Updated: Dec 30, 2022
Minimum wages are the minimum amount of remuneration that an employer is required to pay their employees for the work performed during a given period of time. Governments impose minimum wages because they care about ensuring that workers earn a fair wage for their work, which should be above the national poverty line. The national poverty line, also known as the living wage, is a level that the government decides is the minimum level of income that households need to receive in order to be able to live an adequate standard of living within an economy. It is usually calculated as fifty per cent of the median income of workers in an economy. Those earning below the minimum live in relative poverty. Furthermore, people working full-time could still be in this category and these are known as the ‘working poor.
Governments imposing minimum wages would guarantee that workers receive fair returns on their labour and prevent them from being in a state of poverty. The extra money is meant to come from the profits of firms creating a redistribution effect from the rich to the poor. However, this could create an equity-efficiency trade-off where such a policy would undermine economic growth as well creating other inefficiencies such as unemployment and inflation.
The goal should be distinguished between equality and equity of the income distribution. Equality would refer to giving everybody the same opportunities to achieve their goals. Equity refers to fairness and acknowledging that different people live in different circumstances, therefore this refers more to giving individuals the ability to achieve their full potential. Whilst this is quite a normative concept, poverty is a clear issue regarding equity. This is because people considered to be in states of poverty are unlikely to be able to increase their income levels on their own, throughout generations. This is because people in poverty are typically more likely to face more adversity so they are less likely to be able to reach their potential. Poverty is quite a multidimensional issue which should take into account a range of factors, not just income. However, we will focus on this policy and evaluate its merits in improving equity in the distribution of income.
A minimum wage could be considered to be essential for a government to impose as these so-called ‘working poor’ are in the lowest income levels and so may not have a lot of bargaining power to improve their wages as the supply of their labour is quite competitive as these tend to be lower-skilled jobs. This issue is of greater importance over time for if their wages do not meet inflationary levels, their real incomes will fall. This is why some trade unions are calling on the UK government to increase the minimum wage to £15, according to BBC News. Therefore, the government, arguably, has to intervene to impose a greater minimum wage in order to prevent a growing gap between their incomes and the poverty line or increase the number of households below that level.
Raising a minimum wage in an economy could, however, be counterproductive. By raising minimum wages, firms will be less willing and able to employ more workers due to higher costs. Therefore, firms will have to either reduce hours or workers to reduce costs. This can be seen in the following diagram.
This diagram shows that if the labour market was left to free markets, the equilibrium wage level would be at We and the quantity of labour employed would be Qe. The equilibrium wage is below the living wage but if the government were to impose a minimum wage at that wage level, it would create structural unemployment. This unemployment is shown in the diagram by the excess supply between the quantity of labour demand (by firms) and the quantity of which is supplied (by workers). At higher wage levels, more workers are attracted to work, however, firms are less willing and able to employ more workers. The level of employment actually decreases after the government intervention. People working minimum wage will be the ones who are most hurt by adverse effects and so this neoclassical model shows how the implementation of a minimum wage could increase the inequity of the distribution of income within an economy. Structural unemployment in Los Angeles also rose in another way as automation is starting to replace low-skilled workers. An implementation of a minimum wage could catalyse a move towards machines doing jobs previously done by humans as higher costs would justify investing in these machines.
Furthermore, a rise in minimum wages will hurt small businesses as they are less well-equipped to handle such rises in costs, especially if there is a sharp increase. It will also undermine entrepreneurship and startups as they are much harder to afford, especially ones relied on to bring poorer-income households to higher income levels. This all clearly shows inequity rather than a redistributive effect, as lower-income households will lose jobs and small businesses will be less able to handle higher costs. Such adverse effects will disproportionately hurt lower-income households.
However, whilst implications from the neoclassical model are clear, research and empirical evidence have not shown any definite conclusions that minimum wage rises lead to unemployment. A 1990 study by economists George Akerlof and Jannet Yellen discovered the psychological impacts of higher wages. Whilst there is the argument that higher wages will lead to higher costs for firms, and therefore more unemployment, the higher wages will in most cases motivate workers to work harder, and therefore the extra productivity can offset the growing costs of firms, therefore allowing them to maintain their profits, preventing the need for firms to reduce the size of their workforce, and thus reducing unemployment. By increasing the minimum wage, it encourages people to join the labour market, people who previously believed that it would not be worth working before the minimum wage rise, and so this can reduce unemployment.
With higher minimum wages, a larger number of individuals and families would be able to escape the poverty trap, which would importantly improve equity. This is especially important to improve equity for them as they are the ones who lack the most opportunities, therefore these households struggle to fulfil their potential so that their children have a better opportunity for social mobility. Consequently government expenditures on transfer payments to the poor could decrease, allowing governments to increase spending in other areas of the economy, potentially offsetting any trade-off to economic growth from higher minimum wages.
Higher wages can feed through to greater economic growth, as consumers are receiving more income, and so they are able to spend more, meaning that more money would be flowing to firms. This can therefore act as an incentive for firms to keep workers, since the extra cost of wage rises can be counteracted by the extra demand for their goods and services, reducing the need for firms to make workers redundant.
A country which has seen a more equitable distribution of income over the years following steady rises in the minimum wage in Brazil. Between 1996 and 2012, the earnings gap between the upper and lower earnings levels in Brazil decreased by eleven per cent. Notably, the country also increased the real minimum wage by one hundred nineteen per cent during this period, which is considered by data analysts to be the main catalyst in creating a more equitable distribution of income within the country.
However, studies have once again concluded that there is a lack of empirical evidence
backing up this claim as being fully true.
Overall, we believe that minimum wages are an important tool to create a more equitable distribution of income. By reducing the number of people in poverty, it can create more equity. Whilst counterarguments of unemployment and inflation do not have empirical evidence, it does not mean that too radical policy implementations would not have trade-offs. Incremental rises usually are quite good as it allows actors within an economy to react more seamlessly.
Governments also need to be careful of implementing such policies during periods of
economic turmoil. For example, a rise in minimum wages during higher levels of inflation would likely create an inflationary spiral or an increase in unemployment.
Discrimination between businesses of different sizes will also be useful, at least in the
short-run, in order to protect smaller ones until they grow in size by implementing a lower the minimum wage for workers in such places.