The Minimum Wage

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The Minimum Wage

The minimum wage has become a very popular topic with examiners in recent years due, in large part, to the introduction of the National Minimum Wage in April 1999, set at £3.60 an hour for workers aged 22 and over, and £3.00 for 18-21 year olds. Before we look at the controversies surrounding this policy, we must look at the theory behind the minimum wage.

The minimum wage is a pay floor. Employers are not allowed to pay their employees a rate below the minimum wage. This only causes problems if the minimum wage set is above the equilibrium wage rate that would otherwise prevail in the labour market.

The Minimum Wage

The diagram above is the classic minimum wage set up. You see the 'normal' supply and demand curves. The equilibrium wage and employment levels are £2.50 and L1 respectively. The government then imposes the National Minimum Wage at the rate £3.60. As with the situation when the union forces the wage up, the new supply curve is the solid green line SMW. So the new equilibrium is at point A, giving a wage (obviously) of £3.60 and a reduced level of employment L2.

Of course, the fall in employment (L1 - L2) is significant, but the effect on unemployment is even worse. The unemployment figures have to include those who will now offer their labour services at the higher wage rate but cannot actually get a job (L3 - L1). This gives a total level of unemployment in this labour market of L3 - L2, which is larger than the loss in employment.

Of course, most industries in the UK were broadly unaffected by the National Minimum Wage (NMW). Any industry whose wage rate was already above £3.60 an hour had an equilibrium wage rate above the price floor imposed.

The Minimum Wage

To put the size of the NMW into perspective, let's use the example of a nurse earning £12,000 a year. Remember, some nurses actually earn less than that (outrageously!). This means she (or he) will earn £1000 a month. If she works a busy 50 hours per week (more than most workers), then that is 200 hours a month. £1000 divided by 200 hours gives a £5 per hour wage rate. I think most of you would agree that nursing is an appallingly paid profession, and yet even nurses earn well above the NMW. In the diagram above, you can see that the wage floor is below the equilibrium wage rate. In this example, the NMW has absolutely no effect on that equilibrium.

The industries that do tend to be affected are hospitality (a third of the workforce affected); security and cleaning (30% affected) and agriculture, retailing and social care (all 20%, figures from the Labour Force Survey).

One last point. You can probably see that the elasticity of both the demand and supply curves will affect the amount of unemployment caused by a minimum wage. The flatter (more elastic) the two curves are the larger the unemployment will be. The steeper (more inelastic) the two curves are the smaller the increased unemployment will be.

  1. Reducing poverty: Unsurprisingly, households whose earners were paid less than the NMW also tended to be those who were officially defined as 'in poverty' (income of less than half median earnings). It was felt that the NMW would lift households out of poverty. Of course, this leads to another advantage of the NMW; it should, therefore, lead to a fairer distribution of income.
  2. Tax and benefits: If earnings rise as a result of the NMW, government tax receipts from earners will rise and the benefits paid to those in work but on low incomes should reduce. Government finances will improve, which could be spent on reducing the national debt, reducing taxes or spending on important services like education or health.
  3. The effect on productivity: Some economists believe that the increased wage might improve labour productivity. Workers may respond to their higher wage rate by working harder, possibly as a result of worrying about losing their job now that the increased wage rate has made it a more 'sought after' job. Employers may force through productivity improvements. They may feel that the increased wage rate needs to be earned through increased efforts!

    The Minimum Wage

    In the diagram above, you can see what happens when productivity improves. The shift to the right of the demand curve (the MRP curve, remember) reduces the 'unemployment' gap. The initial demand curve, D1, gives an 'unemployment gap' equal to AC. The shift to D2 reduces the gap to BC. If the curve shifts all the way to D3 then the gap is eliminated. Employment has risen to L2 at wage £3.60. Before the minimum wage was introduced the wage was lower at W1 and employment lower at L1. The demand curve may even shift all the way to D4. This would push the wage and employment levels even higher (equilibrium point D).

  4. Improved incentives: It may be difficult to believe, but there are a number of people who are voluntarily unemployed. They are not prepared to supply their labour services at the given equilibrium wage in the labour market that is appropriate to their skills. To put it in cruder terms, who would want to clean toilets for £2 an hour? Many would rather collect unemployment benefit and do nothing. A NMW puts a floor of these low wage rates and acts as an incentive to encourage some of these 'voluntarily unemployed' people back to work. This will save the government money on benefits, increase income tax revenues and improve the productive potential of the economy.
  1. Unemployment: We have already seen how a NMW can cause unemployment. Pessimists did not accept that huge productivity improvements were feasible. This is the main disadvantage, but we shall see in the last section whether this problem proved to be as widespread as the pessimists believed it would.
  2. The maintenance of pay differentials: There was a worry that a higher wage rate at the low end of the scale may cause those higher up the pay scale to insist on pay rises to maintain the pay differentials. In theory, this could happen all the way up the pay scale and be very inflationary. If you were earning £3.60 an hour, and then someone in an inferior job earning £2.50 an hour was suddenly earning £3.60 an hour as well, simply because of the NMW, you would probably be a bit annoyed. You might ask your employer for an extra £1 an hour to restore the difference between the two wage rates. If you were successful, then your wage rate would rise to £4.60 an hour, which may be the same as someone else in a slightly better job. He may then ask for a pay rise. This process could go on forever!
  3. Are those in poverty wage earners? One of the main advantages of the NMW was its success in reducing poverty by increasing the wage of low-income families. But many households in poverty are struggling precisely because no one in the household has a job. The NMW is useless to the unemployed.
  4. High cost to employers: The bureaucracy involved in complying with the new law, plus the actual cost of the higher wage (assuming productivity improvements are not significant) may force firms to increase the price of their products, which is detrimental to consumers. They may also cut back on expensive training for employees.
  5. Regional differences: The NMW is national. The wage floor is the same rate nationwide. Is that fair? It costs a lot more to live in London than anywhere else in the UK, and yet a struggling cleaner will be paid the same wherever he/she works in the country.

The NMW has been operational for well over a year now. Were the optimists right (see the 'case for' above) or were the pessimists closer to the truth (see the 'case against' above)?

The big disadvantage of the NMW was unemployment. Has this happened? Well, not really. Unemployment is lower than it has been for 20 years, and there does not seem to be much evidence in particular industries of significant job losses. Perhaps the government was lucky that the NMW was introduced at a time of rising employment and strong economic fundamentals. There is evidence that employers are, on the whole, adhering to the law (and paying the NMW), and yet employment keeps rising. Perhaps productivity has improved, offsetting the rising wage, as some economists predicted. There was certainly evidence from America to suggest this might be the case. Employment levels were assessed at fast-food restaurants before and after an increase in the minimum wage. In some cases, employment levels actually rose (the rises were small, though).

Others argue that the main reason why there was little effect on employment was because the NMW was set at such a low rate. If the wage floor is set only just above the equilibrium, then one can see that the effect on employment will be small, especially if there are some improvements in productivity.

The big disappointment with the NMW appears to be the fact that it has had little success in reducing poverty. We mentioned the point about many of those in poverty being unemployed, and therefore unaffected. Another point to note is that many of the workers who benefited were part-time workers, and in particular, female part-time workers bringing a second income into the household. These were not poor households. In fact, the Institute of Fiscal Studies estimated that only 4% of households in the bottom half of the UK's income distribution gained from the NMW compared with 7% in the richer half! So not only did the NMW do little to reduce poverty, it also did little to make the distribution of income in the UK fairer.