The Effects of Minimum Wages on Employment: Theory and Evidence from the US

Abstract

Recent work on the economic effects of minimum wages has stressed that the standard economic model, where increases in minimum wages depress employment, is not supported by the empirical findings in some labour markets. In this paper we present a theoretical framework which is general enough to allow minimum wages to have the conventional negative impact on employment, but which also allows for the possibility of a neutral or a positive effect. The model structure is based on labour market frictions which give employers some degree of monopsony power. The formulated model has a number of empirical implications which we go on to test using data on industry-based minimum wages set by the UK Wages Councils between 1975 and 1990. Some strong results emerge: minimum wages significantly compress the distribution of earnings and, contrary to conventional economic wisdom but in line with several recent studies, do not have a negative impact on employment. If anything, the relationship between minimum wages and employment is estimated to be positive.