The pros and cons of

minimum wage, and policy

recommendations.
MGNT801 Economics and markets
Tuesday PM class

REPORT BY: Sushmita Rao Vankala

44158408
 TABLE OF CONTENTS

Executive Summary .................................................................................3

Minimum Wage and its characteristics ....................................................4
Implications to Firms ...............................................................................5
Implications to the labour force ............................................................... 6
Implications to the government ............................................................... 7
Implications to consumers .......................................................................7
Policy recommendations and Conclusion ................................................8
Appendix ..................................................................................................9

2
 EXECUTIVE SUMMARY
Minimum wage is a legal wage floor enforced by the government for the benefit of the countrys poor
and low skilled populations, to help them earn higher wages to combat the higher costs of living. Theoretically,
when the government intervenes and sets a minimum wage higher than equilibrium wage, the quantity
supplied of labour will increase and the quantity demanded of labour by firms will reduce. Clearly, this leads
to an excess supply of labour in the market, leading to higher unemployment. Therefore, one can argue that a
wage floor would lead to a higher rate of unemployment.

In Australia, the minimum wage is set by the specialised Minimum Wage Panel of the Fair Work
Commission, and is currently $17.7 per hour before tax. Theoretically, at the higher wage rate, the firms are
required to spend more per employee and this increases their costs. In effect, since firms are forced to comply
with the government regulations, they reduce the quantity demanded of labour, as they can afford less labour
at the higher rate. There are two main consequences to the firm when a higher wage is imposed on them:
Greater risk of automation and/or outsourcing, and the cost being passed on to consumers through higher
prices. It is also more likely that a firm will be forced to lay off employees upon the introduction of a minimum
wage if the market is in a recession. When a firm has access to high as well as low skilled workers, a minimum
wage can induce firms to trade off existing low-skill workers with high skilled workers at the higher wage
rate.
With the implementation of a minimum wage, as the quantity demanded of labour decreases, there
will be some workers who gain from the policy, and others who lose out. If the majority of the workers who
retain their jobs are high-skill workers, the policy would have failed to achieve its desired result. At the higher
wage, the quantity supplied by the labour market increases, as people would like to work more at the higher
wage rate, as the opportunity cost of leisure to them has increased.
The government of a country has no immediate monetary consequences with the introduction of a
minimum wage. As lower-skilled workers would be laid off for higher-skill workers when the wage increases,
eventually, these households would have to be supported by the government welfare system, in effect
increasing government spending. However, better paid workers are more likely to increase economic growth
by increasing spending in investments and family education. With an increase in skills, more workers are able
to attain higher paying jobs, and spend more money. This will likely bolster the GDP of the country over the
long term.
The minimum wage policy adopted by a firm can have two implications on consumers: A reduction in
employment at the firm, or an increase in price per product offered by the firm. In both cases, the consumer
will be affected as the labour market is made up of consumers themselves.
I would recommend utilising a more concentrated policy tool, such as the Earned Income Tax Credit,
or certain provisions to the minimum wage policy. Practiced in the US, the UK and Canada at the moment,
the Earned Income Tax Credit is a tax credit for low income workers, especially those with children, sharing
a living arrangement. The tax credit amount is mainly dependent on the income of the worker and, the
number and age of dependents. The policy must be specific for varying groups of workers based on criteria
such as age, number of dependents, skill-level and sector. This would be more beneficial in reaching the
targeted group of workers. Raising the minimum wages slowly to the right level can avoid the side-effect of
unemployment and also have the intended effect of higher wages for all workers.

3
 MINIMUM WAGE AND ITS CHARACTERISTICS
What is a Minimum wage?

Minimum wage is a legal wage floor enforced by the government for the benefit of the countrys
working population. The reasoning behind the wage floor is that it would help the poor and low skilled
populations earn higher wages to combat the higher costs of living. The minimum wage can also induce more
unemployed labour to seek employment and avail of this higher basic salary. Without government
intervention, firms would pay labour wages at a price less than the minimum wage, and may be able to exploit
the labour market, where labour is eager for work. However, one can argue that a wage floor would lead to a
higher rate of unemployment.

