The Behavioral Effects of Minimum Wages Armin Falk (University of Bonn) Ernst Fehr (University of Zurich Christian Zehnder (University of Lausanne)

Why studying Minimum Wages? Minimum wage laws are an important labor market instrument 25 of 29 OECD countries have some form of minimum wage legislation The behavioral effects of minimum wages are still not fully understood Anomalously low utilization of opportunities to pay subminimum wages for certain categories of workers (Katz and Krueger 1991, 1992)

Spillover effect: firms often raise wages of workers who earned less than the new minimum wage above the level of the new minimum wage (Katz and Krueger 1992, Card and Krueger 1994) Contested employment effects of minimum wages Card (1992), Card & Krueger (1994), Machin & Manning (1994) Important for policy evaluation Important for the question whether labor markets are imperfectly competitive or approximate the competitive ideal.

Main Message I Minimum wages have a direct impact on workers perception of what constitutes a fair wage and thus affect reservation wages Introducing a MW increases reservation wages Therefore, a sizeable share of workers who earned less than the MW before the introduction is paid more than the MW after the introduction Explains the spillover effect

Main Message II The introduction and the removal of MW has asymmetric effects on reservation wages Introduction: strong rise in reservation wages Removal: Small decrease in reservation wages Asymmetric effects on actual wages Actual wages strongly increase after introduction of MW but only weakly decrease after removal of MW Explains the low utilization of opportunities to pay subminimum wages

Main Message III Asymmetric effects on employment Actual employment increases after introduction but does not decrease after removal of the MW Sheds light on the sources of positive employment effects

Minimum Wage & Reservation Wages For some time economists speculated that minimum wages might affect reservation wages The minimum wage becomes a focal point, representing the going, or acceptable wage..... workers perceive the minimum as the 'fair wage. In this way the minimum wage might influence workers reservation wages. (Card and Krueger 95) However, reservation wages are difficult to measure in field data

Why a laboratory experiment? Empirical evidence for zero or positive employment effects highly contested (e.g. Neumark and Wascher). Measurement errors regarding employment and wages. Important determinants of employment and wages are unobservable or very difficult to observe. marginal revenue product of labor (labor demand) workers reservation wages (labor supply) wage setting mechanism Information conditions unknown in the field what do firms and workers know about marginal revenue product, average product, profits and reservations wages. Unknown interactions between MW, labor demand or supply may occur.

In a Laboratory Experiment no measurement error with regard to wages and employment perfect knowledge of marginal revenue product precise measurement of reservation wages possible control over information conditions.

Experimental Game Market Participants 6 Firms 18 Workers Exogenous Matching At the beginning of a period each firm is randomly matched with three workers Stage 1 of a period Firms can offer the same wage to 0, 1, 2 or 3 workers, w [0, 1000] Stage 2 of a period Workers simultaneously accept or reject the offer they received

Design continued Two Treatments: Without minimum wage (NO) With minimum wage (MW) Each treatment lasts 15 periods Two Treatment Orders: Introduction of MW (NO/MW)[5 Sessions] Elimination of MW (MW/NO)[5 Sessions]

Design continued

Firms payoff Revenue – wage employed workers Workers payoff Wage if employed, zero otherwise Minimum wage equals 220 < MRP of third employed worker Information conditions MRP, payoff functions, number of workers and firms and the matching technology are common knowledge Firms are informed about how many workers accepted their offer Workers are informed about firms profits

Elicitation of reservation wages Ask workers for their acceptance thresholds r before they know the wage offer If w > r the offer is accepted, if w < r it is rejected Supply Schedule observable

Matching technology If acceptance thresholds are heterogeneous firms face – on average - upwards sloping labor supply schedules However, with perfectly random matching the distribution of reservation wages a firm faces may not be very representative of the overall labor supply schedule May generate a lot of randomness at the firm level Needs many periods to converge to whatever the behavioral equilibrium is in this setting Solution Each firm gets matched with one worker from each third of the distribution of acceptance thresholds

Standard Predictions Assumptions Firms and workers are rational and selfish Firms know that workers are selfish Implications Workers accept every positive wage offer Labor supply is horizontal at a wage of one Firms offer always the smallest acceptable wage to all their workers NO-Treatment: w = 1 MW-Treatment: w = 220 (Minimum Wage) There is full employment in both treatments The minimum wage does not change employment but has strong distributive effects

Predictions with fairness preferences Workers have heterogenous acceptance thresholds Firms face an upward sloping supply schedule Wages are much higher than predicted by the self-interest model Minimum wage may increase employment because more workers accept the wage offer Example 1 Reservation wages of 0, 10, 100 Marginal cost of hiring 3 instead of 2 workers are 3*100 – 2*10 = 280 > 260 (= MRP of 3rd worker) Third worker is not employed without the MW With the MW law the third worker will be employed because the marginal cost of the 3rd worker is 220

Example 2 Reservation wages of 30, 80, 130 Marginal cost of hiring 3 instead of 2 workers are 3*130 – 2*80 = 230 < 260 Third worker is employed without the MW MW law has no employment effect

The effect of MW on actual wages (increase and spillover effect) Why do firms pay non-minimal wages in NO and more than the minimum in MW? NO-MW sequence

The effect of MW on reservation wages (heterogeneity, fairness, increase) NO_MW sequence

Employment effects Without MW employment is inefficiently low? MW have the chance to raise employment

If reservation wages were constant across conditions average employment per firm should approximate 3 in the MW treatment However, the MW increases reservation wages

Minimum wage leads to a small but significant increase in employment

Do firms chose profit maximizing wages? Employment effect is the result of profit maximizing firm behavior

A temporary MW has permanent effects – pre- and post-MW economy exhibit different wages

Distribution of wages in the pre- and the post-MW economy Why are wages in the post-MW economy so high?

Why do employers not take more advantage of the elimination of the MW? Related to the underutilization of subminimum wage opportunities in the field In Katz & Krueger 92, 62% of restaurant managers believed that they could not attract qualified teenage workers at the subminimum wage Suggests that employers are labor supply constrained But why could they fill their ranks before the increase in the MW?

Reservation wages in the pre- and the post-MW economy Pre-MW median = 150 Post-MW median = 200 Given these distributions, was it optimal to pay higher wages in the post- MW economy?

Distribution of profit maximizing wages in the No condition across sequences

Difference in reservation wages between pre and post-MW economy is significant

Removal of MW has no employment effect

Summary Economists focus on how economic policy changes the incentives for private agents Economic policies have effects that go far beyond changing incentives Results suggest that minimum wages affect the perception of what constitutes a fair wage Minimum wage increases reservation wages Results suggest that minimum wage creates a kind of entitlement effect that is not fully reversible Explains asymmetric response of reservation wages

This effect on reservation wages gives rise to important wage & employment effects Firms pay on average more than the minimum wage after the introduction of the MW Wages in the pre-MW economy are much lower than in a post-MW economy Employment rises less after the introduction compared to a situation with stable reservation wages Employment does not fall after the removal of the MW Our results lend support to the idea that the spillover effect and the under utilization of opportunities to pay subminimum wages in field data are driven by the impact of minimum wages on reservation wages