Economics of Minimum Wage Legislations—Lessons for Emerging Market Economies

Abstract

Philosophical bases for the origin for minimum wage legislation are implicit in the concepts of subsistence and natural wages evolved by classical economists.¹

The earlier version of this article was presented in the annual conference organized by The Indian Society of Labour Economics, held at IIT Guwahati in November 2016. The comments given by the participants of the conference have been incorporated.

However, conceptualization of the working of market, evolved by microeconomic theory, propounded that minimum wage law distorts working of the labor market. These alternative formulations give impression that this law is politically correct but not based on sound economics. Since the beginning of the process of economic reforms in most of the emerging market economies, some of the scholars, following the strand of thought advocated by microeconomic theory, are arguing for the amendments in minimum wage legislations to make the labor market flexible. In the present article, an attempt has been made to evaluate the appropriateness of this strand of thought with the help of existing theoretical and empirical studies. The evaluation clearly shows that strand of thought based on microeconomic theory is not appropriate. This is because demand of the factor of production in an economy is not based on the price of the factor alone. It also depends on price of substitute factor and the growth rate of the economy. Moreover, minimum wage legislations act as determinant of efficiency wages for the workers employed at the bottom of the job ladders.

Keywords

Natural wage minimum wage efficiency wage income inequalities unemployment

For a considerable period of human history, before the private acquisitions of land and accumulation of capital, there was absence of labor market. In the absence of labor market, wages did not exist as a separate category as a reward of labor. In such circumstances, entire output accrued to labor. This happened because output depended on only exertions of labor. The other factor, land, was a free gift of nature; therefore, entire output was attributed to labor. At that stage, labor had ‘neither landlords, nor masters to share with him’ (Smith, (2003 [1976]) p. 91). Hence, laboring population reproduced itself with the help of self-produced means of subsistence. The evolution of private property in the form of ownership of land and capital necessitated the emergence of labor market. The existence of labor market created separation between the process of production and social reproduction of labor. In altered circumstances, laboring population no longer reproduced itself with the help of self-produced means of subsistence, but acquired it by process mediated through labor market. Therefore, in the market economies, wages emerged as a separate category, representing a compensation for the contribution made by the labor in the process of production.

The emergence of labor market destroyed the autonomy enjoyed by subsistence economy, by expropriating the means of subsistence of labor. The absence of self-produced means of subsistence forced independent labor to participate in the labor market to earn means of his subsistence.

Evolution of labor market was favored because of its distinct advantage over earlier forms of control over labor, whether brutal (slavery) or paternalistic (feudal). Once a worker begins to participate in the labor market, his worth is determined by how successfully he has been able to sell his services in the labor market. This is because his wage fluctuates, like prices of all other objects, in accordance with the vagaries of the market. The problem emerges, in most of the economies, where there exists permanent excess supply of unskilled workers. In such economies, if wages are left to be determined by market-clearing level, wages may fall below the level of their subsistence.

The classical political economists believed that wage of a worker should be at least equal to his subsistence level ‘otherwise it would be impossible for him to bring up a family and race of such workmen could not last beyond their first generation’ (Smith, 2003 [1976], p. 97). In the writings of other classical economists such as Malthus and Ricardo, payment of wages equal to the subsistence level of workers became almost like an Iron Law of Wages (Galbraith, 1991; Weatherhall, 1976). Acceptance of this argument suggests that the government intervention is necessary for fixing a minimum support price of labor, equal to the level of subsistence in the form of minimum wages. Following this logic, governments in most of the economies, in general, and in India, in particular, put in place minimum wages legislations.

Contemporaneously, there exist alternative strands of thought regarding appropriateness of government interventions in the working of labor market in the form of minimum wage legislations. The antagonists of the legislations believe that these legislations are based on bad economics, despite the fact that they are politically correct. According to antagonist of the legislations, in a free market economy, wages of workers of a given level of productivity get equalized and do not get altered by age, race, sex and location of employment (Hammermesh, 1988, 1993). Therefore, it is argued that in the absence of minimum wage legislation, the labor market will set wages, which will be equal to the social opportunity cost of labor. They also argue that free labor markets are efficient markets. The efficiency of labor market is compromised by minimum wage legislations. In the absence of minimum wage legislations, wage remains flexible, which facilitates the process of adjustment in the labor market.

