New models of employment show that there are some cases in which a minimum wage can have positive effects on employment and social welfare. The effects depend ultimately on the prevailing market wage and the frictions in the market. Evidence to date does not support the view that raising the minimum wage will lead to positive employment effects.Minimum wage ; Labor market

Guillaume Rocheteau

Murat Tasci

English

Research Papers in Economics

The Minimum Wage and the Labor Market
by Guillaume Rocheteau and Murat Tasci 
May 1, 2007
ISSN 0428-1276
The federal minimum wage was 
established in 1938 by the Fair Labor 
Standards Act. Initially set at 25 cents 
an hour, the wage has been raised peri-
odically to reﬂ  ect changes in inﬂ  ation 
and productivity. 
From September 1997 to the begin-
ning of 2007, the minimum wage stood 
at $5.15 an hour, but its real value 
declined steadily from about 40 per-
cent of the average private nonsuper-
visory wage to a mere 30 percent. 
Adjusted for inﬂ  ation, the minimum 
wage was lower at the beginning of 
2007 than at any time since 1955 
(see ﬁ  gure 1). Meanwhile, the wage 
affected fewer people, as the frac-
tion of hourly workers who earned no 
more than the minimum dropped from 
around 15 percent in 1980 to just 
2.2 percent in 2006. On May 24, 
2007, Congress passed a bill raising 
the federal minimum wage to $7.25 in 
three phases over two years. 
To assess whether the recent increase 
in the minimum wage is excessive or 
not, one must know what it is intended 
to achieve. The wage’s proponents 
have argued that it exerts positive 
effects on labor market outcomes by 
reducing employers’ excessive market 
power. Its opponents, however, believe 
that labor markets are competitive and 
any wage regulation is bound to reduce 
employment, especially among low-
skilled workers.
This debate can be clariﬁ  ed with the 
aid of economic theories that analyze 
the effects of the minimum wage on the 
labor market. These theories can help us 
answer questions such as: Does a mini-
mum wage necessarily increase unem-
ployment? Does it expand the num-
ber of people participating in the labor 
force? Does it improve social welfare? 
  Competitive and 
Noncompetitive Labor 
Markets
The effect of a minimum wage depends, 
in part, on whether the labor market 
is competitive—or not, in which case 
employers exert signiﬁ  cant power over 
wage decisions. We review the employ-
ment effects of the minimum wage 
under two extreme assumptions: In the 
ﬁ  rst case, there are a lot of employers 
competing to attract workers; in the sec-
ond, there is a single employer. These 
extremes give us two benchmarks from 
which we can discuss speciﬁ  c situations 
and markets. 
A perfectly competitive labor market is 
a composite of many ﬁ  rms that are in 
competition for workers. Firms have no 
power to set wages; the market deter-
mines a competitive wage. If a ﬁ  rm 
deviates from this wage, it either pays 
less and loses workers or pays more, 
sustains losses, and exits the market. 
At the other extreme is a labor market 
that is a collection of small local 
markets. In each local market, some 
ﬁ  rms are in a dominant hiring position 
(think of a large retailer near a small 
New models of employment show 
that there are some cases in which 
a minimum wage can have positive 
effects on employment and social 
welfare. The effects depend ulti-
mately on the prevailing market 
wage and the frictions in the market. 
Evidence to date does not support 
the view that raising the minimum 
wage will lead to positive employ-
ment effects.
Federal Reserve Bank of Cleveland
0.00
0.75
1.50
2.25
3.00
3.75
4.50
5.25
6.00
6.75
7.50
8.25
1947 1957 1967 1977 1987 1997 2007
0.0
1.5
3.0
4.5
6.0
7.5
9.0
10.5
12.0
13.5
15.0
16.5
Dollars per hour
Nominal
Real
Percent
Projected
Portion of hourly paid
workers at or below 
minimum wage
FIGURE 1  FEDERAL MINIMUM WAGE AND 
WORKERS AT OR BELOW IT
Source: U.S. Department of Labor, Bureau of Labor Statistics.city, for example). In such an employer-
dominated market (referred to as a 
monopsonistic market by economists), 
a major employer has the power to 
set a wage unilaterally without fear of 
competition.
In both extremes, there are large num-
bers of potential workers, each of 
whom has a wage below which he will 
not work (his reservation wage). As the 
market wage increases, more and more 
people become willing to work. The 
relationship between the market wage 
and the number of workers who want to 
work for that amount is called the labor 
supply; it is represented by the upward-
sloping curve in ﬁ  gure 2.
