Economic effects of Increases in Minimum Wage

Name: Taimur Khan

UW ID: 20235103

Course: Econ 381

Professor: Anindya Sen

Date: July 27, 2010

Abstract
The purpose of this paper is to discuss the economic effects of increases in minimum wage laws

in Canada. The application of this law leads to several benefits and costs to the society as well as

to certain individuals who are directly affected. To assess the spillover effects of such legislation

the research of numerous economists has been used covering aspects such as employment and

poverty alleviation. Moreover, the application of economic theory and models has been used to

predict further benefits and costs to the society that have not been elaborated upon before. The

results this paper achieves are that the minimum wage increase can create inefficiencies in the

market, reduce consumer surplus hence decreasing societal welfare, but can also lead to benefits

regarding lower student debt and maximization of the social welfare function. As is the case with

most controversial economic policies there is no straight answer of whether minimum wage

increases are beneficial to the society. Although, there seem to be more costs than benefits,

which implies that other laws may be more effective in combating poverty and improving the

standard of living.
 Introduction
Minimum Wage legislation refers to a law that sets a minimum amount that employers must pay

their employees regardless of their level of work. This is used to ensure a certain standard of

living for those who work at the lowest level. In 1912 the first minimum legislation was passed

in the state of Massachusetts which led to British Columbia and Manitoba to enforce this law in

1918 (Prasch 1999).i Since then Canada has ranked amongst the countries with the highest

minimum wage legislations. However, the level of minimum wage differs slightly between

provinces due to differences in cost of living. Currently, the province that has the highest

minimum wage is Ontario, set at $10.25/hour on March 31, 2010 (Ontario Ministry of Labor).

The lowest minimum wage in Canada is in the Prince Edward Island province set at $8.40/hour.

These wages may be slightly lower in certain occupations (or age groups) such as those working

as waiters/waitresses at restaurants as they make majority of their income from service tips.

Over the years this legislation has lead to debates over its effectiveness as a simple demand

supply model would show its inefficiency. Therefore, in the first section of this paper I plan to

review the existing literature analyzing the economic effects to the economy and certain

individuals. The majority of the existing research has been focused on the two main effects,

which are employment effects and poverty alleviation (including redistribution of income

effects) with subtle mentions of further benefits or costs. In the second section I will analyze

further economic effects on the economy and will reach a conclusion on whether or not this law

creates surplus for the society. This section will include detailed analysis of effects that may not

have been discussed in the preceding literature or may have been slightly touched upon. The last

section of this paper will include my results and a summary of the important effects followed by

a bibliography stating my sources.

 Literature Review

As mentioned in the introduction, the Minimum Wage legislation has lead to vast amounts of

research especially in the US and Canada. There will likely be additions to this bank of research

with Canada increasing its minimum wage on March 31, 2010 in Ontario. Most of the work

analyzed in this section is by well known authors and has been published in various economics

journals as well as research specially conducted by the Government of Canada to help in policy

creation and implementation.

From the start of the minimum wage law in the early 1900’s economists were against it as

elementary economic theory using simple demand and supply curves suggests that the

implementation of a minimum wage law would definitely lead to unemployment. One of those

who strongly opposed it was Economist J. Lawrence Laughlin of the University of Chicago who

described it as an “injurious palliative” (Prasch). However, over time economists have not

opposed this legislation as strongly, due to the claims of some economists illustrating the lack of

adverse effects and possible benefits regarding poverty alleviation.

In regard to employment effects “the impact of minimum wage on employment has been

controversial in part because of the diversity of the estimates and methodologies”.(Campolieti,

Gunderson, Riddell 2006). In the research paper where that excerpt is extracted from, they used

the Neumark (2001) equation, which was used to obtain employment effects for the US and

applied it to the data available for Canada. Equation used was as follows:

Eit = α + β1MWit + β2MWit-1 + β3Xit + β4Regioni + β5Yeart + εit

Where E= employment ratio, MW= minimum wage (ratio of the minimum wage to the average

wage of workers between the ages of 16-64 in region i and year t. X is a vector of control
variables, Regional and year sets of regional and year dummy variables. This regression used the

April Labor force survey. This lead to the conclusions that the increase of minimum wages had a

larger impact on the employment levels of lesser skilled workers. Furthermore, it was also found

that the implementation of minimum wages had adverse employment effects on full time

workers (Campolieti, Gunderson, Riddell).ii

Moreover, the same conclusions were reached by Kevin B. Kerr in a paper presented to the

House of Commons in regard to the implications of minimum wages. He stated that a 10%

percent increase in the minimum wage reduces employment between 0 and 3%. This would

mean that the increase from $9.50 to $10.50 in Ontario on March 31 2010 which is 7.89% will

lead to unemployment between 0 and 2.36%. Most economists agree with this range (0-3%) but

the differences arise in whether it is at the lower end or higher end of the scale. (Kerr 2006)iii

In regards to the conclusion of the decrease in part time employment by Campolieti, Gunderson,

and Riddell, the research conducted by McKee and West on part time employment also reaches

the same conclusion stating that in the case of Canada it is clearly evident “that minimum wage

increases have caused the proportion of part time work to fall”. Thus, the increase in minimum

wage leads to a fall in the part time/full time worker ratio. Other research calculated that the

adverse employment effects for teens were larger at an elasticity of -0.282 than young adults (-

0.155) (Campolieti, Gunderson, Riddell). This can be seen to prove the negative employment

effects as Benjamin accounted that 36% of minimum wage workers were teenagers.