On the other side of intellectual divide are those economists and policy makers, who believe that minimum wage legislation is not only a good politics but also a sound economics. Their argument is based on the proposition that social and economic reality that exist in most of the economies make the labor market to deviate from competitive market. Therefore, real markets do not work according to textbook models of free market. Hence, they emphasize the potential benefits of minimum wage legislation, because regulated markets adjust better to market shocks and also help in minimizing social cost of adjustment process (Standing & Tokman, 1991).

In most of the emerging economies, in general, and India, in particular, this debate has assumed significance after the beginning of the process of liberalization of the economy in 1991. Successive governments, since then, have significantly liberalized commodity markets, financial markets, and foreign trade regime. However, almost all these governments have postponed the liberalization of the labor market. This is perhaps due to the reason that the labor market ‘is a social construct based on specific rules and compromises’ (Picketty, 2014, p. 308). This is an obvious fact that the labor market is a social institution and reflects the current nature of social contract. The nature of social contract depends on the extent of harmonization of interest of different stakeholders at a point in time (Gademen, 2001). It is because of this reason that wages of workers and employment are not like prices and quantities. These are, in fact, the bases on which people evaluate themselves and think about their social status. Through their wages, they also judge whether they are appropriately rewarded and are receiving a fair share out of society’s prosperity (Datta Chaudhri, 1994). Hence, liberalization of the labor market amounts to playing with human sentiments.

There is consensus amongst scholars regarding political appropriateness of minimum wage legislation, where they differ from each other on the issue of soundness of its economics. Therefore, in the present article, an attempt has been made to analyze the economics of minimum wage legislation by evaluating the strength of arguments advanced by protagonists and antagonists of minimum wage legislation. It has been argued here that minimum wage laws are based on not only good politics but also on sound economic principles. Hence, policy makers, who are evolved in labor market reforms, have no ground to repeal them. For the purposes of analysis, rest of the article has been organized into four sections, where each section deals with a specific aspect of the problem. Here, the first section deals with the origin and continued existence of minimum wage legislations. In the second section, we provide arguments given by the antagonists of the minimum wage legislation. The third section gives the alternative formulation of the problem, and finally, in the last section, we present summary and conclusions of the article.

Emergence of Minimum Wage Legislations

The history of minimum wage legislations began in the United States in 1912 when Massachusetts passed the minimum wage law. This was followed by a minimum wage legislation, which was introduced only for women workers in Oregon in 1913. During the period 1913–1922, 16 other states of the United States adopted minimum wage laws. However, the US Supreme Court declared that all such legislations were not compatible with the US Constitution in 1923 (David, 1936). The persistent efforts by different stakeholders changed the attitude of the Supreme Court toward these legislations. Finally, in 1937, the Supreme Court reversed its verdict of 1923. Following this verdict, the Fair Labor Standards Act was passed in 1938. This law created conditions which facilitated the emergence of minimum wage legislations in the United States. In Britain, minimum wage legislations were introduced in 1936. By the end of the World War II, most of the market economies had introduced minimum wage legislations (Card & Krueger, 1995; Picketty, 2014). In India, Minimum Wages Act was introduced in 1948. Since then, minimum wage legislations have become an important component of labor market regulations in most of the market economies of the world.

It is also interesting to mention that in the construct of market, developed by the microeconomic theory, there always existed a theoretical opposition to minimum wage laws. However, concerted effort has been made by a section of economists, against minimum wage laws, since developed market economies experienced stagflation during the 1980s. The transformation in the attitude of economists against minimum wage legislations needs explanation. To understand the changes in the attitude of economists, there is a need to view the changes that have occurred in the macroeconomic environment of these economies. The change in the macroeconomic environment has made a paradigm shift in the nature of policy formulation from demand side economics of Keynes to supply side economics evolved by neoclassical economists.

