The Market Price and Quantity In addition to the shortage, there are other consequences of the government’s price ceiling. Because of the increased quantity demanded landlords have less incentive and because of the lower rent they have less rental income to maintain the rental properties. This usually leads to a deterioration of the rental units. Due to the shortage of rental units in the inner city, the demand for properties not subject to rent controls increases. This increases the price of non-rent-controlled properties. In the graph above, the market is at equilibrium at a price of $11 and a quantity of 9. If the price were set at $7, a shortage of 7 products results. At $7 the quantity demanded is 13 (from $7 go straight over to the demand curve) and the quantity supplied is 6 (from $7 go straight over to the supply curve). Similarly, if the price were set at $14, a surplus of 5 units (11 minus 6) results. For a video explanation of the equilibrium price and quantity, please watch: Below are some supply and demand applications, in which we study what happens when the government, instead of the free market, determines the price. The Case of Rent Control Rent control is an example of a price set below the equilibrium point. This is called a price ceiling. In the graph below, the equilibrium (market) price of a rental unit is $1,800 per month. The city government wants the rental units priced at no more than $1,000 per month, so that more tenants can afford to live in the inner city. The lower-than-equilibrium rent causes the quantity supplied of rental units to decrease to 700 units, because suppliers have less incentive to build and own rental units at the lower price. The quantity demanded increases to 1,200, because the lower price encourages more buyers. This results in a shortage of 500 rental units (1,200 minus 700). In addition to the shortage, there are other consequences of the government’s price ceiling. Because of the increased quantity demanded landlords have less incentive to provide an excellent product, and because of the lower rent they have less rental income to maintain the rental properties. This usually leads to a deterioration of the rental units. Due to the shortage of rental units in the inner city, the demand for properties not subject to rent controls increases. This increases the price of non-rent-controlled properties. Rent control also makes discrimination more likely. Hopefully, landlords don’t discriminate when they accept tenants. However, when landlords have a waiting list of people applying for the lower-rent units, landlords who want to discriminate can more easily do so. At market prices, this is less likely to be the case. As rents are higher, there are far fewer waiting lists, and landlords are more likely to accept tenants based on their ability to pay, rather than on their race, ethnic origin, and lifestyle. Despite these disadvantages, rent controls are still in existence in various big cities around the industrialized world. Politicians often focus on the short-term social benefits of helping the poor, but are not always aware of the long-term economic disadvantages. Furthermore, they receive pressure from tenants, who ask for lower rent and more-affordable housing. Politicians are tempted to oblige tenants’ wishes, because there are far more tenants who vote than landlords.The Case of the Minimum Wage The minimum wage is an example of a price set above the equilibrium point. This is called a price floor. In the graph below, the equilibrium price of labor (the market wage) is $6.00 per hour. The government determines that it wants firms to hire workers at a minimum of $7.50, so that workers can earn more money per hour and better afford their daily expenditures. The higher-than-equilibrium wage causes the quantity supplied of labor to increase to 1,100 workers, because workers have more incentive to work at a higher wage. The quantity demanded of labor decreases to 900 workers, because the higher wage discourages firms from hiring workers. This results in a surplus of workers (unemployment) of 200 workers (1,100 minus 900). Minimum wage is a hotly debated topic. The graph above predicts that an increase in the minimum wage causes unemployment. Some studies, however, claim that an increase in the minimum wage has no significant effect on unemployment. Both studies can be correct, depending on the market conditions. Below is an example of a case study in which the minimum wage increases, but there is no effect on employment or unemployment. The Case when the Market Wage is above the Minimum Wage Let’s say that the equilibrium (market) wage in the New York metropolitan area for a certain type of worker is $10.00 per hour (see graph below). If the state government of New York raises the minimum wage from $7.50 to $8.50 (hypothetical example), the minimum wage will still be below the market wage. Therefore, there is no effect of an increase in the minimum wage on employment. The Case when the Market Wage is below the Minimum Wage If in another state the equilibrium (market) wage is $4.50 per hour, and the state government increases the minimum wage to $6.50 per hour, then businesses are required to pay many workers more per hour compared to what they were paying at the market wage. This will increase the incomes of workers who are able to keep their jobs. And it will lead to unemployment of workers (especially full-time