As mentioned before the literature on employment effects of minimum wage vary greatly as this

next paper discussed illustrates. An economic security survey report claims that the “weight of

the evidence suggests little or no impact on employment from minimum wage increases”. Their

research claims that the relationship between employment rates and increases in minimum wage
are not consistent as sometimes a minimum wage rise decreases employment while in some

cases it increases employment. Further claims stated that the increases in minimum wage did not

play a major role in unemployment as that is more dependent on large scale economic changes,

such as economic booms or recessions (Murray & Mackenzie).iv

On a brief note it is important to mention that there were findings that suggested minimum wage

increases resulted in no effect on job employment and in some cases led to job growth. (Card &

Kreuger).

Before the discussion of the second most discussed effect of increases in minimum wage

(poverty alleviation) it is imperative to discuss some of the other smaller benefits and costs.

Advocates of minimum wage state that increases in the wage will lead to a more productive

workforce as productivity is a function of the wage rate. Furthermore, they state that firms that

would compete by paying low wages would need to become more efficient in their ways which

would not necessarily create unemployment. This would lead to increases in entrepreneurship.

Moreover, increases in minimum wage can result in a) increased bargaining power of the

workers and b) has the potential to generate an independent middle class (Prasch).v Those against

minimum wage increases argue that the fact that such few people work at the minimum wage

and those too are mostly teenagers so it does not matter to the economy. Therefore, it is evident

that the “negative employment causes more harm than good”. In response to those arguments it

has been said that valuing the work of younger members of the society at a lower amount would

be discrimination on the basis of wage (Murray & Mackenzie).vi

The other main focus of minimum wage increases is the potential they have to alleviate poverty

with redistribution of income in society. Gramlich argued that those who received the minimum

wage were not the poorest but were instead from middle and high income families. Therefore, it
did not qualify as an effective poverty reduction policy. Although the data presented by Fortin &

Lemieux does show a slight redistribution effect. Strong opposition of the redistributive

properties of such legislation has come due to the belief that those who live at or below the

poverty level are the non-workers and the minimum wage rise “can affect only families with

workers”.vii This analysis suggests that minimum wage increases can slightly reduce poverty for

a segment of the population that is known as the ‘working poor’, “which is a term used to

describe individuals and families who maintain regular employment but remain in relative

poverty due to low levels of pay and dependent expenses” and leaves out the large portion of self

employed individuals who earn less than the minimum wage viii.

However, the consensus as expected seems to be somewhere in between of the two extremes.

The consensus would be that minimum wage increases can help alleviate poverty but cannot be

the only tool used to do so. For the minimum wage to have high redistribution effects the

minimum wage should be increased yearly taking into account inflation as the delays in changes

erode the real value of money. “While levels of education and experience have increased and

GDP has grown, real wages remained stagnant from 1981 to 2004”. In 2003 only 4.1% of the

workforce or 547,000 people worked at the minimum wage which shows that even there are

positive effects it would not affect too many individuals. One important point from this study

which has not been focused much on is the fact that increases in minimum wage not only

increase those currently at minimum wage but also increase the wages of those who are close to

the minimum wage.ix (Murray & Mackenzie).

Overall, the work of economists on the consequences of minimum wage increases provides great

insight to the effects to the society in regard to employment and redistribution of income.

Moreover, the diversity of conclusions adds further confusion as to whether the increase of
minimum wage in Canada will lead to favorable or unfavorable results. However, the fact that

much emphasis has been put on these two consequences leaves out other positive and negative

effects of such legislation which affect other individuals in the economy. The different variables

used in their regression analysis leads to these inconsistencies in results. Moreover, there has

been a bias in the literature as at the start of this legislation researchers work was geared towards

proving economic theory correct while those papers that went against economic theory were not

published (Fortin and Lemieux). Therefore, one cannot assert with great confidence on one

certain opinion. Although, some researchers have mentioned other effects, they have not been

assessed in detail. Those consequences will be discussed in the next section with the help of

research on the basis of some underlying assumptions.

