Example of a government imposed minimum price is the fixation of minimum wage. The effect of this policy is illustrated in Fig. 2.28, which shows the supply and demand for labour. The wage is fixed at Wmin, which lies above its market clearing level W0.
As a result the number of job seekers (those who are willing to work at this wage those) or supply of labour exceeds the number of jobs available or the demand for labour.
In other words, there is the problem of involuntary unemployment. Beginning from the initial equilibrium quantity of L0, the minimum wage induced L0 – L2 more workers to offer their services. At the same price employers reduced the quantity demanded by L0 – L, units. A law requiring that workers be paid at least Wmin creates an excess supply of labour equal to L1 – L2, which results in non-wage rationing of jobs.
The magnitude of such unemployment is L2 – L1 and the deadweight loss is given by the two triangles B and C. This loss arises due to the fact that firms are not allowed to pay less than Wmin, even if unemployed workers are willing to accept the market clearing wage W0.
In such a situation the supply curve of labour is completely elastic up to point G and upward sloping thereafter. So the portion of the original labour supply curve below point G is no longer relevant. The same effect is produced when a trade union fixes a wage above the market- clearing level.
However, if the minimum wage is fixed below the equilibrium level, i.e., at W1 it will not be ineffective. Now the supply curve of labour will be W1MEGS thus the quantity of labour supplied and demanded remains at L0. It is because the excess demand for labour at this wage (MN) will push up the wage rate to the market clearing level and there will be neither unemployment nor shortage of labour.
The Response of Firms:
The excess supply of labour at the minimum wage frees any firm belonging to an industry from the competitive forces in the labour market. The firm can eliminate annual bonuses, overtime wages, profit sharing and paid holidays, vacations, and sick-days without any cost to the firm.
The actions merely reduce the excess supply. In addition to increasing its profit by reducing the fringe benefits that the employees receive, the firm can also reduce its expenditure on the employers’ safety and comfort. In other words, the firm has no incentive to offer attractive job conditions, because it cannot derive the benefit of lower wages.
Since there is excess supply, some non-price (wage) method has to be found from rationing available jobs. Less productive workers will face the problem of job loss. Moreover, the employers can now dispense jobs with economic rent.
There is likely to be favoritism and nepotism in giving jobs. Friends and relatives of the owners of firms will get jobs even if they are not competent enough for the same. Empirical studies suggest that the minimum wage law is a major cause of high unemployment rates for young workers.
Winners and Losers:
It appears that any benefits accruing to unskilled labour from the imposition of a minimum wage are significantly reduced by the resulting loss of employment. As Fig. 2.28 shows, at least L0 – L1 workers who were previously employed will now be unemployed.
To the extent that some new entrants to the labour market displace those originally employed, the number of unemployed people who previously had jobs will exceed L0 – L1. Of course, those who remain employed are better off at a wage of Wmin than they were at a rate equal to W0.
Some workers are better off as a result of minimum wage legislation. Since the minimum wage raises the price of unskilled labour, the ratio of the skilled wage rate to the unskilled wage rate will fall. This will lead the firm to substitute unskilled labour by skilled labour as skilled labour becomes relatively cheap.
Thus the minimum wage law will cause the demand for skilled labour to increase. As a result the wage rate of skilled workers will also increase. Thus more skilled workers will be employed at a higher wage.