trade-offs of a minimum wage law, it remains, at its heart, a redistribution tool that has subjective viability. Taking numbers from Aaronson and French’s study, let us assume that a 10% rise in the minimum wage increases inflation by 1%. Using US statistics as an average, where 2% of the working population earn the minimum wage, the trade-off is thus: 98% of the working population will be 1% worse off (due to inflation), while the 2% of the working population on the minimum wage is 10% better off. Is this a good trade? Perhaps, if income inequality is a pressing issue in the country.

A MINIMUM WAGE IN SINGAPOREIn a recent article titled ‘What can Singapore learn from Europe’, Professor Tommy Koh suggests, contrary to the conventional Singaporean taboo, that the minimum wage policy could be a solution to Singapore’s rising inequality. His case is valid, and drawing comparisons between Singapore and the Nordic Countries, the evidence suggests that a minimum wage may not significantly compromise economic growth. Denmark was a case in point, having a much more equitable society with a lower Gini coefficient (0.27, compared to Singapore’s 0.46) but a higher per capita income in 2010. Even if there are negative consequences, the sheer magnitude of income inequality in Singapore means that the minimum wage trade-off between equity and growth is rather appealing.

The Singapore government has always


been quick to refute the minimum wage suggestion, and it is easy to see why. Singapore’s competitiveness is significantly accounted for by its price elastic supply of cheap unskilled labour, courtesy of a lax foreign policy. Having an all-inclusive minimum wage would severely increase the operating costs of firms, but a citizen-only minimum wage would be ineffective as firms turn to foreign labour as substitutes. However, what could hurt Singaporeans most from such a policy may not be the shortfall in growth, but the exacerbation of inflation. Singapore’s inflation rates are already dangerously high, accelerating to 5.4% in April 2012. Implementing a minimum wage would only push this up further. Could you imagine paying $8 for chicken rice at the local hawker center or seeing the price of fresh fruits in NTUC continue to rise?

But there is much more to the issue. The debate isn’t just a simple mutually exclusive decision. Look at the issue this way: It is not whether to have a minimum wage or not, but what type of minimum wage. When analyzing the example countries Professor Koh used in his article, it is important to note that Nordic countries like Denmark and Sweden do not have the minimum wage hard-coded into the legislation. Instead, they work on a collective bargaining system, where the workers’ union reaches a consensus with the employer’s union in to attain an industry-specific fair wage. The law only protects this system of collective bargaining and does not enforce an economy-wide rigid minimum wage, like those of the US or the UK. It is no wonder that these countries performed better, as it allowed for the creation of a fair minimum wage that was more effective in dealing with market failures of the labour market instead of a distortionary form of intervention.

This is not to say that such a system would be perfect for the Singapore situation, but it is a reminder that we

This is an extreme case, since total revenues increase as the rise in price by the firms sees a less than proportionate fall in quantity demand. Total revenues rise more than rise in total costs from higher wages due to the minimum wage.

If we compare the percentage of the population that gains against the percentage of the population that suffers from higher cost. Given Singapore’s acute income inequality problem, the scale seems to be tilted in favour of the large proportion that can potentially benefit from a minimum wage.


International Labour Organization. (2012). Global Wage Report 2012-13. Conditions of Work and Employment Branch(TRAVAIL). International Labour Organization.

Neumark, D., & Wascher, W. L. (2008). Minimum Wages. MIT Press. Krugman, P. (2009, December 16). Would cutting the minimum wage raise employment? Retrieved June 2012, from The

New York Times: The Opinion Pages: http://krugman.blogs.nytimes.com/2009/12/16/would-cutting-the-minimum-wage-raise-employment/

United States Department of Labor. (n.d.). Wage and Hour Division (WHD). Retrieved June 2012, from Minimum Wage: http://www.dol.gov/whd/minimumwage.htm

International Citizen Service, Denmark. (n.d.). Work in Denmark. Retrieved June 2012, from Work in Denmark: https://www.workindenmark.dk/en

Friedman, M. (2008, June 14). Milton Friedman on Minimum Wage. Joint Economic Committee, Congress of the United States. (1995, Feb 15). Retrieved June 2012, from 50 Years of

Research on the Minimum Wage: http://web.archive.org/web/20110629183749/http://www.house.gov/jec/cost-gov/regs/minimum/50years.htm

Wu, A. M. (2012, May 15). China Daily Asia Pacific. Retrieved June 2012, from Negative side of minimum wage legislation is exaggerated: http://www.chinadailyapac.com/article/negative-side-minimum-wage-legislation-exaggerated

Koh, T. (2012, May 19). SG Hard Truths. Retrieved June 2012, from What Singapore can learn from Europe: http://sghardtruth.com/2012/05/19/what-singapore-can-learn-from-europe-by-tommy-koh/

BIBLIOGRAPHY

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must not be too quick to reject certain governmental policies or developmental pathways because they are deemed distortionary. A little creative policy design and innovation may shift the economic opportunity costs and trade-offs in Singapore’s favour. This is a lesson not just in policy-making, but in everyday decision-making, as well.

The distortionary effect of a minimum wage comes about because of the welfare loss resulting from those who are left unemployed due to the minimum wage.


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p38-43 Vol4-4 Minimum wage