During the last century, developed market economies have witnessed two major economic crises, which compelled them to evolve new structures to overcome these crises. In the 1930s, developed market economies experienced their first major crisis known as the Great Depression of the 1930s. The emergence of this crisis validated the prediction made by Marx that these economies have built-in tendency to experience instability in the form of business cycles. However, outcome of this crisis revealed an important strength of the market economies, identified by Schumpeter that these economies are capable of overcoming such crisis by ‘outgrowing their own frame’ (Schumpeter, 1928, p. 361). This is because market economies were able to avoid reoccurrence of recessionary tendencies after restructuring their economies along Keynesian economics. Economists diagnosed that the crisis had emerged due to fall in aggregate demand, which could not support the growing potential of supply side. Keynes observed that sometimes the market fails to arrive at equilibrium with full employment. Under such circumstances, government should intervene to maintain full employment by managing aggregate demand. The result was the creation of elaborate institutional and legislative structure to regulate different markets. The need for reconstruction of war-shattered economies further provided legitimacy to Keynesian macroeconomics after World War II. The social consensus built around Keynesian economics encouraged policy makers to maintain high level of aggregate demand to achieve near full employment. The consensus helped in evolving a regime of regulations, which empowered working classes with range of rights through legislations. One of such legislations was minimum wage legislation, which provided income security to working classes.

The minimum wage laws, which supported the maintenance of high-level aggregate demand, evolved symbolic relationship with the methods of mass production. The regime of accumulation based on methods of mass production and regime of regulation to create mass consumption evolved their own virtuous circle (Boyer, 1988, 1990; Coriat, 1980). This virtuous circle resulted in high standard of living and prosperity in most of the developed market economies. The speed of this circle received momentum by high long-term growth rates, accompanied by continuous productivity gains, which were made possible by methods of mass production and economies of scale. The high aggregate demand was also maintained by sharing gains of higher productivity with organized working classes. Massive government spending on public enterprises, social and economic infrastructure, and other welfare schemes also helped in sustaining high level of aggregate demand. Since minimum wage legislations were compatible with macroeconomic objectives of the policy makers, there did not emerge serious opposition to minimum wage laws, despite the fact that these laws were not consistent with microeconomics.

This virtuous circle discontinued to rotate on its orbit. This happened because the symbiotic relationship that evolved between regime of accumulation and regime of regulation broke down. The process began with 1973–1974 and then 1978–1980 oil crisis, which resulted in high rates of inflation accompanied by high unemployment rates. For the first time, inflation, instead of creating more employment opportunities, as envisaged by stylized fact represented by Philips Curve, resulted in clustering of high unemployment rates (Philips, 1958). As a consequence of this situation, for the first time, there occurred simultaneous existence of high rates of unemployment and inflation. The simultaneous existence of these twin evils, unemployment and inflation, established a one-way causality that welfare, regulations, and statism catapult Eurosclerosis, stagnation, and unemployment, that is, stagflation (Anderson, 1999; Lindlebeck, 1994; Seth, 2001). The Keynesian economics could not provide solution to this crisis. This time economists identified that the main reason for the simultaneous existence of inflation and unemployment had emerged as a consequence of a lack of response of supply side to market stimulus, that is, inflation. This happened because supply side of the market was kept as hostage by the institutions and regulations that these economies had evolved following Keynesian prescriptions for maintaining high level of aggregate demand. This realization provided objective conditions for the growing popularity of supply side economics.

The supply side economics is based on premise that institutions and regulations, created by the state to regulate markets, create market rigidities, which make it difficult for the supply side to respond to market conditions. Therefore, it advocates for the removal of all institutional and regulatory mechanism to make markets flexible. The existence of market flexibility facilitates faster macroeconomic adjustment process of different markets. The achievement of this objective necessitated the shift in policy regime from regulated markets to liberalized markets. The shift in policy regime will not be complete without liberalization of labor market from labor market regulations. Since minimum wage legislations also create labor market rigidities by making wages downward rigid, they hamper the process of adjustment in the labor market. Not only this, these economists advocated that since labor markets take longer time lag for adjustment, the process of liberalization should begin with the liberalization of the labor market (Horton et al., 1999).

