Minimum Wage Laws: A General Equilibrium Analysis

Author(s): Harry G. Johnson

Source: The Canadian Journal of Economics / Revue canadienne d'Economique, Vol. 2, No. 4
(Nov., 1969), pp. 599-604
Published by: Wiley on behalf of the Canadian Economics Association
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 - --?C-Cf;

NOTES
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MINIMUM WAGE LAWS: A GENERAL EQUILIBRIUM ANALYSIS

HARRY G. JOHNSON The London School of Economics and Political Science

and The University of Chicago

It is a familiar notion to economists, though a strangely unfamiliar one to the

general public, that minimum wage laws, though they benefit those workers
who are successful in obtaining employment in the industries subject to them,
tend to create unemployment or else to drive a number of workers into the
equivalent of the "subsistence sector" of the economy. This conclusion is
derived from an application of the elementary theory of demand and supply
as to the effects of price-support policies. The problem has not to my knowledge
been investigated in the context of a general equilibrium analysis. In this con-
text it has some affinities to the problem of the effects of unionization, analysed
in a previous paper by the present writer and Peter Mieszkowski,1 but sufficient
analytical difference to merit separate investigation. This is the purpose of the
present paper. It is shown that, contrary to the conclusions drawn from partial
equilibrium analysis, there are possible circumstances in which a minimum
wage law that applies to only a part of the productive activities of the economy
may benefit workers in all sectors. On the other hand, if the minimum wage
law applies to all sectors, or to all sectors but those regarded as constituting a
"subsistence sector," the traditional conclusion can be rigorously demonstrated.
Before commencing the analysis, it is relevant to note that minimum wages
are invariably legislated in terms of money, and that while they may have
been originally intended to raise real wages above the level prevailing under
competition, the intention may have been frustrated, and the minimum wage
have become ineffective, through the joint influence of price inflation and
increasing productivity resulting from technical progress. This fact is disre-
garded in the ensuing analysis, in which it is assumed that the minimum wage
is effective in raising the real wage of labour. It is further assumed, for pur-
poses of analysis, that the minimum wage law is intended to raise the marginal
product of labour in the industries to which the law applies in terms of the
produce of those industries.
For the purposes of the analysis, the economy is initially divided into two
sectors, producing two commodities with the employment of two factors of
production. Commodity X is assumed to be relatively capital-intensive by
comparison with commodity Y; both are assumed to be produced subject to
constant-returns-to-scale production functions. The three figures all depict the
standard Edgeworth-Bowley production contract box, the endowment of the
economy with capital being represented by the vertical side of the box and the
1H. G. Johnson and Peter Mieszkowski, "The Effects of Unionization on the Distribution of
Income: A General Equilibrium Approach" (forthcoming).
CanadianJournalof Economics/Revue canadienne d'Economique,II, no. 4
November/novembre 1969. Printed in Canada/Imprime au Canada.

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600 HARRY G. JOHNSON

labour endowment being represented by the horizontal side. The isoquants

(for simplicity not depicted) for commodity X start from the southwest corner
and those for commodity Y from the northeast corner of the box.
In Figures 1 and 2, OyP"PO, represents the contract curve under conditions
of competition. P is the point on the contract curve that would prevail under
competition. It is assumed that this equilibrium is unique - the possibility that
the redistribution of income between labour and capital that occurs as produc-
tion shifts along the contract curve is assumed not to result in the possibility of
multiple equilibrium. In other words it is assumed (for both these figures and
figure 3) that an increase in the relative price of a commodity reduces the
excess demand for it, through the usual income and substitution effects, regard-
less of the redistribution effect.
Figure 1 represents the case in which the minimum wage law is imposed on
the X industry, the capital-intensive industry. The effect of the law is to
increase the capital-labour ratio in the X industry from the slope of OP to the
slope of O,P"P', and to make the economy's new contract curve consist of
the curved section of the old contract curve between O, and PF"and the straight
line section P"P' extended.
As production moves from O, to P" along the old contract curve, the relative
price of X in terms of Y must increase. The same holds true as production of X
continues to increase along P"P' extended. This is proved by reference to
Figure la. In the figure, units of X and Y are chosen to have equal costs of
production at the factor price ratio prevailing with production at P", their
common costs of production being given by the budget line MM. The overall
endowment ratio of the economy is represented by OR, and the optimal factor
utilization ratios in the two industries by OR,, and ORy respectively. In order
to increase the production of X, with the fixed factor utilization ratio prevailing
to P" and set by the minimum wage law, it is necessary to free the relevant
capital required by reducing the capital-intensity in the Y industry, the new
ratio of capital to labour in that industry being represented by OR,'. The new
factor price ratio in the Y industry will be M'M'. Since capital is mobile be-
tween the two industries and its price unrestricted, competition will equalize
the price of its services in the two industries; hence capital can serve as the
numeraire for measuring the effect of the production change on relative com-
modity prices. And since Al' lies below M on the C-axis, the relative price of X
must rise.
Return to Figure 1, at P" both the production of X and the price of it in
terms of Y are necessarily lower than at P; hence P" cannot represent a possible
equilibrium, which equilibrium must lie to the northeast of P" on OFP'
extended. At P', the quantity of X produced must be lower, and of Y produced
higher, than at P; and the price of X in terms of Y must be higher than at P
(this can be proved by considering the effect of an increase in R., in Figure
la). With a lower quantity produced and a higher relative price of X, PF'could
be an equilibrium position. If it is, the marginal product of labour in the Y
industry is unchanged, while its marginal product in terms of X (through
exchange in the market) must be lower than at P. Hence if P' is the new
equilibrium position, labour in the Y industry can at best be no worse off (if it