What are the consequences of a minimum wage?

Theoretically, we can plot the effects of change in wages and consequently quantities, on a graph as
shown below. The downward sloping demand curve, blue in colour, exemplifies the Law of demand, where a
marginal reduction in wage rate will lead to a marginally higher quantity of work demanded by the firms. The
upward sloping supply curve, orange in colour, signifies the Law of supply, where the higher the wage rate,
the more eager the labour market is to supply its services.
Under normal circumstances with no external intervention, the firms and consumers reach a wage that
is suitable for both parties after much negotiation, and this wage is known as Equilibrium wage. The
equilibrium can be viewed in the graph at point x, where the demand and supply curves intersect, at
equilibrium quantity Q e and equilibrium wage We.
When the government intervenes, and sets a minimum
wage higher than equilibrium wage, denoted by Wn in the
graph, we can observe two important changes. At the higher
wage rate, the quantity supplied of labour will increase
denoted by point y on the graph, where a higher quantity Qsn
is being supplied at the higher wage rate Wn. Simultaneously,
the quantity demanded of labour by firms will reduce at the
higher wage rate to be paid, denoted by z, where at the higher
wage rate Wn, less quantity Qdn is demanded. Clearly, this
leads to an excess supply of labour in the market, signified by
the horizontal distance between point z and y, leading to
higher unemployment.

Who sets the minimum wage?

Countries such as the UK and Australia use external expert bodies to identify and recommend a rate
to the government. In Australia, the minimum wage is set by the specialised Minimum Wage Panel of the
Fair Work Commission, and is currently $17.7 per hour before tax. In the US, the respective government has
complete control of the federal and state minimum wage. Countries such as Austria and Germany, use a
collective bargaining system to arrive at the minimum wage. France uses a formula to calculate the
minimum wage, taking into consideration inflation.

4
 IMPLICATIONS TO FIRMS
Is a minimum wage in the best interest of the firm?
Theoretically, at the higher wage rate, the firms are required to spend more per employee and this
increases their costs. Assuming the firms are earning Zero economic profit, which is a healthy state of
operations where accounting as well as opportunity costs are being covered, an increase in wages will increase
accounting costs, causing an economic loss. In effect, since firms are forced to comply with the government
regulations, they reduce the quantity demanded of labour, as they can afford less labour at the higher rate. In
reality, minimum wage impositions have caused firms to have to lay off even highly skilled labour due to
unaffordability. This can lead to lower overall productivity of the firm, compared to a low wage country. The
policy can also lead to an increase in productivity by retained workers who will be more motivated to be
efficient as they are being paid higher wages. In the Netherlands, where the minimum wage is higher than in
Britain, labour productivity is 20% greater[3]. The question is, how long will an employee be motivated to
cover his as well as the tasks of the laid-off employees? Rationally, not very long.
There are two main consequences to the firm when a higher wage is imposed on them
1. Greater risk of automation/outsourcing: Firms are better off investing the additional wage
expense amount on machinery to replace labour with automation in jobs (self-checkout counters),
which they would otherwise have found expensive. They will also be more inclined to outsource
possible units of operation to lower wage countries like India and China. Certain jobs such as
cleaning are more difficult to automate, and these jobs may survive the minimum wage, but only
if the firm is able to create greater demand for their product. Rising demand for goods and services
in fast-growing economies like New York and San Francisco can help afford the minimum wage.
2. Rise in prices: With the increase in accounting costs, firms need to charge a higher price per unit
of good to break even. As per the law of demand, the labour market will demand less quantities of
the good now that the price is higher.
It is also more likely that a firm will be
forced to lay off employees upon the
introduction of a minimum wage if the market
is in a recession. Under economic growth, the
firm may sustain the higher costs by raising
its prices, when there is an increased demand
for its products. The firm is also more likely
to lay off low skilled labour than high skilled
labour during recession, as established by the
graph.
When a firm has access to high as well
as low skilled workers, a minimum wage can
induce firms to trade off existing low-skill
workers with high skilled workers at the higher wage rate. This may be because high-skilled workers would
now be satisfied with the higher wage, and the firms would get a better offer from a government forced
program. Additionally, as the unemployment of low-skilled workers is being replaced with the employment
of high-skilled workers, as an overall statistic, they would see no change to employment due to the
implementation of the minimum wage. However, the low-skill workers unemployment rate would increase
as an effect of the minimum wage. Since the minimum wage is intended to be a social welfare system for the
poor, low-skilled workers, the trade-off of low-skilled workers for high-skilled workers would be a step in the
wrong direction.

