Wage and employment effects of non-binding minimum wages

1. Wage and employment effects of non-binding minimum wages Marcus Dittrich Andreas Knabe TU Chemnitz & CESifo FU Berlin & CESifo Social Choice and Welfare Moscow, July 2010

2. Motivation • “The effects of the minimum wage on employment and the distribution of income have been hotly debated policy question for over 50 years.“ (Brown 1999) • Pro: raising the wages of the lowest-paid would help fighting poverty • Contra: introducing such rigidities impedes allocative role of flexible wages, causing more unemployment and possibly even more poverty • Oneissuethatmostproponentsandopponentsagree on: MW have to be binding to have any effect!

3. Motivation: Spillover effectsofmw • But: Many studies report that raising the MW has spillover effects (Katz/Krueger 1992, ILLR; Manning 2003, Neumark et al. 2004, JHR). • Two important stylized facts: • Firms raise the wages of workers that used to earn less than the new MW above the minimum level required. • Workers already earning wages above the new MW receive wage raises as well. • Possible explanation: Employers attempt to maintain their internal wage hierarchy.

4. Motivation: Spillover effectsofmw match if firm‘s offer ≥ res. wage Experimental evidence (Falk et al. 2006, QJE) • excludes wage hierarchy effects or effort considerations • similar to “ultimatum game” • firm proposes a wage • worker sets reservation wage • main finding: introduction of MW increases wages above the new minimum, because it drives up reservation wages • Potential explanation: MW affects what people consider to be a ”fair” compensation for their work. • How can these findings be explained by theoretical models?

5. Outline • Motivation: spillover effects of MW • Model economy • Nash wage bargaining • Kalai-Smorodinsky wage bargaining • Conclusion

6. Model economy • economy with large number of sectors • bargaining over wages (w ) between unions and firms • representative firm’s profit: • representative union’s utility: • alternative income:

7. Nash wage bargaining Nash bargainingsolutionfollowsfromfouraxioms (Nash 1950,Econometrica): • Pareto efficiency • Invariance to equivalent utility representations • Symmetry • Independence of irrelevant alternatives

8. Nash wage bargaining • Nash bargaining solution: where = player i ’s utility, = conflict utility, S = utility possibility set • applied to wage bargaining problem:

9. Nash wage bargaining

10. Nash wage bargaining

11. Nash wage bargaining What do non-binding MW do? 1. sectoral level • w0 exogenous  Sectoral MW has no effect on bargained wage.

12. Nash wage bargaining

13. Nash wage bargaining What do non-binding MW do? 1. sectoral level • w0 exogenous  Sectoral MW has no effect on bargained wage if it is non-binding. 2. national level •  no change in any wages • hence, w0 unchanged  National MW has no effect on bargained wage if it is non-binding.

14. Kalai-Smorodinsky wage bargaining alternative axiomatic solution (Kalai/Smorodinsky 1975, Econometrica) maintain first three axioms of Nash solution replaces IIA with “individual monotonicity” axiom  a player must not suffer from an enlargement of the bargaining set that leaves the maximum utility attainable by the other player unchanged

15. Kalai-Smorodinsky wage bargaining • both bargaining parties agree to a solution that equalizes the relative utility gains ( ratio of the actual gains to the maximum feasible gains) • maximum feasible gain is determined by the payoff one can secure by pushing the other party to the minimum payoff it would just be willing to accept • could be interpreted as “fairness” (McDonald / Solow 1981, AER)  if a player could have more (without hurting the other player), he should have more

16. Kalai-Smorodinsky wage bargaining • general KS solution: both parties make equal proportional concessions from their respective favored points  KS curve: • applied to wage bargaining problem:

17. Kalai-Smorodinsky wage bargaining • “utopia points”: • bargained wage:

18. Kalai-Smorodinsky wage bargaining

19. Kalai-Smorodinsky wage bargaining What do non-binding MW do? •  change in utopia point: • KS curve: • bargained wage:

20. Kalai-Smorodinsky wage bargaining What do non-binding MW do? 1. sectoral level • w0 exogenous • bargained wage raises to a level above the former wage • implication: MW is non-binding, but effective!  Sectoral MW reduces the firm‘s utopia payoff and hence drives up the wage.

