M ARCUS D ITTRICH Wage and employment effects of non-binding minimum wages Marcus Dittrich Andreas Knabe TU Chemnitz & CESifo FU Berlin & CESifo Social Choice and Welfare Moscow, July 2010

M ARCUS D ITTRICH 2 “The effects of the minimum wage on employment and the distribution of income have been hotly debated policy question for over 50 years.“ (Brown 1999) – Pro: raising the wages of the lowest-paid would help fighting poverty – Contra: introducing such rigidities impedes allocative role of flexible wages, causing more unemployment and possibly even more poverty One issue that most proponents and opponents agree on: MW have to be binding to have any effect! M OTIVATION

M ARCUS D ITTRICH M OTIVATION : S PILLOVER EFFECTS OF MW But: Many studies report that raising the MW has spillover effects (Katz/Krueger 1992, ILLR; Manning 2003, Neumark et al. 2004, JHR). Two important stylized facts: 1.Firms raise the wages of workers that used to earn less than the new MW above the minimum level required. 2.Workers already earning wages above the new MW receive wage raises as well. Possible explanation: Employers attempt to maintain their internal wage hierarchy. 3

M ARCUS D ITTRICH M OTIVATION : S PILLOVER EFFECTS OF MW Experimental evidence (Falk et al. 2006, QJE) excludes wage hierarchy effects or effort considerations similar to “ultimatum game” firm proposes a wage worker sets reservation wage main finding: introduction of MW increases wages above the new minimum, because it drives up reservation wages Potential explanation: MW affects what people consider to be a ”fair” compensation for their work. How can these findings be explained by theoretical models? 4 match if firm‘s offer ≥ res. wage

M ARCUS D ITTRICH 5 1.Motivation: spillover effects of MW 2.Model economy 3.Nash wage bargaining 4.Kalai-Smorodinsky wage bargaining 5.Conclusion O UTLINE

M ARCUS D ITTRICH 6 economy with large number of sectors bargaining over wages (w ) between unions and firms representative firm’s profit: representative union’s utility: alternative income: M ODEL ECONOMY

M ARCUS D ITTRICH N ASH WAGE BARGAINING Nash bargaining solution follows from four axioms (Nash 1950, Econometrica): 1.Pareto efficiency 2.Invariance to equivalent utility representations 3.Symmetry 4.Independence of irrelevant alternatives 7

M ARCUS D ITTRICH 8 Nash bargaining solution: where = player i ’s utility, = conflict utility, S = utility possibility set applied to wage bargaining problem: N ASH WAGE BARGAINING

M ARCUS D ITTRICH 9 N ASH WAGE BARGAINING

M ARCUS D ITTRICH N ASH WAGE BARGAINING 10

M ARCUS D ITTRICH N ASH WAGE BARGAINING What do non-binding MW do? 1. sectoral level w 0 exogenous  Sectoral MW has no effect on bargained wage. 11

M ARCUS D ITTRICH N ASH WAGE BARGAINING 12

M ARCUS D ITTRICH N ASH WAGE BARGAINING What do non-binding MW do? 1. sectoral level w 0 exogenous  Sectoral MW has no effect on bargained wage if it is non-binding. 2. national level  no change in any wages hence, w 0 unchanged  National MW has no effect on bargained wage if it is non-binding. 13

M ARCUS D ITTRICH K ALAI -S MORODINSKY WAGE BARGAINING alternative axiomatic solution (Kalai/Smorodinsky 1975, Econometrica) maintain first three axioms of Nash solution replaces IIA with “individual monotonicity” axiom  a player must not suffer from an enlargement of the bargaining set that leaves the maximum utility attainable by the other player unchanged 14

M ARCUS D ITTRICH 15 both bargaining parties agree to a solution that equalizes the relative utility gains (  ratio of the actual gains to the maximum feasible gains) maximum feasible gain is determined by the payoff one can secure by pushing the other party to the minimum payoff it would just be willing to accept could be interpreted as “fairness” (McDonald / Solow 1981, AER)  if a player could have more (without hurting the other player), he should have more K ALAI -S MORODINSKY WAGE BARGAINING

M ARCUS D ITTRICH 16 general KS solution: both parties make equal proportional concessions from their respective favored points  KS curve: applied to wage bargaining problem: K ALAI -S MORODINSKY WAGE BARGAINING

M ARCUS D ITTRICH 17 “utopia points”: bargained wage: K ALAI -S MORODINSKY WAGE BARGAINING

M ARCUS D ITTRICH K ALAI -S MORODINSKY WAGE BARGAINING 18

M ARCUS D ITTRICH 19 What do non-binding MW do?  change in utopia point: KS curve: bargained wage: K ALAI -S MORODINSKY WAGE BARGAINING

M ARCUS D ITTRICH K ALAI -S MORODINSKY WAGE BARGAINING What do non-binding MW do? 1. sectoral level w 0 exogenous bargained wage raises to a level above the former wage implication: MW is non-binding, but effective!  Sectoral MW reduces the firm‘s utopia payoff and hence drives up the wage. 20