Arguments Given by Antagonists of Minimum Wage Legislations

The antagonists of minimum wage legislation have developed their arguments on the basis of working of markets as described in the mainstream microeconomics. In the framework evolved by microeconomic theory, adjustment in the labor market occurs through wage flexibility. In a competitive market, with complete information, an individual firm takes wages as exogenously determined (i.e., the notion of price-taking firm). The optimizing firm hires number of workers as long as marginal revenue productivity of additional unit of workers is equal to the wage rate. Since the labor market has capacity to set wages, which clears the labor market, unemployment in this theoretical construct occurs if workers are not willing to work on the current wage rate. Therefore, according to this construct, unemployment is totally voluntary unemployment. According to this theoretical construct, when minimum wage legislation sets wages of workers above the market-clearing level, it motivates more workers who are willing to work on the basis of new wage rate. Hence, excess supply of labor, who are willing to work, over the capacity of the market to absorb, results in involuntary unemployment (Stigler, 1946). This logic is further extended to explain harmful consequences of all the labor market laws, which affect wage rate (Brown, 1988; Brown, Gilroy, & Kohen, 1982). Following the same logic, Baumol and Blinder mention in their textbook on microeconomics that ‘consequence of minimum wage law is not an increase in income but a restriction on their employment’ (Baumol & Blinder, 1979, p. 3).

Microeconomic theory also provides an alternative formulation regarding consequence of minimum wage legislation, when market is imperfect. In a situation, when firm has the power of setting the wage rate, the situation is being described as monopsony market (i.e., a market where firm is the only player in the market to hire workers). This term was used for the first time by Joan Robinson in her book The Economics of Imperfect Competition (Robinson, 1933). The wage-setting power enjoyed by a firm gives it opportunity to evolve its own strategy. A firm may choose to set wages at low level and experience higher number of vacant positions and high level of turnover rate. On the contrary, a firm may pay higher wages, hire workers up to the extent of its requirement, with no vacancy, accompanied by lower turnover rates. Under these strategic options available to a firm, a firm can choose from a range of wage levels. In such situation, it can change the expected negative consequences of minimum wage legislations. Under the conditions when employers have the power to fix wages, they may fix minimum wages much below their marginal revenue productivity. Such behavior of the employers justifies the imposition of minimum wages through legislations, which will not only be just but also increase market efficiency because it would move the economy near competitive equilibrium and increase employment. This occurs because fixing a minimum wage higher than market-clearing level may force a firm to hire more workers. What we can conclude under prevailing circumstances is that the employment effect of minimum wage legislation may vary and need empirical verification.

The minimum wage legislations that increase the supply price of labor (wages) cause several kinds of labor market distortions. Initially, the scale effect will reduce employment of labor by reducing demand of labor by the product of wage elasticity of labor demand and percentage change in wage rate. We have come across several empirical studies as well as surveys of the literature of empirical writings that have assessed the role of minimum wage law on employment. However, it must be known that most of the research studies on minimum wage legislations pertain to the economies of the United States and other European countries. The earliest empirical studies were conducted by the United States Department of Labor (Macesich & Stewart, 1960; Mincer, 1976). The empirical studies conducted by the department were reported and debated in the papers published by Lester and Peterson (Lester, 1960; Peterson, 1957). These studies did observe small unemployment effect of minimum wage laws. This was followed by another survey of the literature that appeared in 1982. According to this survey, 10 percent change in minimum wages results in unemployment from 1 to 3 percent. This study confirmed the belief of economists that minimum wages have negative consequences on employment of less-skilled workers (Brown et al., 1982). In 1992, several empirical studies were conducted using new methodology that incorporated the impact of interstate variations in minimum wages in the United States. This group of studies was described as new minimum wage research. These studies obtained different conclusions and, unlike earlier studies, did not provide conclusive evidence regarding negative impact of minimum wage legislations on employment. This happened because some of the studies obtained negative impact (Neumark & Washer, 2008) to no effect to positive effect (Card & Krueger, 1995). From these studies, later on, two important books appeared which articulated each strand of thought in detail. Card and Krueger published a book, which contained most of the studies which they had conducted along with other coauthors for the last several years (Card & Krueger, 1995). Most of the studies established that the anticipated negative effect of minimum wage hike failed to materialize. These studies confirmed the conclusions which were arrived at by earlier studies that impact of minimum wages laws are overrated by both the antagonists as well as protagonists of these legislations. This is because even the positive effects or negative effects are either small or insignificant, which can be ignored by the policy makers (Brown, 1988; Castillo-Freeman & Freeman, 1990).

