Finance
WHITONOMICS ISSUE 8
The myth of the perfectly competitive labour market As new evidence has arisen, the case for a high minimum wage has become stronger and stronger, casting doubt on traditional models of the labour market David Lawrence Once upon a time, if you asked academic economists their opinion on the minimum wage the consensus would be pretty clear; they lead to higher unemployment, higher prices and -perhaps worst of all- lower economic growth. Indeed, this opinion still holds sway, with 74% of economists opposing a $15 per hour minimum wage in the US. The above depicts a typical However, new evidence seems to supply and demand diagram to repcontradict claims minimum wages resent the market for low skilled decrease employment. labour. W1 and E1 are the equilibrium values for wage rate and emThe foremost two economists ployment levels, respectively, meanwho began to find evidence reing the quantity demanded and butting traditional claims about quantity supplied of labour are wage floors were Alan Kreuger and equal at W1 and there is no excess David Card. In 1992, New Jersey unemployment. Superficially, the raised its minimum wage to $5.05 implementation of a minimum wage per hour, whereas neighbouring raises wages from W1. However, the Pennsylvania raised it marginally to graph shows that at the new wage $4.25. Card and Kreuger decided to rate, more people are willing and exploit the opportunity for a natural able to work, raising the quantity of experiment and measured changes labour supplied to ES; and at the in employment levels along the bornew rate, it costs more for firms to der. What they found surprised employ workers so they lay off marthem- employment actually fell in ginally productive workers, decreasPennsylvania compared to New Jering the quantity of labour demanded sey, casting doubt on traditional to ED. The difference between ED models of the labour market. and ES represents unemployment Since then, there has been an caused by the minimum wage. abundance of academic debate on Yet the findings of Card and the issue. However, one thing seems Kreuger, as well as many economists clear- it cannot be guaranteed that since, seem to dispute this concluminimum wages will always cause sion. And when economic models unemployment. And this points toare wrong, its usually because one wards the fact that the neoclassical of the assumptions they are predimodel of the labour market may not cated on do not hold true. In this be wholly accurate. case, economists are especially interested in one critical assumption 28
the neoclassical model makes- that of perfect competition. To explain why a high level of competition is an important assumption in the labour market, one first has to explain why firms pay for labour. The answer is simple- firms are willing to pay wages to workers so they give up leisure time to produce goods. In general, a firm will never pay a worker a cent more than the worker is worth to them on the long run, and a worker’s worth to a firm is called the marginal physical product of labour (the increase in output occurred from hiring another unit of labour). However, if a firm pays a worker less than their marginal physical product of labour then, assuming some competition, another firm can come and offer this worker slightly more, confident the arrangement is profitable as long as the higher wage is lower than the marginal physical product of labour. In conditions of perfect competition, eventually the worker’s wage is bid up until it is equal to the marginal physical product of labour. And this explains why minimum wages are bad under a neoclassical framework. The invisible hand of the market has found an optimum wage. If well-meaning politicians try to increase the wage directly instead of worker productivity, then firms have to fire marginally productive workers. Because there are diminishing returns to labour, the firm does not fire every worker, but many have to be made
