With the Covid-19 pandemic handicapping people in their homes, many workers suddenly found themselves out of work, and thousands of businesses fell apart. As a consequence, an outcry from workers put pressure on many governments to increase minimum wages, reigniting debates on its impacts between economists and politicians.
While many economists agree that low pay is bad for workers, others believe that increasing the wage would bring about worse effects on low-skilled workers due to a fall in the employment rate. This argument is, of course, supported by conventional economic theory: If the cost of labor increases, production would become less profitable, and hence, businesses would lay off workers. To make matters worse, firms would lay off low-skilled workers out of all employees due to their lack of productivity. As a result, those whom the minimum wage was intended to help lose out of the game.
However, reality is far more complex than what textbooks state. In reality, firms are not able to determine or quantify the productivity of each and every employee, nor can they make every possible comparison between them. This asymmetric information puts firms in less advantageous positions: they could potentially pay more wage to workers who are actually worth less. From the perspective of firms, overpaying workers signals a loss of profit, and so most firms pay workers less than their marginal revenue product. This, in other words, is a monopoly of firms where a firm acts as the only “buyer” of the employees of the firm and hence utilizes its power to negotiate the price of the employee (wage) as low as possible.
Minimum wage, in this framework, attempts to reduce the power of firms in strong negotiation positions. In fact, research conducted by David Card and Alan Krueger has proven that it successfully reduced the power of firms and, in fact, increased the employment rate. In 1992, New Jersey’s hourly wage was increased from $4.25 to $5.05, while Pennsylvania’s wage was kept at $4.25, and the two economists gathered information on employment of fast-food restaurants in these states before April and again several months later. The result turned out to be counterintuitive: the employment rate increased in New Jersey, whereas it fell in Pennsylvania.
The result of David Card and Alan Krueger’s research seems absurd. Why would the employment rate increase when the labor cost increases? It turns out that minimum wage has acted as a correction of the market failure by monopsony: the wage that was capped artificially below the market equilibrium was raised by the minimum wage policy back to its equilibrium where buyers and sellers can exchange freely. People are more allured to enter the market.
Minimum wage is essential to market failure in the labor market. It artificially raises the wage that was once artificially kept low by the monopsony of employers. If the suitable minimum wage is applied, it would encourage more people to enter the markets. Yet, debates are still ongoing about what is a suitable minimum wage. Would raising the minimum wage to $12 per hour be suitable? Or would $15 per hour be suitable? This varies by the country’s circumstances and assessments of other potential benefits or harms of the minimum wage.