What's the real impact of the minimum wage?

Economists often disagree on things. One of those ‘things’ is the minimum wage.

Let’s think about minimum wages. A minimum wage is a form of price intervention by governments. They intervene in the free market, they get their hands dirty, to ‘fix’ the equilibrium wage in the market.

You see, by imposing a minimum wage, the government is saying that the equilibrium wage (represented by point A) in the market is too low. It needs to be higher. So, the government sets it higher.

The whole process is laid out in the graph below. The government’s minimum wage (WMIN) is above the equilibrium wage and leads to the quantity of labour supplied (people looking for work, point C) exceeding the quantity of labour required by firms (point B). The result is the excess supply of labour and unemployment.

Some annotated class work about the economic impact of a minimum wage.

But! It’s important to note that this is what economic theory suggests. The reality is far more contested. Economists have a range of views on what actually happens when a minimum wage is imposed, or increased. 

Many economists do not believe that a rise in minimum wages will increase unemployment. Some economists have found that minimum wages may increase unemployment for some groups, such as young workers, but not all workers. And other economists have found that if minimum wages are imposed, employers will look to save money in other areas, such as by reducing the quality of working conditions.

I did a quick look at some of these different views and you can see the video below.

The point is that, in Economics, we need to be able to distinguish between the economic theory and the real world. Sometimes they don’t precisely match up and it’s important for us to point this out.

Australia's employment contracts

In the Australian labour market, there are three main ways of determining wages/conditions: awards, enterprise or collective agreements, and individual contracts. Let’s give you a quick run down on each.

Awards

These are the minimum standards and conditions for a particular job/occupation. They set out minimum rates of pay and the basic level of employment conditions that a worker must receive in their job.

This is a more centralised way of determining wages. Everyone at the same level may receive the same pay and conditions. Some employers pay above-award wages, and this is great news for an employee.

The role of awards is to act like a ‘safety net’ for workers that are vulnerable in the labour market. These workers may be relatively unskilled or inexperienced, and could be victim to exploitation in terms of receiving low wages or unsafe conditions.

Enterprise/collective agreements

These are agreements that apply across entire workplaces or even occupations. They are typically negotiated between unions and employers. 

These agreements are more decentralised arrangements. This is because there is some scope for negotiation between employees and employers. So, employees can agree to work harder (increase productivity) to receive higher wages. Also, employees can agree to trade-off some working conditions for others, or even for higher wages.

We can also see some inequality emerge from this type of agreement. This is because some workers will receive higher rewards than others — even if they’re in the same job.

Please note: enterprise agreements must meet the Better Off Overall Test (BOOT). This means that employees on enterprise agreements must be better off under their relevant agreement than the award. This ensures employees aren’t exploited and trade-off too many conditions.

Individual contracts

These contracts are negotiated one-on-one between employers and employees. They typically apply to high skill, high wage workers who are very valuable and this gives them bargaining power. They can argue for certain wages and specific conditions because they are very valuable. 

These contracts will exacerbate inequality in the labour market as the rewards may be very uneven. A highly skilled worker will command much higher wages than someone relying on the award.

I’m not saying that inequality is a wholly bad thing in the labour market. Inequality encourages people to work harder and help boost output. But it can create additional economic and social issues.

Centralised vs decentralised labour markets

Labour markets are an important concept in economics. There’s one element in particular that can confuse students but you absolutely 100 per cent must be across this: centralised versus decentralised labour markets.

The best way to think about these concepts is to think in extremes. On one side you have a centralised type of labour market...then all the way on the other side you have a decentralised labour market.

To clarify: a labour market is a factor market (market for the factors of production, or resources) where demand for labour comes from firms, and where supply of labour comes from individuals. Equilibrium occurs where the demand for labour meets the supply of labour. And! The price in this market is wages. 

Look at this here image of a labour market:

The market for labour. Notice: demand for labour comes from firms; supply of labour comes from people.

Now, let’s start with a centralised labour market. Here, the wages and conditions of workers are determined by the government. They are determined in one ‘centralised’ location. The government decides the wages and conditions for workers across the economy. 

Just think about the word ‘central’ in the word ‘centralised’. A central location is one, main location where the action happens. 

Jump to the other extreme. A decentralised labour market is the opposite of this. In a decentralised labour market, wages and conditions are determined in many places. They are determined in individual workplaces as unions bargain with employers; they are determined in negotiations between individual workers and their employers. 

In a decentralised system, there is no ‘one’ decision about wages and conditions. Instead, there are many decisions, occurring all across the economy, all the time.

In Australia, we have shifted from a highly centralised labour market to one which is increasingly decentralised. Aside from setting minimum wages and conditions, the government may have no role in determining how much you get paid or what your conditions are. This will be determined in discussions between you, unions and your employer.

There are pros and cons of each system, and I’ll get into these in a future post. But one thing to think about is that in a highly centralised system there is no financial reward for greater productivity. If workers in a company produce more, they are not rewarded with higher wages or conditions as everyone gets the same wages and conditions. So there is no reward for being more productive and helping the economy increase output.

Who's in and out of the labour force?

As economists, the labour force is an important deal.

I grew sick of teaching it from scratch each year and instead filmed a lesson of me going through who’s in and who’s out (see below). It’s a bit messy but I think it works just fine. As a bonus, you’ll get a sneak peak into my eco classroom.

If you were going to use this, maybe as some pre-learning, I think it’d be valuable to get students to construct a very simple table with two columns:

• Column one: Who’s in (and why)

• Column two: Who’s out (and why)

By doing this first, you could have some more interesting discussions about the concept of the labour force in class, rather than using valuable class time to set out a series of accepted facts.

If you use this, please let me know how it goes!