Studies on alternative strands of thought were reported in another book (Neumark & Wascher, 2008). The empirical evidence provided in the book supported the view that the minimum wages led to decline in employment opportunities of less-skilled workers. However, the results reported in the book received effective response from two empirical studies (Allegretto, Dubey, & Reich, 2011; Dube, Lester, & Reich, 2010). The authors claimed that these empirical studies intended to make sense out of the contradictory evidence that existed on the issue (Dubey, 2011). In order to identify the employment effect of minimum wage legislations, they used methodology which took into account a counterfactual group of workers as a control group to understand what would have been the scenario in the absence of minimum wage laws. This new methodology concluded that minimum wages do not reduce employment (Allegretto et al., 2011; Dube et al., 2010). However, Neumark along with his coauthors responded with their detailed new empirical work (Neumark, Salas, & Wascher, 2014). They argued that the methodology used by both the studies mentioned above was flawed and led to incorrect conclusions. By making correction in their methodology, they attained employment elasticity, with respect to change in minimum wages—0.15. As a result, they concluded that ‘minimum wages pose a trade-off of higher wages for some and job losses for others’ (Neumark et al., 2014, p. 645). A number of empirical studies, which have tried to identify the relationship between minimum wage law and employment, that have been reported above have not been able to conclusively establish the nature of relationship between the two. In the absence of established relationship, one can agree with the statement made by Castillo-Freeman and Freeman. They state that ‘To find a clear cut employment effect, one need to examine a minimum wage that bites rather than nibbles at the edges of the job market’ (Castillo-Freeman & Freeman, 1992, p. 250).

The impact of scale effect of minimum wage law on employment, which has been described above, is also accompanied by substitution effect of minimum wage laws. The substitution effect of minimum wage laws emerges when firms substitute labor hours for labor employment. This occurs when firms instead of hiring new workers begin to intensively use existing workforce by increasing overtime working. It is now an accepted fact that labor costs are quasi-fixed cost, because a portion of total cost of labor is invariant with respect to changes in labor hours, and a portion is variable with respect to changes in hours worked (Oi, 1962). The quasi-fixed nature of labor costs provides possibilities of substitution, between increasing the working hours of existing workers and new employment. It is hypothesized that minimum wage laws increase relative price of new employment in comparison to labor hour increase. These cost differences induce performance or long working hours for existing workers at the cost of creation of new employment opportunities. This possibility of substitution increases over time working of existing workers and reduces employment potential (Hammermesh, 1988; Seth, 1994). The possibility of substitution between hour of work and new employment, when viewed in the presence of heterogeneity of workforce, creates serious labor market distortions. The minimum wage legislations result in a higher percentage increase in the cost of employment of workers with low wages than those with high wages. Therefore, these legislations cause a wider gap between the cost of new employment and an additional hour of work amongst low- than high-wage workers. If all levels of workers’ employment and labor hours are perfect substitutes, then minimum wage legislation will result, for each category of workers, in substitution of longer hours of work in lieu of new employment. But the most affected section of the workers will be low-wage workers, because in their case there will be much larger number of hours of work substituted for new employment. Therefore, employment potential will decline maximum in the case of low-wage workers (Hammermesh, 1988, 1993; Hart, 1984).

The other harmful consequences caused by minimum wage legislation that have been identified by the antagonists of these laws are that these laws increase the relative price of labor in comparison to the price of capital, which discourages the selection of project which are labor intensive. Hence, minimum wage legislations increase capital intensity. Increase in capital intensity directly affects the magnitude of labor absorption in the economy. This argument ignores quite an obvious lesson of neoclassical economic theory. Neoclassical economic theory of factor demand clearly states that the demand of a factor is not determined by its price alone (i.e., own price elasticity) but also by the price of its substitute (i.e., price of capital), measured as cross-price elasticity and growth of output of the industry or economy, measured as employment–output elasticity. It is generally accepted that apart from negative coefficient of own price elasticity, all other coefficients are generally positive. Therefore, positive cross-price elasticity and employment–output elasticity overcome the impact of negative price elasticity (Seth, 1994; Seth & Seth, 1991). Hence, minimum wage legislations may not reduce employment. However, in most of the emerging economies, price of capital is deliberately kept low by subsidies on investment in fixed capital. Subsidies are given to encourage investments. In fact, subsidized capital motivates employers to use subsidized factor most intensively. This increases capital intensity and reduces employment opportunities. Increased capital intensity also reduces the magnitude of employment-output elasticity because employers use more capital to increase output. Hence, instead of minimum wage legislations, the subsidies on capital are more responsible in reducing the employment potential. Several economists have argued that in the case of India, the existence of minimum wage legislations along with other labor market regulations are not responsible, for falling demand of labor, which has resulted in jobless growth (Bhalotra, 1998; Dutt, 1994; Seth & Aggarwal, 2004; Uchikawa, 2002).