Analysis
With the minimum wage increase in Ontario to $10.25, one might argue that this amount is quite

high as some employees work may not add value of $10.25/hour. A lot of the literature

mentioned above covered aspects of employment effects but failed to take into account the value

of the work. It would not make sense for a company to hire someone for a wage, w, when he/she

does not create revenue for the firm in excess of w (MR=MC). This fact, in theory makes sense

but in reality firms spend high amount of revenue on parts of the company that are not a part of

the core business. However, in the case of minimum wage workers this may not apply all the

time.

For e.g. let’s look at the case of a firm that produces ribbons. To make this analysis simple let us

assume that this firm has no fixed costs or marginal costs apart from the minimum wage paid to

the employees, w1, further assuming that this wage is not calculated through derived demand but

by the value it adds to the product which is the case in some minimum wage jobs. To justify 0
marginal costs assume that the owner of the firm inherited an unlimited supply of high quality

fabric. One ribbon can be sold for a price, p. The five employees work is to cut the fabric and

perform some elementary stitching on the sides of the ribbon that adds market value, v, where

p = v and v – w1 > 0, which is marginal profit, π. The Canadian government announces a

minimum wage increase from w1 to w2. However, this increase leads to v – w < 0 (-π) and since

this owner cannot afford to buy a machine the owner of the fabric shuts down production and

keeps the fabric unused. Therefore, the minimum wage, w1, increasing to w2 led to the

unemployment of 5 of the employees (unemployment effect) but deprived consumers of high

quality ribbons who had to switch to the same price lower quality ribbons, which reduced their

welfare.

Most of the research on minimum wages has shown its adverse effects, while only a few have

put emphasis on its social benefits. When the government makes policy changes it does not only

take into account the efficiency of the law or how much excess burden it creates but it also takes

into account the social welfare function (SWF). This social welfare function can justify the

promotion of the study of humanities and arts in the countryx. With respect to social welfare

functions it can be understood that although minimum wage increases might lead to inefficiency

it can have welfare maximizing effects. Examples of SWF are W = Y1 + Y2 + ….Yn, where W is

the social welfare function and Yi is the income of individual i among n in the society. Another

example may be W = min (Y1, Y2… ,Yn ). The second welfare function mentioned is different

from the first one as it shows that maximizing welfare in the society would mean maximizing the

income of the poorest whereas the first function aims to maximize total incomexi. In Canada, the

second SWF seems to be in practice which would show that a minimum wage increase can in

fact lead to welfare maximization as the income of the poorest is increasing.

Furthermore, the effects of the minimum wage increase in Canada could have the ability to result

in cost push inflation. Simply put, with the increase of the minimum wage those people working

at a wage close to it would also rationally experience an increase in their wage. This would lead

to the variable costs of the firm increasing inevitably leading to a lower profit margin. To

compensate for this drop, the firm might shift the burden of this increase in cost to the consumer

by increasing the price by that amount (assuming relatively inelastic demand), leading to cost

push inflation. Since, proving this with data would be difficult as inflation is a function of many

other economic effects I will present a model that can clearly illustrate this concept.

Assume a firm whose product has relatively inelastic demand and has two sets of employees, one

set earns the minimum wage, MW1, while the other set earns wage, W1, where W1 > MW1 by a

small amount. The profit equation for the firm is π1 = P1Q – c(Q, L) where p = price, Q =

quantiy, c = cost, L {Set of MW and W employees}. However, the increase in minimum wage

(MW2) makes W1 = MW2 and therefore, to stop the workers in the second set to quit working, the

firm has to increase their wages to W2, where W2 > MW2. Assuming that in the short run (SR)

quantity is fixed, which makes the profit π2 = P1Q – c(Q,L) , (π2 < π1). Since the demand for this

product is relatively inelastic the producer can shift this increase in cost to the consumer by

charging P2 (p2 > p1) which makes π2 = π1. This price increase would lead to lower consumer

surplus as individuals will now be paying a higher price.

Red = consumer surplus

Grey + Blue = loss of consumer surplus

Blue = Excess Burden (deadweight

loss)
*note: L is fixed due to a trade union, or the amount of L is still profit max.

The labor market effects discussed earlier spoke mostly about the direct effect of minimum wage

increases to unemployment. However, apart from that I predict a high possibility of distortion

created in the labor market which can lead to severely complicated results which would create

ambiguity in the final consequences. A minimum wage high enough can cause several effects

simultaneously, such as new entrants into the labor market as well as the closing down of several

small businesses in search of higher income. Labor economics introduces a term known as

‘reservation wage’ which is basically the lowest wage a person will work for. If the wage is

lower than his reservation wage he/she will exit the labor market. While, if the wage is higher

than the reservation wage he/she will find it satisfying to work. Therefore, when the minimum

wage increased from $9.50/hour to $10.25 all those individuals whose reservation wage was >10

would enter the market and look for employment. Apart from these entrants, a segment of the

working poor who are self employed people (265,000 in 2001) earning less than $20,000/year

might find it easier to shut down and enter the labor force working at the minimum wagexii. This

would further increase the labor supply, while the increase in wage would further reduce the

demand for labor. Keeping these scenarios in mind, people might become ‘discouraged workers’,

who are left out of most unemployment statistics. Therefore, the increase of minimum wage can

have a larger impact than what is reported by economists.

