The starting point here is the standard neoclassical analysis. The clue to understanding the minimum wage debate is the nature of the labour market in determining the overall level of employment and unemployment. The standard textbook treatment shows that if average wages are held at a minimum above the equilibrium wage then labour supply exceeds labour demand, resulting in unemployment. There is considerable empirical research on the labour market in Australia and the effect of rises in average wages on employment (see, for instance, Lewis and Seltzer 1996; Bernie and Downes 1999; Lewis and MacDonald 2002). This research indicates that a 10 per cent increase in average wages reduces employment by about 8 per cent. Thus, moderation in average wages increases employment and, with the usual caveat that all other things are equal, unemployment will fall.
One of the major factors in the fall in the unemployment rate since the mid 1980s is the fall in real unit labour costs (RULC) over the same period. RULC is the cost of employing labour adjusted for inflation and labour productivity, expressed as an index. RULC can fall due to wages rising slower than inflation or rising by less than the growth in productivity. The Australian Bureau of Statistics (ABS) has recently begun publishing historical estimates of RULC for the Australian economy and these are shown Figure 3. It is generally recognised by economists that the demand for labour (employment) is strongly inversely related to RULC (Lewis and MacDonald 2002).
Source: Australia’s National Accounts, ABS cat no 5206.0, Table 38
The very high level of RULC in the early 1980s is clearly evident and was associated with the very high levels of unemployment (see Figure 1) at that time. The success of the Prices and Incomes Accord in breaking the nexus between wages and prices, particularly through the ending of full indexation, was particularly important in reducing RULC and unemployment (Lewis and Spiers 1990). The continuing fall in RULC through the 1990s and 2000s was due to microeconomic reform, including labour-market deregulation by successive ALP and Coalition governments.
It is tempting to use the above analysis to argue the effects of imposing a minimum wage for the lower paid. However, the above analysis needs to be adjusted for the analysis of minimum wages. Since most workers would obtain a wage higher than the minimum anyway, the effect of imposing a minimum wage is to increase the wages only of those who would otherwise receive the lowest wages. The effect on the average wage is small and, thus, the impact on total employment and unemployment is also small. The international empirical evidence confirms that the impacts of minimum wages on total employment and unemployment are small (Brown, Gilroy and Kronen 1982; Neumark et al. 2000). In the only recent study for Australia, Leigh (2003; 2004) also presents evidence which indicates a small but significant effect. However, despite small effects on total employment, the impact on the low-skilled is high.
To get to grips with the effects of a minimum wage it is necessary to dig deeper into the operations of the labour market. The impact of the minimum wage on employment depends on four effects — the substitution effect, the truncation effect, the leakage effect and the output effect.
An important characteristic of the multitude of labour markets is substitutability. In reality there is not a single labour market but, rather, very many labour markets, each with its own supply and demand. Although it is common, particularly in the professions, to think of occupations being rigidly defined, in practice there is a great deal of substitutability between workers (Lewis 1997). There is also strong evidence that, given the degree of substitutability, the demand for labour in these more narrowly defined labour markets is highly responsive to relative wages (Hamermesh 1993; Lewis 1985; Daly et al. 1999).[3]
The imposition of minimum wages only directly affects those in or seeking low-skilled, low-paid jobs. These individuals are, generally, very poor substitutes for the majority of the workforce and, therefore, minimum wages have little impact on the wages and employment of most workers. However, those workers who have a market wage just above the minimum wage are highly substitutable for minimum wage workers.
Firms employ fewer of those who would have earned below the minimum wage and, therefore, unemployment among this group rises. However, these workers are substituted by more workers earning just above the minimum wage. The net effect on total employment may be difficult to detect.
In summary, the impact of the minimum wage on total employment may be proportionately small but the impact on low-skilled, low-paid workers is disproportionately high. There is a large fall in employment of workers who could otherwise have earned below the minimum wage. Minimum wages are all about distribution. Jobs and income are redistributed away from the worst off.
The truncation effect relates to the extent to which the imposition of the minimum cuts into the distribution of jobs. The larger the minimum wage relative to what the market wage would otherwise be, the larger the truncation effect (the loss of jobs). In Australia the minimum wage is high relative to average weekly earnings by international standards (Lewis 2006). The estimates of excess supply earlier in the paper, between 500 000 and 1.7 million, suggest that the truncation effect is high. Of course, because Australia has long had a minimum wage we cannot tell what the market wage would be if there were no minimum. However, it can be deduced from the characteristics of the unemployed, particularly the long-term unemployed, namely that they are low skilled, that their market wage would be low (Argy 2005).
In summary, the characteristics of the unemployed plus the magnitude of the number of jobless suggests that the substitution and truncation effects are very high. Therefore, the minimum wage is clearly well above the wage which would equate demand and supply.
With regard to the leakage effect, there is little evidence except casual empiricism that ‘cash out of the till’ payments may be common for many employers of unskilled workers in some industries. The high preponderance of students and overseas backpackers in these industries may also be some indication of the willingness of people to supply labour in these jobs.
Finally, the output effect depends on how large labour costs are as a proportion of total costs and how sensitive is consumer demand to increases in prices resulting from wage rises. Minimum-wage jobs are generally in labour-intensive industries with high responsiveness to prices and therefore we would expect that the output effect is relatively large.