The amount of output that one addi-
tional worker can contribute to the total 
output of the ﬁ  rm (the marginal prod-
uct of labor) declines as the size of the 
workforce grows. The diminishing mar-
ginal product of labor, represented by 
the downward-sloping curve in ﬁ  gure 2, 
is sometimes called labor demand.
Wage Setting in Competitive 
Labor Markets
When a large number of ﬁ  rms compete 
for workers, the market wage must be 
equal to the marginal product of labor. 
To see the intuition behind this statement 
suppose that the “marginal” worker pro-
duces $5 worth of goods and services an 
hour. If the market wage is $4, ﬁ  rms can 
bid it up to $4.50, attract workers from 
other ﬁ  rms, and still turn a proﬁ  t. If the 
market wage is higher, say $6, ﬁ  rms take 
a loss because workers cost more than 
their production is worth. In this situa-
tion, ﬁ  rms cut their payrolls to restore 
their proﬁ  ts. In this case, the market 
wage should be $5 (w* in ﬁ  gure 2). 
The market wage must also equal the 
highest reservation wage of workers in 
the labor force: Those whose reserva-
tion wage is above $5 stay out of the 
labor force, whereas those whose res-
ervation wage is below $5 enter it. In 
other words, under competitive con-
ditions, the wage adjusts to clear the 
labor market, equalizing labor supply 
with labor demand. Figure 2 (left panel) 
shows the market wage as the intersec-
tion of the downward-sloping demand 
curve (the marginal product of labor) 
and the upward-sloping supply curve.
Suppose that Congress introduces a 
mandatory minimum wage of $6 (w). 
Because it is more than the market 
wage, the minimum wage is binding. 
At this higher wage, ﬁ  rms’ demand 
for workers declines (from N* to N1 in 
the left panel of ﬁ  gure 2), whereas the 
number of people who want to partici-
pate in the market rises (from N* to N2 
in the same panel). The labor market 
is thrown into disequilibrium. Some 
unemployed workers would gladly 
work for a lower wage but cannot ﬁ  nd 
a job, and some employers would be 
happy to hire workers at a lower wage 
but the law forbids it.
Thus, in a competitive labor market, 
a binding minimum wage reduces 
employment and creates involuntary 
unemployment.
Wage Setting in an Employer-
Dominated Labor Market 
Now consider a local labor market in 
which a large coal mine is the commu-
nity’s dominant employer (a monop-
sony). Because the mine has negligible 
competition from other ﬁ  rms, it can 
set a wage that maximizes its proﬁ  ts. 
Unlike a competitive ﬁ  rm, however, a 
monopsony cannot hire as many work-
ers as it wants at a constant wage. If 
the mine wants to add workers, it must 
offer a higher wage to attract new labor-
force entrants. Suppose, for instance, 
that 10 potential hires have reservation 
wages below $5 and another candidate 
has a $6 reservation wage. If the mine 
wants to hire 11 workers, it must raise 
its wage from $5 to $6 across the board. 
Thus the mine’s cost of adding one 
worker, the marginal cost of labor, has 
two elements: the $6 hourly wage it pays 
one person plus a $1 hourly increase 
for each of the other 10. In this case, the 
marginal cost of labor is $16 ($6 + $10).
The ﬁ  rm maximizes its proﬁ  ts when 
the cost of having an additional worker 
equals the value of that person’s output. 
Thus, in the right-hand panel of ﬁ  gure 
2, the point where the marginal prod-
uct of labor intersects with the marginal 
cost of labor is the employment level 
for a monopsonistic ﬁ  rm. Notice that 
the employment level is lower than it 
would be in a competitive labor mar-
ket. The wage, which can be read on the 
labor supply curve for the monopsonis-
tic employment level (denoted wM in 
ﬁ  gure 2), is lower than the competitive 
wage. So a monopsonistic ﬁ  rm employs 
fewer workers and pays them less than 
their marginal product.
Suppose that Congress sets a federal 
minimum wage that is higher than the 
monopsony’s wage but still below the 
competitive one. In that case, the curve 
representing the marginal cost of labor 
(right-hand panel of ﬁ  gure 2) ﬂ  attens 
until it intersects with the labor supply 
curve. This happens because the cost 
of an additional worker is now simply 
the minimum wage (as long as the ﬁ  rm 
does not want to hire more workers than 
the number willing to work at or below 
this minimum wage). In this case, a 
minimum wage increases employment 
by mitigating the negative effects of a 
monopsony’s power. All workers gain: 
More of them have jobs, and those who 
do receive a higher wage. The employer 
loses because the minimum wage policy 