Alternative Formulation

Most of the arguments given by the antagonists of minimum wage law are based on textbook model of working of free market. It is quite obvious from general observation that the organization of work in the real market is hierarchical and authoritarian, which makes it difficult to be compatible with ideal, noncoercive exchange. The functioning of the ideal market assumes that (a) all units of labor are homogeneous, (b) there is a spot market labor, that is, there is instantaneous adjustment in the labor market, and (c) labor market regulations cover the entire labor market. If one relaxes any one of these assumptions, the logic on which arguments of the antagonists of minimum wage legislation are based ceases to be valid. The empirical studies on minimum wage legislation have observed that in most of the emerging economies, minimum wage legislated by the authorities are either too low or are not seriously enforced; therefore, these legislations do not have distortionary effect on employment (International Labour Organization, 1990; Tokman, 1991). In a study on labor market regulations in India, it was found that wages of unskilled workers in the large enterprises were much higher than the legislated minimum wages, while smaller enterprises were paying wages either equal to legislated minimum wages or with 20 percent deviation from the legislated minimum wages. Thus, it was quite evident that policy makers generally fix minimum wages equal to the going market wage rate for small enterprises (Fallon, 1987). Empirical studies have also established that policy makers rarely set minimum legislated wages at a level that may have negative consequences on employment. If statutory minimum wages are set at a high level, it will become unenforceable in practice, because it will be advantageous for workers as well as for employers to overlook the law to save jobs and employment (Freeman, 1992).

In most of the emerging economies, labor market regulations regarding minimum wages do not cover the entire industry. Therefore, minimum wage laws do not affect in the same proportions all employees in a firm, to all firms in industry, to all industries in the economy. This happens when government provides segmented economic environment to small enterprises, or lack of enforcement of government regulations on unorganized sector. The net impact of partial coverage of the labor market is that it leads to reduction in the employment of covered sector of the economy and expansion of employment in the uncovered segment of the economy (Welch, 1974). The wage differentials between organized and unorganized sectors discourage growth of employment in the organized sector because the enterprises in the organized sector can either subcontract or farm out production to small enterprises. The notable examples of this tendency are visible in the prevailing organizational structure of the garment export sector, growth of power loom sector in textile industry, shoe and footwear industry, electrical appliances, and electronics and pharmaceutical industries in India. This process of shifts in the employment from formal to informal sectors has been observed in the case of most of the emerging economies (Hart, 1972; Piore & Sabel, 1987; Tokman, 1992).

Some of the studies have observed that minimum wage legislations, which set wages above the market-clearing level of less-skilled workers, encourage technological change and innovation amongst firms. This happens because firms which earn high monopoly rent (i.e., abnormal profit) from innovations are better equipped to absorb the impact of wage legislation than technologically laggard firms. The minimum wage legislations may speed up the Schumpeterian process of creative destruction, because innovating firms will reduce the advantage of firms using the old vintage of capital stock. This suggests that absence of minimum wage legislations may increase the probability of survival of lazy firms, because it will facilitate the firms to continue to use old stock of capital. It has also been argued by some of the economists that in the absence of minimum wage legislations, wage of the workers will be so low that it may pose additional social cost arising from work shirking, stealing, and lethargy. These factors emerge as a constraint in the efficient use of human resources by the organization. The social costs of these behavioral factors to economy may be enormous. These costs can be minimized by paying to workers minimum wages that are higher than market-clearing level. Under these conditions, minimum wages assume the role of efficiency wages for the lower strata of the workforce.