M ARCUS D ITTRICH K ALAI -S MORODINSKY WAGE BARGAINING 21

M ARCUS D ITTRICH K ALAI -S MORODINSKY WAGE BARGAINING What do non-binding MW do? 1. sectoral level w 0 exogenous  Sectoral MWreduces the firm‘s utopia payoff and hence drives up the wage. 2. national level direct effect in each sector if plus: changes in w 0 affect wages in other sectors  National MW does not have to be binding, but is effective 22

M ARCUS D ITTRICH 23 Empirical evidence suggests that MW have real effects even if they are not binding. Implications for economic theory: KS solution is able to describe these effects, Nash solution is not. Implications for public policy: Even relatively low MW might have negative employment effects  policy implications depend on whether union-firm- bargaining follows Nash or KS solution. C ONCLUSION

M ARCUS D ITTRICH 24 Thank you very much!

M ARCUS D ITTRICH M OTIVATION : S PILLOVER EFFECTS OF MW Empirical evidence Katz and Krueger (1992, ILRR): Texan fast-food restaurants – one-third “maintained their wage hierarchy” (workers who earned more than the old MW will also earn more than the new minimum) – 60% of restaurants who had starting wages already above new minimum still increased their wages Manning (2003): US data  spillovers for wages up to 150% of the MW Neumark et al. (2004, JHR): US data  spillovers for wages up to twice the MW 25

M ARCUS D ITTRICH M OTIVATION : S PILLOVER EFFECTS OF MW Three popular theoretical explanations 1.Substitution effects (Pettengill 1981) increase in demand for above-minimum wage workers raises their wages, too 2.Monopsonistic firm behavior (Manning 2003) some firms pay high wages to attract workers from low-wage firms if low-wage firms pay more, also high-wage firms have to raise their wages 3.Efficiency wages (Grossman 1983, JHR) smaller wage differential between skilled and unskilled workers has to be compensated to keep up effort of skilled workers 26

M ARCUS D ITTRICH 27 E XPERIMENTAL EVIDENCE Falk, Fehr & Zehnder (2006, QJE) conduct a laboratory experiment in which a rent is distributed between “workers” and a “firm”. In the experiment’s first step, workers state their reservation wages, which are not observed by the firm. Then, the firm makes a wage offer and workers with reservation wages below this wage offer are hired.

M ARCUS D ITTRICH 28 E XPERIMENTAL EVIDENCE The introduction of a minimum wage raises workers’ reservation wages: Before its introduction, 91% of workers stated a reservation wage below the later minimum wage. After it had been introduced, 59% reported that their reservation wage was equal to the new minimum wage, and the other 41% said that their reservation wage was even larger than the new minimum wage. Result: minimum wages affect the wage level that people are willing to accept even if they are not directly affected by the new minimum wage.

M ARCUS D ITTRICH 29 reference scenario: monopolistic union sets the wage, firms set employment monopoly union behavior: M ODEL ECONOMY : MONOPOLY UNION

M ARCUS D ITTRICH 30 M ODEL ECONOMY : MONOPOLY UNION

M ARCUS D ITTRICH 31 M ODEL ECONOMY : MONOPOLY UNION

M ARCUS D ITTRICH M ODEL ECONOMY : M ONOPOLY UNION & MW What do non-binding MW do? 1. sectoral level w 0 exogenous  Sectoral MW has no effect on monopoly union‘s desired wage. 32

M ARCUS D ITTRICH M ODEL ECONOMY : M ONOPOLY UNION & MW 33

M ARCUS D ITTRICH M ODEL ECONOMY : M ONOPOLY UNION & MW What do non-binding MW do? 1. sectoral level w 0 exogenous  Sectoral MW has no effect on monopoly union‘s desired wage. 2. national level  no change in wages w 0 unchanged  National MW has no effect on monopoly union‘s desired wage if it is non-binding. 34

M ARCUS D ITTRICH 35 N ASH ‘ S AXIOMS Find a bargaining solution that satisfies the following four axioms: 1.Pareto efficiency (PAR) 2.Invariance to equivalent utility representations (INV) 3.Symmetry (SYM): symmetric utility functions should ensure symmetric payoffs 4.Independence of irrelevant alternatives (IIA): If S is the Nash bargaining solution for a bargaining set X, then for any subset Y of X containing S, S continues to be the Nash bargaining solution.

M ARCUS D ITTRICH 36 KS‘ S AXIOMS Find a bargaining solution that satisfies the following four axioms: 1.Pareto efficiency (PAR) 2.Invariance to equivalent utility representations (INV) 3.Symmetry (SYM): symmetric utility functions should ensure symmetric payoffs 4.Individual monotonicity (MON): If the bargaining set is enlarged such that the maximum utilities of the players remain unchanged, then neither of the players must not suffer from it.