reduces its proﬁ  ts. In fact, the optimal 
level for the minimum wage is the com-
petitive wage that maximizes employ-
ment (right-hand panel of ﬁ  gure 2). 
   Labor Markets with Search 
Frictions
Of course, the previous descriptions are 
extremely stylized and neglect several 
aspects of reality. In actual labor mar-
kets, both ﬁ  rms and workers have some 
power to set wages, and the market is 
not frictionless: It takes time and effort 
for a worker to ﬁ  nd a job or for a ﬁ  rm to 
hire a suitable worker. 
We can use the benchmark scenarios 
and a couple of new ideas illustrated 
in ﬁ  gure 3 (and explained in detail in 
“Understanding Unemployment”; see 
the Recommended Readings) to dis-
cuss the effect of a minimum wage in 
a labor market with frictions. (This 
approach is referred to as the search 
model of unemployment.)
In this model of the labor market, 
workers are either employed or 
unemployed, and jobs are either vacant 
or ﬁ  lled. Unemployed workers look 
for jobs, and ﬁ  rms open vacancies 
to maximize their proﬁ  ts. The num-
ber of vacancies that ﬁ  rms decide to 
post is given by the downward-slop-
ing vacancy-supply curve in ﬁ  gure 
3. Intuitively, when the wage is low, 
each worker generates more proﬁ  ts for 
the ﬁ  rm; as a result, ﬁ  rms post more 
vacancies. The wage is determined by 
bargaining between ﬁ  rms and workers 
(the wage-setting schedule in ﬁ  gure 3). 
When vacancies outnumber unem-
ployed people, ﬁ  rms may infer that 
workers have better job prospects else-
where. As a ﬁ  rm’s vacancies increase, 
the bargained wage rises. Finally, with 
a given number of vacancies, the Bev-
eridge curve, which summarizes the 
matching process of unemployed work-
ers and vacancies, speciﬁ  es the econo-
my’s unemployment rate. Labor market outcomes such as wages, the number 
of vacancies, and the number of unem-
ployed are determined by these three 
building blocks—the vacancy-supply 
curve, the wage-setting schedule, and 
the Beveridge curve.
Suppose the government introduces a 
minimum wage that exceeds the market 
wage (ﬁ  gure 3). The wage-setting curve 
then has a vertical portion at the mini-
mum wage. As higher wages cut into 
their proﬁ  ts, ﬁ  rms open fewer vacancies, 
and the unemployment rate increases 
(from U* to U in the ﬁ  gure). So in this 
scenario, a binding minimum wage 
raises both wages and unemployment. 
   Workers’ Job-Search Effort
Let’s enrich our description of the 
labor market now by assuming that 
workers can choose the intensity with 
which they search for a job—how 
much time they spend looking for a 
job, how many application letters they 
send out, and so on.
Under these conditions, a higher wage 
exerts two opposing effects: It raises the 
payoff when workers ﬁ  nd a job, which 
motivates them to look harder. At the 
same time, it weakens ﬁ  rms’ incen-
tives to create jobs, making workers 
less likely to succeed and so dampen-
ing their search efforts. The net effect 
depends on where the wage stood 
before the increase. To see this, consider 
two extreme cases where wages initially 
are either high or low, depending on the 
extent of workers’ bargaining power.
First, suppose that workers have no bar-
gaining power, ﬁ  rms post wages uni-
laterally, and workers search until they 
ﬁ  nd an acceptable wage offer. Since 
employers appropriate the entire sur-
plus from their relationship with labor, 
unemployed people have little incentive 
to search actively for a job; the result 
is high unemployment. Next, consider 
the other extreme, where workers have 
all the bargaining power to set wages. 
Firms make no proﬁ  t from hiring more 
workers. Because opening and advertis-
ing vacancies is costly, ﬁ  rms do not do 
so, and unemployment is high.
This means that in markets which 
tend to be dominated by employers or, 
equivalently, in markets where work-
ers’ bargaining power is not too high, 
a compulsory increase of the wage 
can lead to higher search intensity and 
higher employment. If the market wage 
is low, a binding minimum wage can 
make employment more attractive to 
workers, which strengthens their search 
efforts and so reduces unemployment. 
If the market wage is high, a binding 
minimum wage might discourage work-
ers from looking for a job because there 
are fewer vacancies. 
The search model’s results are con-
sistent with the monopsony model: A 
minimum wage can, in theory, reduce 
unemployment. 
One can also show that workers’ search 
effort and social welfare move together. 
The wage that maximizes one also max-
imizes the other. Because of that fact, 