workers), because the higher wage decreases the quantity demanded of labor and increases the quantity supplied. Critically Analyzing Minimum Wage Studies As you can see, the effect of an increase in the minimum wage differs, depending on whether the market wage is above or below the minimum wage. Another reason for discrepancies in studies on the minimum wage is that employment definitions vary. Economists Card and Krueger concluded in their study on the minimum wage that after the minimum wage increased in New Jersey, employment actually rose. The measure of employment they used was “the number of jobs held by people.” However, another measure of employment, which they did not use, is “the number of hours worked by people.” Using the latter definition, employment decreased. To illustrate this difference, consider the following example. Let’s say that as a result of an increase in the minimum wage, the number of full-time jobs decreases by 400, and the number of part-time jobs increases by 500. This can be expected as businesses, faced with a higher wage, decide to replace full-time workers with part-time workers in order to save money on benefits and reduce the total hours worked. Assuming that full-time workers work a 40-hour week, and part-time workers work a 20-hour week, the total number of hours worked declines by 16,000 (400 workers times 40) hours, and increases by 10,000 (500 times 20) hours. On balance, the number of hours worked decreases by 6,000. However, the total number of jobs increases by 100. As you can see, measuring employment by the total number of jobs (this is how our nation’s unemployment rate is calculated and this is the definition Card and Krueger used – see Unit 1, section 7 on critical thinking) can be deceiving and can lead to bad government policy. For a video explanation of how the minimum wage affects employment, please watch:
In the United States, the minimum wage was first introduced in 1938 via the Fair Labor Standards Act. This original minimum wage was set at 25 cents per hour, or about $4 per hour when adjusted for inflation. Today's federal minimum wage is higher than this both in nominal and real terms and is currently set at $7.25. The minimum wage has experienced 22 separate increases, and the most recent increase was enacted by President Obama in 2009. In addition to the minimum wage that is set at the federal level, states are free to set their own minimum wages, which are binding if they are higher than the federal minimum wage. The state of California has decided to phase in a minimum wage that will reach $15 by 2022. This is not only a significant increase to the federal minimum wage, it is also substantially higher than California's current minimum wage of $10 per hour, which is already one of the highest in the nation. (Massachusetts also has a minimum wage of $10 per hour and Washington D.C. has a minimum wage of $10.50 per hour.) So what impact will this have on employment and, more importantly, the well-being of workers in California? Many economists are quick to point out that they're not sure since a minimum-wage increase of this magnitude is pretty much unprecedented. That said, the tools of economics can help outline the relevant factors that affect the impact of the policy.
In competitive markets, many small employers and employees come together to arrive at an equilibrium wage and quantity of labor employed. In such markets, both employers and employees take the wage as given (since they are too small for their actions to substantially impact the market wage) and decide how much labor they demand (in the case of employers) or supply (in the case of employees). In a free market for labor, and equilibrium wage will result where the quantity of labor supplied is equal to the quantity of labor demanded. In such markets, a minimum wage that is about the equilibrium wage that would otherwise result will reduce the quantity of labor demanded by firms, increase the quantity of labor supplied by workers, and cause reductions in employment (i.e. increased unemployment).
Even in this basic model, it becomes clear that how much unemployment an increase in the minimum wage will create depends on the elasticity of labor demand. In other words, how sensitive the quantity of labor that companies want to employ is to the prevailing wage. If firms' demand for labor is inelastic, an increase in the minimum wage will result in a relatively small reduction in employment. If firms' demand for labor is elastic, an increase in the minimum wage will result in a relatively small reduction in employment. In addition, unemployment is higher when the supply of labor is more elastic and unemployment is lower when the supply of labor is more inelastic. A natural follow-on question is what determines the elasticity of labor demand? If firms are selling their output in competitive markets, labor demand is largely determined by the marginal product of labor. Specifically, the labor demand curve will be steep (i.e. more inelastic) if the marginal product of labor drops off quickly as more workers are added, the demand curve will be flatter (i.e. more elastic) when the marginal product of labor drops off more slowly as more workers are added. If the market for a firm's output is not competitive, the demand for labor is determined not only by the marginal product of labor but by how much the firm has to reduce its price in order to sell more output.