5
 IMPLICATIONS TO THE LABOUR FORCE
With the implementation of a minimum wage, as the quantity demanded of labour decreases, there
will be some workers who gain from the policy, and others who lose out. The members who gain will
receive a higher wage for the same amount of work, and the workers who lose out will be the ones who lose
their jobs or have reduced number of work hours due to the new policy. It is important to understand how
many workers in each type are low-skill workers, and how many are high-skill workers. If the majority of
the workers who retain their jobs are high-skill workers, the policy would have failed to achieve its desired
result.
At the higher wage, the quantity supplied by the labour market increases, as people would like to
work more at the higher wage rate, as the opportunity cost of leisure to them has increased. Assuming that
the Income effect, an increase in the individuals purchasing power leading to an increase in leisure hours, is
shadowed by the Substitution effect, the quantity supplied of labour will increase. Even in the case that the
Income effect is higher than the Substitution effect for existing workers, there will be rise in the number of
workers who would be ready to work at the higher rate. If the minimum wage is higher than say, an office
administrators salary, she would be well served to apply for minimum wage roles.

Youth unemployment:
The current labour market is a competitive market with dynamic, changing needs. Young workers
are legally allowed to work in Australia from the age of 16. Halfway through high school, it is unlikely that
these workers would be very skilled. However, it is not difficult for them to find medium-skill level jobs, as
the firms would like to pay as low as possible, and skilled workers would not be ready to supply labour at
that wage. With a minimum wage policy, it is more likely that firms will seek out the more skilled workers
as they are forced by law to pay a higher wage. This results in loss of employment for young, unskilled
labour. Consequently, as the young workers are unable to enter or stay in the labour market for long, their
total income in their working life is reduced, as they only get and retain jobs once they are reasonably
skilled. In this way, they also lose out on learning & development on the job, and may have to learn the
skills elsewhere, which may be more expensive. Minimum wage also causes an influx of labour into the
market as more workers are prepared to work at the higher wages. It also reduces the number of jobs offered
by firms. Young, unskilled youth will suffer the most from the newly created, intensely competitive
environment, and are most likely to be unemployed.

Penalty rates in Australia:

As per the Fair Work Ombudsman, Employees often get a higher pay rate when working: weekends,
public holidays, overtime, late night shifts or early morning shifts.[1] . The higher pay rates are to encourage
workers to give up more of their leisure time for work. Recently, the Fair Work Commission introduced a
provision to the existing penalty rates. In the hospitality industry, the Sunday rates will be reduced from
175% to 150%, and the Public holiday penalty rates will be reduced from 250% to 225% for full time
workers. The commission has introduced these rate cuts to encourage firms to hire more labour. In reality, it
is more likely that the firm will not hire more workers, and take advantage of the reduced costs by over-
working existing employees. Employees face a loss of morale with wage cuts. The additional compensation
is fair for missing leisure time with family and friends on Sundays and public holidays. Employees will now
need to work longer hours to make up for the lost amount, and many of these employees live week to week.
If the government has to enforce wage cuts, I would recommend the commission enforce these rate cuts on
firms that have proof of hiring more workers after the introduction of the rate cuts.