if the market wage is small enough, a 
minimum wage improves labor market 
conditions and increases social welfare. 
Another interesting result of this model 
is that the minimum level of unemploy-
ment occurs when the market wage is 
below the one that maximizes workers’ 
search effort. This means that a mini-
mum wage can make workers better off 
even if it increases unemployment.
  Labor Force Participation 
If we focus instead on workers’ deci-
sion to participate in the labor force 
(the analog of labor supply in the fric-
tionless models), we can use logic sim-
ilar to that followed above: If the mar-
ket wage is very low because workers 
have little bargaining power, they 
might decide not to search for a job at 
all. They have no incentive to enter the 
market because nonmarket activities 
(such as gardening) are more valuable 
than working; hence, employment is 
low. Conversely, if the market wage is 
very high, ﬁ  rms are not hiring, unem-
ployment spells are long, and workers 
stay out of the labor force. In general, 
employment is a hump-shaped func-
tion of the wage.
But unlike the model with workers’ 
search effort, unemployment always 
decreases with the wage. Although par-
ticipation is weaker when wages are 
low, ﬁ  rms still create jobs because their 
proﬁ  ts are high. This swells the number 
of vacancies relative to the number of 
job seekers, making it more likely that 
they will ﬁ  nd work. 
If the market wage is too low and work-
ers lack bargaining power, the intro-
duction of a binding minimum wage 
strengthens labor force participation, 
even though the duration of unemploy-
ment increases. In contrast, if the mar-
ket wage is high, a minimum wage 
reduces the supply of vacancies and 
increases unemployment duration, 
FIGURE 3  MINIMUM WAGE IN A SEARCH MODEL
FIGURE 2   COMPETITIVE AND MONOPSONISTIC LABOR MARKETS
N N
(Marginal) 
cost of labor
(Marginal) 
product of labor Labor demand
Unemployment
M N
M w
Labor supply Labor supply
Competitive Monopsonistic
* N N*
1 N
2 N
Optimal 
minimum wage w*
w
Vacancies Vacancies
Wage Unemployment rate
Vacancy
supply
Beveridge
curve
Wage
setting
U*
V*
U w* wGuillaume Rocheteau is an economic 
advisor at the Federal Reserve Bank of 
Cleveland, and Murat Tasci is an econo-
mist at the Bank.
The views expressed here are those of the 
authors and not necessarily those of the 
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which discourages workers from enter-
ing in the labor force.
Ultimately, then, we need to know the 
prevailing market wage and the extent 
of market frictions before we can deter-
mine whether raising the minimum 
wage will improve or harm social wel-
fare. Christopher Flinn tried to do just 
that when he estimated workers’ bar-
gaining power in a 2006 study. He ﬁ  nds 
that the market wage exceeds the wage 
that maximizes workers’ participation 
in the labor market, which seems to rule 
out positive welfare effects of a mini-
mum wage: “Our estimates of the bar-
gaining power parameter...yield an opti-
mal minimum wage rate less than the 
then current value of $4.25.” 
  The Weight of Evidence
The analysis presented here omits sev-
eral important elements of actual labor 
markets. Many empirical studies have 
sought to quantify the employment 
effects of a minimum wage. According 
to David Neumark and William Washer, 
who surveyed this literature thoroughly,  
most evidence suggests that a minimum 
wage leads to greater unemployment. 
And contrary to popular belief, most 
evidence suggests that the least-skilled 
workers are those most likely to be 
harmed the most.
  Recommended Readings
Bureau of Labor Statistics. 2007. Char-
acteristics of Minimum Wage Workers: 
2006.
Pierre Cahuc, and Andre Zylberberg, 
2004. Labor Economics, Cambridge, 
Mass.: MIT Press. 
David Card, and Alan Krueger. 1994. 
“Minimum Wages and Employment: A 
Case Study of the Fast-Food Industry in 
New Jersey and Pennsylvania.” Ameri-
can Economic Review, 84, 772–93.
Christopher Flinn. 2006. “Minimum 
Wage Effects on Labor Market Out-
comes under Search, Matching, and 
Endogenous Contact Rates,” Economet-
rica, 74, 1013–62.
David Neumark, and William Washer. 
2006. “Minimum Wages and Employ-
ment: A Review of Evidence from 
the New Minimum Wage Research,” 
NBER Working Paper no. 12663.
Christopher Pissarides. 2000. Equi-
librium Unemployment, Cambridge, 
Mass.: MIT Press.
Guillaume Rocheteau. 2006. “Under-
standing Unemployment,” Federal 
Reserve Bank of Cleveland, Economic 
Commentary (October 15).

The minimum wage and the labor market

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