A Feasible Measure for Mitigating Income Inequality: Raise the Minimum Wage!

In the wake of New Jersey’s raise in the minimum wage, [0] it seems like a good time to re-assess the case for a nationwide increase. Back in the February State of the Union message, President Obama proposed an increase to $9.00 by the end of 2015. Figure 1 places in historical context the proposal.
Figure 1: Nominal minimum wage (blue) and real CPI-deflated minimum wage (red). Obama proposal for 2015M12 in nominal (blue triangle) and real terms (red square). CPI for 2015M12 calculated assuming forecasted inflation rates from WSJ October 2013 survey.In other words, an increase to $9.00 would merely re-establish a real level of the minimum wage that held in 1981M07.

A partial equilibrium analysis, assuming full employment, an increase in the minimum wage (ignoring monopsony power, information asymmetries, etc., [1] i.e., a neoclassical world) would lead to lower employment and increased unemployment. In a world with economic slack, another outcome is plausible, even in the absence of these other market imperfections.

As I noted in this post, if the minimum wage increase enlarges the low-income wage bill, and this group has a higher marginal propensity to consume out of income, then the effect on the economy will be positive. Figure 2 illustrates this logic.

Figure 2: Low wage labor market, initial equilibrium and after imposition of minimum wage.Initially, quantity labor supplied equals quantity demanded at N1. With the imposition of a minimum (real) wage, the wage rate rises from W1 to W2. In standard partial equilibrium analysis, there is excess labor supply Ns2 – Nd2. However, labor demand is derived; the income variable shifts out the labor demand curve (plausible if the marginal propensity to consume is high for low income households, and the wage bill increases).

Then, quantity of labor demanded rises to Nd3. While unemployment rises, employment also rises. Hence, the standard Econ 1 prediction that employment necessarily falls in response to the imposition of a (binding) minimum wage is a special case of a more general model.

Notice that the impact on the real wage bill, even when no spillover effect is present, is ambiguous. The original real wage bill is the orange shaded area, while the bill afterwards (once again ignoring spillover effects) is the lined area. Clearly, if demand is inelastic, then the wage bill will increase.

The larger the response of income to the low income wage bill, the larger the ultimate increase in the wage bill (to the dotted area).

The White House backgrounder on this proposal is here. Here are 2007 CBO calculations of the impact of a minimum wage increase, assuming net employment impact is zero. John Schmitt at CEPR.net reviews some recent literature, as well as the earlier.