6
 IMPLICATIONS TO THE GOVERNMENT
The government of a country has no immediate monetary consequences with the introduction of a
minimum wage. The minimum wage would increase costs to a company, and the government does not offer
tax relief to counter that effect. However, there is a cyclical process that includes the government in subjects
of minimum wage spending. Research shows that the minimum wage when increased over a certain margin
will increase unemployment in the country. A recent study of the US finds that a 10% increase in the
minimum wage is associated with a 12% decrease in GDP generated by lower-skilled industries relative to
higher-skilled industries. [2] The reasoning is that lower-skilled workers would be laid off for higher-skill
workers when the wage increases, and as their income reduces, so would their spending. The emphasis here
is on the loss of employment to
lower-skilled workers, who this
policy is aimed at benefiting.
Eventually, the high-skilled
workers would increase
spending and keep demand
steady in an economy with
rising prices, and the lower
income households would have
to be supported by the
government welfare system, in
effect increasing government
spending. As observed in the graph, the Australian weekly minimum wage has been steadily increasing, and
the unemployment rate has increased overall from 5% to 5.7% with a high of 6.3% in 2015. Although this
cannot be entirely attributed to the minimum wage effect, there is clearly no increase in employment.
However, better paid workers are more likely to increase economic growth by increasing spending in
investments and family education. With an increase in skills, more workers are able to attain higher paying
jobs, and spend more money. This will likely bolster the GDP of the country over the long term.

IMPLICATIONS TO CONSUMERS
The minimum wage policy adopted by a firm can have two implications: A reduction in employment
at the firm, or an increase in price per product offered by the firm. In both cases, the consumer will be
affected. The labour market is made up of consumers themselves. In the first scenario, when unemployment
increases, the household income reduces, and the purchasing power of the household reduces. Due to the
substitution and income effect, the household will now be able to afford less of the goods in the economy,
reducing the demand for goods in the market from the workers who are unemployed after the establishment
of the minimum wage policy. However, the remaining workers who are still employed by the firm will enjoy
higher wages, and spend more because they can, and keep the demand steady at equilibrium.

In the second scenario, if the firm is unable to cut jobs, or if the costs are not being covered even
with job cuts, the firms have to increase their revenue per product to cover their costs. This leads to prices of
products being raised. In effect, although the wages are increasing, there is also an inflation in the economy,
causing a stagnant purchasing power of the consumer. Therefore, the real wages of consumers are falling, or
remaining stable, with an increase in the prices of goods in the market.

7
 POLICY RECOMMENDATIONS AND CONCLUSION
The governments intention with the minimum wage policy is to help the low-income, low-skill
workers combat rising costs of living with the help of a higher wage. However, as evidenced above, the
higher wages cause an increase in the rate of unemployment. Additionally, it is more likely that low-skilled
workers are laid off before high-skilled workers as firms benefit more from skilled labour, and would have
no incentive to train the low-skilled labour as they have to bear additional costs in the form of the minimum
wage. With the adoption of the minimum wage policy, the low-income, low-skilled workers will be forced
into poverty when unemployed, and the high-skilled workers who are not poor to begin with, will benefit
more from the wage floor. In reality, it is more likely that managers and existing employees will be forced to
put in more hours as a result of lay-offs caused by the policy. However, it is possible that the positive effects
of spending by the higher earning employed workers will boost the GDP of the economy more than the
negative caused by the reduction of demand from the unemployed workers. But a policy aimed at providing
welfare to low-income families should result in exactly that. I would recommend utilising a more
concentrated policy tool, such as the Earned Income Tax Credit, or certain provisions to the minimum wage
policy.

Earned Income Tax Credit

Practiced in the US, the UK and Canada at the moment, the Earned Income Tax Credit is a tax credit
for low income workers, especially those with children, sharing a living arrangement. The tax credit
amount is mainly dependent on the income of the worker and, the number and age of dependents.
The EITC is a much more concentrated and targeted approach, where the benefit is being offered to
the low-skill workers directly, and not being dispersed among low and high skill workers.
It increases the hourly wage rate of qualifying workers only.
The EITC also does not cause unemployment as a side effect, and in fact boosts employment among
low-skill workers by offering the credit as a stimulus. The additional low-skill workers in the market
can be paid a lower wage rate by the firms, and this creates an effective subsidy for the firms to hire
low-skilled labour.
The burden of the costs fall on the central government, and not on individual firms, leaving less
room for exploitation or unfair practices.
Since it is a central government initiative, it will be harder to convince the general public why their
higher taxes are being used to fund low-income workers. Additionally, since the minimum wage
costs to the government are minimal initially, the general public would be more eager, not knowing
the side-effects of the policy.

