Running head: CASE STUDY 1- INCREASING MINIMUM WAGE 1

Case Study 1- Increasing Minimum Wage

Name

Institution
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Increasing Minimum Wage

In neo-classical model all the market participants of production get paid which

considered as opportunity cost of their activity. In labor market input and output is ‘perfectly

competitive’ and technology shows a constant return to scale. So power and strength are not an

issue which determines the pay to labor other than the market dictates. So the capital and labor

have a harmonious relationship with the output distribution. There is an unambiguous response

in a market when the minimum wage rate increases. The employers cut the employment as an

immediate response to the hike in the wage rate.

Wage-Hike in New Jersey-Pennsylvania

A very popular case is being presented here to understand the theoretical underpinning of

minimum wage concept of the economy. On April 1, the minimum wage rate of New Jersey rose

from 4.25 to 5.05. To measure the impact of the rise in wage rate a survey had been conducted.

410 fast food restaurants were surveyed before and after the rise of wage rate. It was very

surprising phenomenon that contradicts the common economic theories of wage rate and

employment. Comparing the employment in lower-wage stores it was observed that there was no

indication of reduced employment caused by the rise of the minimum wage (Card & Krueger,

2000).

The actual rise took place in recession time though the legislation was passed two years

earlier when the economy was in good condition. The effect of higher minimum wage was

obscured because the tide of economic condition was high. Why this anomaly happened was the

burning question for the economists and researchers in that time. Many researchers found many

reasons behind this anomaly.

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Neo-Classical approach to explain the relationship between wage and employment

To understand the cause of such exception we need to understand several theories related

to the wage and employment. According to the neoclassical theory when the higher minimum

wages are exogenously imposed it will lead to lower employment as long as the negative relation

between the real wage and demand of labor. In general equilibrium, sense has less impact when

any economy has an extensive international trade (Groenewegen, 2002). In this case, the neo-

classical theory accepts the marginalist method of explaining the wage-employment behavior

through its optimism behavior focusing marginal utility. In neoclassical theory, the margin is the

border breaching which leads to decreasing return from all actions. Optimization is doing all the

actions to some point in the margin which creates indifference between producing more or less

output.

Groenewegen (2002) states in standard situation demand for labor falls when the

minimum wage is above the market equilibrium. The increasing cost of wage will lead

decreasing net marginal profit. In a competitive market, the elasticity of wage is high when a

market has an easy substitution for labor in production as wages are a large part of total cost. On

the other hand, labor elasticity is low when the production method is rigid and labor costs are a

small portion of total cost. This model emphasizes the optimization at the margin. But this view

had been challenged by many economists. One basis of the argument is some firms have

decreasing or constant variable costs which are almost 70% to 100% of the production. Machin

& Manning (1994) found the ‘marginalist’ method holds when the decreasing rate of revenue is

more than the decreasing rate of variable cost. According to the neo-classical model, no change

in the level of output will occur at full employment or the level that satisfy the labor demand if

wage rate increases.

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According to Card & Krueger (2000) many researchers have argued that not all firms run

at full capacity. Many firms would respond to the increase in wage by increasing output an

improving the sales effort of the organization which is not compatible with the neo-classical

optimization theory. The full capacity is not long-run equilibrium when there is still chance to

increase marginal profit. Before the monopsony theory provided by Stigler, it was generally

accepted rule that the low wage market is formed in a large number of relatively small

employers. Many empirical studies tried to rationalize the application of Stigler’s model in one

company town (Idson & Feaster, 1990).

The firms use supervision and wages to ensure the non-shrinking behavior as the workers

try to shirk when the expected cost exceeds the utility of doing that work. Industry minimum

wage is set above the market determined unconstrained wage. It increases average cost but

decreases marginal cost which leads to higher employment. In case of a limited number of firms,

firms spend more on the supervision than the wage and it gives a short-term result. On the other

hand in a competitive sector like in the fast-food industry model shows an upward sloping curve.

Higher wage helps firms to retain their employees but lower wage will not result to lose

all employees when an industry has a large barrier to the entry. Idson & Feaster (1990) shows the

minimum wage can increase the employment at firm level but can eliminate the marginal firms

from the industry. In more competitive industry it is likely that the increase in minimum wage

will reduce the employment level. The neo-classical model failed to explain why the

organization operates less than its full capacity. The answer to the question is information. The

decision maker has less information about the consequence of the expansion decision on cost and

profit. This is because of natural risk aversion nature. Monopsony theory suggests that
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organizations have some kind of wage setting power when the market is oligopolistic and closed

for new entrant or has monopolistic characteristics (Machin & Manning, 1994).

Considering all the relevant theories and survey data available it can be said that the

increase of New Jersey’s minimum wage had no effect on the total employment level because of

the friction level in the market. The fast-food industry and other small firms developed a very

competitive environment for which a decrease in employment is caused to rise in employment

level of another firm. These two effects cancel out each other and so that the negative impact of a

rise in the minimum wage hadn’t been found (Card & Krueger, 2000). It is found that the selling

price of products increased instead of lower employment rate. So it means the increase in wage

rate was passed to the consumers.

The success of the fast food industry depends on selling efficiency rather than its labor

cost. When the organization is able to achieve higher sales it can compensate the higher wages.

The goal of a competitive enterprise is to maintain the customer-producer relationship.

Production comes prior to profit and price. Market access, sales, and customers make the status

of a firm. The fast-food market of New Jersey varied in capacity. The market was sales driven

and very competitive. As the overall demand for the product had not affected by increased

minimum wage the firms were able to adjust their cost structure according to the changed

situation.
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References

Card, D., & Krueger, A. (2000). Minimum Wages and Employment: A Case Study of the Fast-
Food Industry in New Jersey and Pennsylvania: Reply. American Economic Review, 90(5),
1397-1420. http://dx.doi.org/10.1257/aer.90.5.1397
Groenewegen, P. (2002). Eighteenth Century Economics. Hoboken: Taylor and Francis.
Idson, T., & Feaster, D. (1990). A Selectivity Model of Employer-Size Wage
Differentials. Journal of Labor Economics, 8(1, Part 1), 99-122.
http://dx.doi.org/10.1086/298238
Machin, S., & Manning, A. (1994). The Effects of Minimum Wages on Wage Dispersion and
Employment: Evidence from the U.K. Wages Councils. Industrial and Labor Relations
Review, 47(2), 319. http://dx.doi.org/10.2307/2524423