21. Kalai-Smorodinsky wage bargaining

22. Kalai-Smorodinsky wage bargaining What do non-binding MW do? 1. sectoral level • w0 exogenous  Sectoral MWreduces the firm‘s utopia payoff and hence drives up the wage. 2. national level • direct effect in each sector if • plus: changes in w0 affect wages in other sectors  National MW does not have to be binding, but is effective

23. Conclusion • Empirical evidence suggests that MW have real effects even if they are not binding. • Implications for economic theory: KS solution is able to describe these effects, Nash solution is not. • Implications for public policy: Even relatively low MW might have negative employment effects  policy implications depend on whether union-firm-bargaining follows Nash or KS solution.

24. Thank you very much!

25. Motivation: Spillover effectsofmw Empiricalevidence • Katz and Krueger (1992, ILRR): Texan fast-food restaurants • one-third “maintained their wage hierarchy” (workers who earned more than the old MW will also earn more than the new minimum) • 60% of restaurants who had starting wages already above new minimum still increased their wages • Manning (2003): US data 1979-2000 • spillovers for wages up to 150% of the MW • Neumark et al. (2004, JHR): US data 1979-1997 • spillovers for wages up to twice the MW

26. Motivation: Spillover effectsofmw • Three popular theoretical explanations • Substitution effects (Pettengill 1981) • increase in demand for above-minimum wage workers raises their wages, too • Monopsonistic firm behavior (Manning 2003) • some firms pay high wages to attract workers from low-wage firms • if low-wage firms pay more, also high-wage firms have to raise their wages • Efficiency wages (Grossman 1983, JHR) • smaller wage differential between skilled and unskilled workers has to be compensated to keep up effort of skilled workers

27. Experimental evidence • Falk, Fehr & Zehnder (2006, QJE) conduct a laboratory experiment in which a rent is distributed between “workers” and a “firm”. • In the experiment’s first step, workers state their reservation wages, which are not observed by the firm. • Then, the firm makes a wage offer and workers with reservation wages below this wage offer are hired.

28. Experimental evidence • The introduction of a minimum wage raises workers’ reservation wages: Before its introduction, 91% of workers stated a reservation wage below the later minimum wage. • After it had been introduced, 59% reported that their reservation wage was equal to the new minimum wage, and the other 41% said that their reservation wage was even larger than the new minimum wage. • Result: minimum wages affect the wage level that people are willing to accept even if they are not directly affected by the new minimum wage.

29. Model economy: monopolyunion • reference scenario: monopolistic union sets the wage, firms set employment • monopoly union behavior:

30. Model economy: monopolyunion

31. Model economy: monopolyunion

32. Model economy: Monopoly union & MW What do non-binding MW do? 1. sectoral level • w0 exogenous  Sectoral MW has no effect on monopoly union‘s desired wage.

33. Model economy: Monopoly union & MW

34. Model economy: Monopoly union & MW What do non-binding MW do? 1. sectoral level • w0 exogenous  Sectoral MW has no effect on monopoly union‘s desired wage. 2. national level •  no change in wages • w0 unchanged  National MW has no effect on monopoly union‘s desired wage if it is non-binding.

35. Nash‘saxioms Find a bargaining solution that satisfies the following four axioms: • Pareto efficiency(PAR) • Invariance to equivalent utility representations (INV) • Symmetry (SYM): symmetric utility functions should ensure symmetric payoffs • Independence of irrelevant alternatives (IIA): If S is the Nash bargaining solution for a bargaining set X, then for any subset Y of X containing S, S continues to be the Nash bargaining solution.

36. KS‘saxioms Find a bargaining solution that satisfies the following four axioms: • Pareto efficiency (PAR) • Invariance to equivalent utility representations (INV) • Symmetry (SYM): symmetric utility functions should ensuresymmetricpayoffs • Individual monotonicity (MON): If the bargaining set is enlarged such that the maximum utilities of the players remain unchanged, then neither of the players must not suffer from it.