The increase in minimum wage can have a positive outcome with respect to the government

funding of education. The research showed that in 2003 57% of the minimum wage workers

were between the ages of 15-19 and 19% were between the ages 20-24 (Murray & Mackenzie).

Assuming that this proportion does not differ greatly with the minimum wage work in Ontario

this could lead to considerable saving by the government of OSAP funds, which could be
diverted to other welfare increasing activities. Those teenagers and young adults working can

save a portion of their income which can help reduce the burden of debt on themselves. This

would mean that they would ask for lower OSAP loans from the government which as

mentioned earlier could divert the governments funding to another cause. Since OSAP loans are

interest free for the duration of the school program lesser amounts given would benefit the

government and society. The literature above suggested the redistributive effects would be

minimal in terms of poverty alleviation but in the case of students it might lead to positive

results. In this case there are positive redistributive effects from owners of capital to students. It

may not have the positive impact that poverty alleviation would but this benefit to society cannot

be ignored. Although the trend of

Ontario spending does not prove

the point (Ontario Ministry of

Training) that has been conveyed

it may be true later on. The

demand for education is still on

the rise but when it reaches its

long run equilibrium it could be

evident that the provincial

government is spending less after

minimum wage increases.

Numerically, my point can be illustrated as follows: 76% of minimum wage earners are

teenagers and young adults in Canada so we assume Ontario follows the same proportion. In

2004 Ontario had the highest number of minimum wage workers at 283,000 peoplexiii.76% of
283,000 = 215,080. Since those under the age of 18 earn a minimum wage of $9.60 as compared

to the general minimum wage $10.25, let’s set an average minimum wage rate of $9.90/hour. If

these individuals work 15 hours per week for the year they earn $7,128. Even if a portion of this

(say $1000) is allocated towards their education the total reduction in OSAP costs would be

215,080 * 1000 = $215,080,000. If they allocated this amount for all the years before university

and during university their debts would be greatly reduced along with the governments funding.

On a brief note, the increase in minimum wage in Canada could be motivation for current

students to want to drop out of school and begin earning money. Although, this might be the

thinking of certain individuals a rational economic agent would quantify benefits of education

against the opportunity cost of spending time in school. Even with a change from $9.50 to

$10.25, it would not justify individuals to drop out of school. Furthermore, the government of

Canada has taken an initiative to reduce high school dropouts. In Toronto, they have spent $19

Million to reduce dropout rates by providing their four pillars which are “academic support

provided by volunteer tutors, social support through a mentoring program, counselling, and

financial assistance, which ranges from bus tickets and lunch vouchers to bursaries for post-

secondary studies”.xiv

Conclusion
Economic theory from the outset claimed minimum wage legislation would have negative effects

to the economy. Therefore, it is not surprising to see most economists not considering it an

efficient way to increase the standard of living or to alleviate poverty. Although, this paper does

emphasise benefits arising from this legislation as it can lead to positive socio-economic impacts.

With regard to unemployment the research has varied greatly which is due to major economic
changes that affect it. It cannot be clearly stated that the increase in minimum wage will increase

unemployment as other forces intervene, which cloud the analysis.

Moreover, my analysis comprised of some benefits and costs to the society which were not

discussed in great detail by economists. The model introduced regarding added value, showed

that by increasing the minimum wage the economy could be inefficient leading to welfare losses.

The second model introduced showed how increases in minimum wage could lead to higher

prices reducing the consumer surplus of employees. If that model assumed a one firm economy

its effects could be even more significant as the employees of that firm would buy its own

product at a higher price making the wage increase useless. Moreover, since the number of

minimum wage workers are mostly under the age of 24 it can lead to lower debts for the students

which would decrease provincial spending on education. Those funds could then be diverted to

other welfare increasing policies. The Government of Canada does not only look at the economic

effects of such policies but tries to maximize its social welfare function which could be

represented as W = min (Y1, Y2…, Yn). Overall, as is the case with most economic policies there

is no straight answer whether the minimum wage increase in Canada will lead to a surplus in the

society as there are opposing forces, although there seem to be more costs than benefits which

suggest that the results achieved by minimum wage legislation could also be achieved by “a

more effective broad-based approach for raising the incomes of Canada’s working poor (which)

might be found in earnings supplementation schemes such as the recently introduced Working

Income Tax Benefit (WITB)”xv(Kerr 2008).

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xv
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