Increase in minimum wages has a number of microeconomic implications. Any attempt to increase wages is likely to face objection from the affected firm. A rise in minimum wages will lead to an increase in production costs since labor is one of the factors of production. This will affect firms’ profits. Consequently, this will have a direct effect on the combination of factors of production and the production level. Firms will be required to reduce their costs through employing less labor and consequently this may lead to decrease in production levels which will also reduce profit earned by the firms. (Karl & Ray 2008).
This can be explained using a graph as shown below.
This graph shows the current situation before any increase in wages. A firm is able to combine lx units of labor with Cx units of capital so as to produce output level depicted by the isoquant 1(say 100 units of services to customers in case of a hotel business). Increase in minimum wages will adversely affect cost of labor. Given that a firm has a budget constraint which determines the isocost curve CL, a firm will reduce number of labor units employed, and consequently this will reduce level of production as shown by the following graph
Increase in wages will alter combination of factors of production and eventually reduce level of production as shown on the graph above. Labor units will be reduced to ls from lx. Capital employed will be reduced from Cx to cs since capital has to be combined with labor. The firm will operate at isoquant 2 where low output is realized. Low production reduces number of services supplied to the customers and this may reduce sale revenue.
In a competitive market it is expected that wage should equate to marginal productivity of labor unit employed. Increase in minimum wage will not equate to this. Instead it will probably be higher than the marginal productivity of a worker. In such a case, the employers will be required to pay more than the productivity of unit of labor required. This will eventually culminate into losses to the firm which may threaten firm’s operations.
On the other hand, increase in minimum wage will be a great relief to worker who is seeking to reduce his/her working hours. Minimum wage increase will lead to an increase in income which will also affect income leisure substitution. This can be explained through income leisure model as shown below.
Income leisure model assumes that a worker has 24 hours which he/she utilize either in work or leisure. In above graph, Y and X represents 24 hours of either leisure or work. LI is a curve showing how income is substituted for leisure.
Increase in income will lead to income and substitution effects as a shown by the graph below
Worker will be at point K before increase in wages where indifference curve C1 is tangent to ck. Increase in wage rate pivots the income leisure constraint on the income axis. I.e. income leisure constraint curve ck will shift to sk. X and K show same level of satisfaction since they are on the same indifference curve. Increase in minimum wage will lead to increase in relative price of leisure which is depicted by the difference between K and X. (income/leisure constraint slope). Difference between X and E solely owes to difference in income (income/leisure constraints slope is same). Movement from K to X represents the substitution effect which will shift ck to dotted income leisure constraint curve mn so as to be parallel to sk. Increase in relative price of leisure will lead to substitution of work (income) for leisure as shown by difference between K and X. Movement from X to E represents income effect which shows a fall in demand for work time or increase in leisure owing to increase in income of the minimum wage worker. Hours worked fall since the income effect will outweighs substitution effect and the worker will end up at point E where indifference curve C2 is tangent to income leisure constraint sk. (Paul 1989; John, Raymond & Leonard 1995).
There are scholars who propose that increase in minimum wages will lead to significant unemployment. Others assert that, this does not significantly increase levels of unemployment. Several theories have been employed by both sides in an effort to support these two arguments.
According to findings of the study by Stephen and Alan (1994), minimum wage had either no effect or positive effect on employment. Increase in minimum wages leads to an increase in level of income with the households. Increase in income among the households will ensure consistent and reliable demand for firms. This will ensure desirable revenue to meet firm’s cost associated with increase in minimum wage. Thus firms will not lay off their workers. Secondly, firms will reevaluate their pricing policy so as to accommodate for increased costs resulting from increase in minimum wages. This will include passing the burden to the final user of their products, and keep checks on the operations so as to reduce any inefficiency that increase production cost.
Additionally, this study found that, increase in minimum wages will eventually lead to increase in employment. This argument can be associated with increase in households’ income which assures more demand for products and services in the economy. Increase in demand for goods and services will act as an incentive to investors and firms. As a result there will be increase in investments and existing firm will expand their operations so as to take advantage of high demand and obtain high profits. This occurrence will create more demand for labor. Consequently, there will be high employment owing to increase in minimum wage.
High minimum wages has also been associated with increase in productivity since it is a form of motivation to the workers. Increase in productivity leads to increase in out put and minimizes cost of production. This increase in productivity will compensate for the increase in cost of production owing to increase in minimum wages. Similarly, in a competitive market, wage should equate to marginal productivity of labor. Increase in minimum wages accompanied with increase in productivity will not prompt any firm to lay off the workers earning the minimum wage.
On the other hand, there are those studies which have found that increase in minimum wages greatly affect level of employment. In their study, David & William (1995), found out that, estimates based on payroll data suggested that the New Jersey minimum wage increase led to 4.6 decreases in employment. The argument behind this claim is that increase in level of minimum wage will lead to an increase in production costs which will adversely affect production costs. Firms will react to this by seeking ways of reducing production cost. One way is through retrenching some of the workers. Borrowing from the law of demand (increase in price will lead to a decrease in demand), the prudent decision by firms will be to continue offering their commodities at the current price and avoid passing increase in cost burden to the consumers. Consumers are very sensitive to increase in prices. They will either opt for substitutes or forego consumption where possible incase of increase in prices. This will reduce sales revenue to the firm and adversely affect its operations.
Increase in wage does not necessarily lead to increase in productivity. In fact, productivity is usually related to use of efficient technology and skills of the worker. Whereas it may seem a good option to continue employing the current workers even after increase in minimum wages and pass burden of increased production costs to the consumers, this will result into low demand which will affect firm revenue. This will consequently threaten firm’s ability to cover cost of production which includes wages. In such a situation, a firm will eventually have to reduce the number of employees. Failure to take such an action may lead to its fall. This proactive measure will lead to increase in level of unemployment. (OECD 1998; Karl & Ray 2008).