The idea of efficiency wages is based on the proposition that over a range, a firm can increase the productivity of workers by raising the wages of workers at a level that is higher than the market-clearing level. This additional payment of wages plays an important role in increasing the productivity of workers. The important historical example of efficiency wage is the introduction of the minimum wage of a five dollar a day by Ford in his automobile manufacturing company Ford Motors in 1914. Ford himself expressed that ‘there is no charity in raising the minimum wages .... We were building for future. A low wage business is always insecure’ (Raff & Summers, 1987, p. 559). If one accepts the logic implicit in the efficiency wage theory, minimum wage legislations play an important role enhancing the productivity of less-skilled workers by (a) reducing turnover rates (Salop, 1979; Stigler, 1985), (b) attracting better workers (Weiss, 1990), (c) improving motivation, and (d) reducing work shirking (Katz, 1986; Stigler, 1984). Scholars have also developed sociological explanations to explain the relationship between efficiency wage and productivity. Scholars argue that higher minimum wages, higher than the market-clearing level, acts as a gift to workers in exchange for workers’ gift of supply of effort in addition to what is expected from them (Akerlof, 1982, 1983, 1984; Akerlof & Yallen, 1986).

We have already mentioned the role of minimum wage laws in maintaining higher aggregate demand that facilitated the emergence of a virtuous circle based on the regime of regulation that facilitated mass consumption, which in turn supported the regime of accumulation of mass production. The minimum wage legislations maintain high level of aggregate demand in an economy, which is wage-led (Bahaduri & Marglin, 1990). Moreover, studies also show the relationship between demand growth and productivity (Verdoorn’s law) and demand-pull led growth in patenting activity (Schmookler, 1966; Vergeer & Kleinknecht, 2014).

The textbook model of free market explains that without the problem of information, wages of workers of a given level of productivity are equalized and they are not affected by age, race, sex, or location of employment. Therefore, it is propagated that in the absence of minimum wage legislations, market has capability to harmonize wages. This particular formulation is not compatible with empirical reality. Studies dealing with wage inequalities in the case of underdeveloped economies revealed that a very large part of existing wage differentials amongst comparable workers cannot be explained by either state regulations or union intervention. These studies created doubt regarding the appropriateness of the hypothesis that wage differentials increase due to labor market regulations. The empirical exercise conducted to understand the nature of relationship between wage dispersions and the existence of minimum wage legislations established that wage differentials were low in those economies which had legislated minimum wages and high in economies which had absence of minimum wage legislation (Freeman, 1986, 1992). A similar view has been expressed by Picketty who has conducted a detailed study on income inequalities (Picketty, 2014, pp. 307–310).

The empirical work of Dinardo, Fortin, and Lemiex conducted in 1996 highlighted the compressing effect of minimum wages on wage inequalities in the United States. They observed that erosion in legislated minimum wages explained between 40 and 65 percent in earning differentials between 1979 and 1988. Similar results were obtained by several other studies which were conducted for the US economy (Acemoglu & Autor, 2011; Card & Dinardo, 2002; Katz & Autor, 1999; Lemieux, 2008; Teulings, 2003). Increase in minimum wages affects income distribution of two kinds of workers. It affects the income of workers (a) who were previously earning equal to fixed minimum wage, (b) who were earning more than former minimum but less than new legislative minimum, and (c) who were earning slightly higher than new level of minimum wage through ripple-effect. In their latest study, David Autor along with two other scholars, using the data covering the period 1979–2012, observed that declining legislated minimum wages made significant impact on gender inequality and insignificant impact on male lower tail inequalities. These scholars do believe that minimum wage legislations affect income inequalities, but its role is much smaller than suggested by earlier studies (Autor, Manning, & Smith, 2016).

The adoption of minimum wage legislation is also supported by classical economists. The neoclassical theory is based on the premise that market wage is determined by the forces of demand and supply. The classical economists distinguished between natural wage and market wage. Natural wage is determined by the cost of reproduction of labor. The understanding of natural wage necessitates the knowledge regarding historical changes that have occurred in the modes of acquiring subsistence. The modes of acquiring subsistence are quite important in the framework evolved by Smith as these are the ethical bases of determining wage (Home, 1985; Meek, 1956). The concept of market wage treats labor like commodities and accepts that like all other commodities; price of labor (wage) is also determined by the forces of demand and supply. This conception of labor ignores the peculiar process of reproduction of labor. It is said that ‘other commodities do no subsist they exist, they do not die, they are consumed or destroyed, they are not born, they are produced, last but not the least they do not acquire habits are not politically active’ (Pichhio, 1992, p. 133). This distinction clearly shows that the minimum price of labor cannot be left to be determined by market forces.