Provisions to the minimum wage policy

The policy must be specific for varying groups of workers based on criteria such as age, number of
dependents, skill-level and sector. This would be more beneficial in reaching the targeted group of
workers.
Governments should offer corporate tax incentives and other stimulus to firms that are under the
minimum wage umbrella.
The policy would benefit more from being combined with subsidy programs, like the Earned Income
Tax Credit.
Truckloads of studies, from both America and Europe, show that at low levelsbelow 50% of
median full-time income, with a lower rate for young peopleminimum wages do not destroy many
jobs.[4]. Raising the minimum wages slowly to the right level can avoid the side-effect of
unemployment and also have the intended effect of higher wages for all workers.

8
 APPENDIX
Dickens, R. (2015). IZA World of Labor - How are minimum wages set?. [online] Wol.iza.org. Available
at: http://wol.iza.org/articles/how-are-minimum-wages-set/long [Accessed 10 Mar. 2017].
Fair Work Ombudsman. (2017). Welcome to the Fair Work Ombudsman website. [online] Available at:
http://www.fairwork.gov.au/how-we-will-help/templates-and-guides/fact-sheets/minimum-workplace-
entitlements/minimum-wages [Accessed 10 Mar. 2017].
Neumark, D. (2014). IZA World of Labor - Employment effects of minimum wages. [online]
Wol.iza.org. Available at: http://wol.iza.org/articles/employment-effects-of-minimum-wages [Accessed
10 Mar. 2017].
Economist.com. (2016). Minimum wages: Maximin. [online] Available at:
http://www.economist.com/news/united-states/21701126-some-cities-have-raised-minimum-wages-
dramatically-they-may-regret-it-maximin [Accessed 5 Mar. 2017].
Kalenkoski, C. (2016). IZA World of Labor - The effects of minimum wages on youth employment and
income. [online] Wol.iza.org. Available at: http://wol.iza.org/articles/effects-of-minimum-wages-on-
youth-employment-and-income [Accessed 10 Mar. 2017].
[1]Fair Work Ombudsman. (2017). Welcome to the Fair Work Ombudsman website. [online] Available

at: http://www.fairwork.gov.au/about-us/news-and-media-releases/website-news/changes-to-penalty-
rates-in-some-awards [Accessed 10 Mar. 2017].
[2]Sabia, J. (2015). IZA World of Labor - Do minimum wages stimulate productivity and growth?.

[online] Wol.iza.org. Available at: http://wol.iza.org/articles/do-minimum-wages-stimulate-productivity-

and-growth [Accessed 10 Mar. 2017].
Tradingeconomics.com. (2017). Australia Unemployment Rate | 1978-2017 | Data | Chart | Calendar.
[online] Available at: http://www.tradingeconomics.com/australia/unemployment-rate [Accessed 11
Mar. 2017].
Burkhauser, R. (2015). IZA World of Labor - The minimum wage versus the earned income tax credit
for reducing poverty. [online] Wol.iza.org. Available at: http://wol.iza.org/articles/minimum-wage-
versus-earned-income-tax-credit-for-reducing-poverty [Accessed 11 Mar. 2017].
[3]Economist.com. (2016). Poor economics. [online] Available at:

http://www.economist.com/news/britain/21695959-who-benefits-introduction-national-living-wage-
poor-economics [Accessed 5 Mar. 2017].
[4]
Economist.com. (2015). Minimum wages: A reckless wager. [online] Available at:
http://www.economist.com/news/leaders/21659741-global-movement-toward-much-higher-minimum-
wages-dangerous-reckless-wager [Accessed 5 Mar. 2017].