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Notes 601

L Oy

IC p" / C

Ox L
FIGURE 1

X R

C M' /

0 M M'
L
FIGURE la

consumes no X) and generally will be worse off than at the competitive equi-
librium position P. If the demand for X is sufficiently inelastic, P' will represent
an excess demand for X, and the equilibrium with the minimum wage will lie
to the northeast of P'; in this case the marginal product of labour in Y will be

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602 HARRY G. JOHNSON

L oy

c C

Ox L
FIGURE 2

x
M Rx

M' R'x
/ R

C
Ry

N
\

0 M

L
FIGURE 2a

lower than before in terms of both products, so that such labour will be unam-
biguously worse off. But if the demand for X is sufficiently elastic, the new
equilibrium of the economy with the minimum wage law in effect will lie
between P' and P"; the capital labour ratio in the Y industry must rise as com-
pared with competitive equilibrium, while the relative price of X in terms of Y
must fall by comparison with P'. The marginal product of labour in the Y indus-
try must rise in terms of Y, and may even rise in terms of X; and depending on
the preferences of the owners of labour in consumption of the two goods,

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Notes 603

L Oy

C // c

Ox O'x L
FIGURE 3

labour in the Y industry may be made better off than it would have been under
competitive equilibrium in the absence of the minimum wage. This possibility
constitutes the exception to the standard conclusion.
Figure 2 illustrates the case in which the minimum wage law seeks to raise
the real wage of labour in the labour-intensive sector in terms of the produce
of that sector. The new contract curve consists of the segment O,P" of the
competitive contract curve, and the straight-line segment P"Oy determined by
the minimum wage law. Figure 2a shows that, as production of X increases
from P" along the straight-line segment, the relative price of X in terms of Y
must fall. At P", the point of division of the segments of the new contract
curve, production of X and its relative price in terms of Y are both lower than
at P; hence P" cannot be a position of equilibrium. Nor can P', since at P' both
production of Y and its relative price in terms of X are higher than at P. The
new equilibrium of the economy must lie somewhere on the straight-line seg-
ment of the new contract curve between P' and 0,. The ratio of capital to
labour employed in the X industry must be lower than it was under competi-
tive equilibrium in the absence of the minimum wage law. Hence the marginal
product of labour in the X industry must be lower than under competitive
equilibrium; and since the price of X must also be lower in terms of Y, labour's
marginal product in Y transformed into terms of X through conversion at the
commodity price ratio must also be lower than under competitive equilibrium
without the minimum wage law. Hence the minimum wage law must neces-
sarily make labour in the non-included industry worse off than it would in the
absence of the law.
Figure 3 illustrates the case in which the minimum wage law is imposed in
both industrial sectors (assumed either to exhaust the economy, or to comprise
the non-subsistence sectors of it), raising the capital-labour ratios in them
from O$P and OyP to O,P" and O,P" respectively. Production at P" involves
a smaller quantity and a lower price of X and hence is incapable of being an
equilibrium point. There is an excess demand for X and an excess supply of Y.

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604 J. BLACK

Reallocation of the economy's resources towards X and away from Y, main-

taining the capital-labour ratios required by the minimum wage law, releases
more labour from the Y industry than can be absorbed in the X industry, given
the relative capital-intensity of the X industry, and necessarily creates unem-
ployment (or, where there is assumed to be a subsistence sector, forces part
of the labour force to retreat into that sector). The resulting equilibrium of
the economy is depicted by the point Q (which may involve more or less pro-
duction of X than point P, since the relative price of X as the capital-intensive
good must have fallen by comparison with Y, the labour-intensive good).
O0,0/, the shift of origin for the production of X, represents the amount of
unemployment created by the minimum wage law.

LEARNING BY DOING AND OPTIMUM SAVINGS*

J. BLACK University of Exeter

I / A simplified presentation of learning by doing

This section presents the completely aggregated single sector model of learning
by doing originated by Arrow' and developed by Levhari2'3, but treats it as a
purely neoclassical growth model. No essential use is made of the marginal
productivity or any other theory of income distribution. No consideration is
given to the rate of discount required to make investors expect to break even.
Except when the economy is on a path of steady growth consideration of the
rate of discount raises great economic and mathematical difficulties, which are
avoided by the approach used here. Steady growth paths are examined, but
interest centres on the path which will be followed by an economy starting
from some arbitrarily stipulated combination of labour force and stock of
machines.
As in Arrow, G is the "serial number" of a machine and y(G) is the output
produced by "the Gth machine." G is, however, treated as a continuous variable,
and equation 1 gives the total output per unit of new machines when a cumu-
lative total of G machines have been built. This output is assumed to be
constant.
(1) y(G) = a.
*The author is indebted for comments and suggestions to C. J. Bliss and F. H. Hahn. Any
remaining errors are his own.
1K. J. Arrow, "The Economic Implications of Learning by Doing," Review of Economic
Studies, 29 (1962).
2D. Levhari, "Further Implications of Learning by Doing," ibid., 33 (1966).
3D. Levhari, "Extensions of Arrow's 'Learning by Doing'," ibid.
Canadian Journal of Economics/Revue canadienne d'Economique, II, no. 4
November/novembre 1969. Printed in Canada/Imprime au Canada.

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