Summary and Conclusions

Objective of the article was to understand whether minimum wage laws are based on sound economics or not. In the course of our exploration to seek answer to this question, we observed that philosophical basis for the formulation of minimum wage legislations is implicit in the concepts of subsistence and natural wages evolved by the classical political economists. Therefore, it is quite evident that minimum wage legislations are based on sound political philosophy. We also learnt from our exploration that the emergence of microeconomic theory, and the idea of market implicit in these theories, established a strong argument that minimum wage legislations result in unemployment amongst working classes. This argument created a thinking, which began to accept that minimum wage legislations are not compatible with good economics.

However, despite the existence of strong microeconomic argument against minimum wage legislations, strong opposition against these laws did not emerge. This happened because at the same time when minimum wage legislations were introduced in different economies, after the World War II, Keynesian economics emerged as a new paradigm in macroeconomics for policy formulations. Keynesian economics had emerged as a solution to reoccurrences of crisis like Great Depression, which stressed on maintaining a high level of aggregate demand. The emerging symbiotic relationship between the regime of accumulation based on high mass production and the regime of regulation to maintain high mass consumption put into the background the apprehension of microeconomists regarding negative consequences of minimum wage legislations. However, during the 1980s, most of the developed market economies experienced stagflation when twin economic evils, inflation and unemployment, existed simultaneously. As Keynesian macroeconomics could not provide an answer for this new crisis which resulted in a paradigm shift in the policy regime in favor of supply side economics, antagonism against minimum wage legislations became more vocal and policy makers began to listen to their arguments.

However, in the course of our analysis, we found that the apprehension of microeconomic theory that the minimum wage laws reduce employment is not supported by empirical studies. It was also surprising that most of the empirical studies were based on the experience of European economies and the experience of the economy of the United States. We observed this as an important gap in the research done by labor economists in India. The fact that the minimum wage legislations do not result in unemployment is also supported by the fact that the demand of a factor is not solely determined by its own price (i.e., wages). It also depends on the price of its substitute (i.e., the price of capital) and the overall growth rate of the industry/economy. Even the price of the product, which is being produced by the workers, determines the demand for labor. If the price of the product is rising much faster than the wage rate, the impact of wages on employment declines.

It has also been observed that in the case of developing economies, the minimum wages fixed by the authorities are too low to affect unemployment. Studies conducted by the International Labour Organization have identified that the minimum wages fixed by the authorities are generally equal to the current wage rate prevailing in the small enterprises of these economies. Even in the case of a developed economy like the United States, it was found that during the period 1980–2000, minimum wages had declined to such a low level that it was possible to raise minimum wages without affecting employment. Based on these findings, Obama administration raised the minimum wages in 2008 (Card & Krueger, 1995; Picketty, 2014, pp. 309, 313).

Our analysis also suggests that labor market regulations like minimum wage legislations do not increase wage differential amongst workers. The empirical studies, which were conducted to know the nature of relationship between minimum wage laws and wage dispersion, established that wage dispersion were low in those economies which had legislated minimum wage laws. Minimum wage legislations affect income distribution of two set of workers. They affect the income of workers (a) who were previously earning lower than minimum wages, and (b) also of workers, who were earning slightly higher than the minimum wages determined by the authorities, through ripple effect.

Analysis presented above establishes that the minimum wage legislation neither increases unemployment nor wage dispersion; they help in improving the efficiency and productivity of labor. This happens because minimum wages fixed by the authorities work as efficiency wages for workers at the lowest strata of job ladder. This suggests that these laws are based on sound politics and correct economics. It is also interesting to mention that most of the memorandums submitted by the associations of employers in India, regarding labor market reforms, do not ask for the removal of the minimum wage law. For reforming the labor market, they are demanding amendments in the Industrial Disputes Act, which either does not permit them to adjust manpower or make it costly to adjust manpower in response to the market condition.

Footnotes

Author’s Biography

Vijay K. Seth is currently a Professor at International Management Institute. Earlier, he was a Professor at the Faculty of Management Studies, University of Delhi. He has published seven books based on his research on various aspects of the Indian economy. He has also contributed numerous research articles in national as well as international journals. E-mail: vkseth1950@yahoo.co.in

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