Effects on employment

Employment effects in different economic theories

Neoclassical economic theory predicts that higher minimum wages will lead to lower employment. This may happen for two reasons: firstly, because minimum wages may force enterprises to raise the prices of their goods and services, and consumers or international buyers who face higher prices may therefore cut back on their demand (the so-called “scale effect”). Secondly, when low-wage workers become more “expensive” due to the minimum wage, firms may decide to replace some of them with more machines and a few skilled workers to operate these (the “substitution effect”).

If these effects are large, aggregate employment levels of low-wage workers may decline. There is also likely to be a “cross-industry” effect, as employment is predicted to fall in labour-intensive industries, where the proportion of low-paid workers is higher and where labour costs represent a high proportion of total production costs for enterprises. In other industries, employment may remain unchanged or may even increase, as consumers spend more of their money on goods and services where prices are less affected by minimum wages.

Other theories, based on different assumptions, take a different view. Different theories start with the hypothesis that many employers exercise a degree of ‘monopsony power’ – that is, they have market power in employing a particular type of labour often in a defined local labour market (retail workers or nurse assistants for example) and can hold wages (the price of labour) below their contribution to productivity. This theory implies that - when faced with higher labour costs – employers may have an incentive to maximize their profits by expanding production and employment (the “monopsony” effect). So-called "search models" also show that in imperfectly functioning labour markets, higher wages for those at the bottom can, up to a certain point, be compensated by a combination of reduced profits, lower wage increases for managers, or other cost-saving or productivity-enhancing measures.

Macro-economic theories highlight the fact that higher wages not only raise labour costs for employers, but they also increase consumption demand among the low-paid workers and their families. Assuming there are no large negative effects on external competitiveness (which might be the case for very export-oriented economies) or investment, such positive “consumption effects” can lead to increases in aggregate demand and employment. Macro-economic perspectives show that even if some low-productivity firms reduce employment or go out of business, this does not necessarily mean that aggregate employment will be reduced. Employment may expand in other firms and higher wages may attract more people into the labour market.