Another way of examining the impact of a minimum wage increase on employment is to consider how the higher wage changes the equilibrium price and quantity in markets for the output that the minimum wage workers are creating. Because input prices are a determinant of supply, and the wage is just the price of the labor input to production, an increase in the minimum wage will shift the supply curve up by the amount of the wage increase in those markets where workers are affected by the minimum wage increase.
Such a shift in the supply curve will lead to a movement along the demand curve for the firm's output until a new equilibrium is reached. Therefore, the amount that quantity in a market decreases as a result of a minimum wage increase depends on the price elasticity of demand for the firm's output. In addition, how much of the cost increase the firm can pass on to the consumer is determined by price elasticity of demand. Specifically, quantity decreases will be small and most of the cost increase can be passed onto the consumer if demand is inelastic. Conversely, quantity decreases will be large and most of the cost increase will be absorbed by producers if demand is elastic. What this means for employment is that employment decreases will be smaller when demand is inelastic and employment decreases will be larger when demand is elastic. This implies that increases in the minimum wage will affect different markets differently, both because of the elasticity of the demand for labor directly and also because of the elasticity of demand for the firm's output.
In the long run, in contrast, all of the increase in the cost of production that results from a minimum wage increase is passed through to consumers in the form of higher prices. This doesn't mean, however, that elasticity of demand is irrelevant in the long run since it is still the case that more inelastic demand will result in a smaller reduction in equilibrium quantity, and, all else being equal, a smaller reduction in employment.
In some labor markets, there are only a few large employers but many individual workers. In such cases, employers may be able to keep wages lower than they would be in competitive markets (where wages equal the value of the marginal product of labor). If this is the case, an increase in the minimum wage might have a neutral or positive impact on employment! How can this be the case? The detailed explanation is fairly technical, but the general idea is that, in imperfectly competitive markets, firms don't want to increase wages in order to attract new workers because then it would have to increase wages for everyone. A minimum wage that is higher than the wage that these employers would set on their own takes away this tradeoff to some degree and, as a result, can make firms find it profitable to hire more workers. A highly-cited paper by David Card and Alan Kruger illustrates this phenomenon. In this study, Card and Kruger analyze a scenario where the state of New Jersey raised its minimum wage at a time when Pennsylvania, a neighboring and, in some parts, economically similar, state did not. What they find is that, rather than decrease employment, fast-food restaurants actually increased employment by 13 percent!
Most discussions of the impact of a minimum-wage increase focus specifically on those workers for whom the minimum wage is binding- i.e. those workers for whom the free-market equilibrium wage is below the proposed minimum wage. In a way, this makes sense, since these are the workers most directly affected by a change in the minimum wage. It's also important to keep in mind, however, that a minimum-wage increase could have a ripple effect for a larger group of workers. Why is this? Simply put, workers tend to respond negatively when they go from making above the minimum wage to making minimum wage, even if their actual wages haven't changed. Similarly, people tend to not like it when they make closer to the minimum wage than they used to. If this is the case, firms may feel the need to increase wages even for workers for whom the minimum wage isn't binding in order to maintain morale and retain talent. This isn't a problem for workers in itself, of course- in fact, it's good for workers! Unfortunately, it could be the case that firms choose to increase wages and reduce employment in order to maintain profitability without (theoretically at least) decreasing the morale of the remaining employees. In this way, therefore, there is a possibility that a minimum wage increase could reduce employment for workers for whom the minimum wage is not directly binding.
In summary, the following factors should be considered when analyzing the potential impact of a minimum wage increase:
It's also important to keep in mind that the fact that minimum wage increase can lead to reduced employment doesn't necessarily mean that an increase in the minimum wage is a bad idea from a policy perspective. Instead, it just means that there is a tradeoff between the gains to those whose incomes increase because of the increase in the minimum wage and the losses to those who lose their jobs (either directly or indirectly) due to the increase in the minimum wage. An increase in the minimum wage might even ease tension on government budgets if the workers' increased incomes phases out more government transfers (e.g. welfare) than displaced workers cost in unemployment payments. |