Introduction

Since 1938, the minimum wage has been used as a tool for reducing income inequality and diminishing the poverty level in America. A historical chart of the federal minimum wage is plotted in figure 1.¹ An incredible amount of analysis has been done, both empirical and theoretical, to determine if setting a wage floor in an economy accomplishes these goals. Two important works, one by David Card and Alan Krueger [4], and another by John Addison and McKinley Blackburn [1], find that increasing the minimum wage leads to higher levels of employment in the economy, lower levels of poverty, and overall makes the economy better off. Contrary to these studies, there are many articles that show just the opposite. This paper presents several of these findings and then draws on two models to aid in the understanding of the results. The following analysis will proceed with a general review of the evidence on the effects of the minimum wage. In section II and III, the monopsony and efficiency wage model will be considered. Both have been cited as possible explanations for some of the counter-intuitive findings that will be discussed. Finally in section IV, an extention of the efficiency wage model is analyzed which involves the impact of a change in welfare policy on the model. Though models do exist to show the positive effects of a minimum wage, most economists agree that it must be used in combination with other work incentive policies, such as the Earned Income Tax Credit (EITC), to combat unemployment and poverty in America. A fairly simple concept obtained from introductory economics courses states that increasing the price of an input will cause a firm to reduce the quantity demanded of that input. Consider the labor market graph in figure 2. A competitive firm always sets $MRP_L$ (Marginal Revenue Product of Labor) equal to $MC_L$ (Marginal Cost of Labor). This is because the firm wants to hire workers just up until the point where the additional revenue gained from that employee equals the amount it costs the firm to hire him. The wage, $w_*$, is set in the market which is in the left panel. This translates into a horizontal $MC_L$ curve for the firm at the wage level. Hence there is a competitive market equilibrium at $L_f*$ laborers and an equilibrium wage of $w_*$. Now consider instating a minimum wage floor of $w_{min}$. The $MC_L$ curve for the firm now shifts up to the new minimum wage. Thus the market equilibrium would now be $L_m'$ workers and a wage of $w_{min}$. The new level of firm employment would be $L_f'.$ As expected, the minimum wage floor causes the level of employment in each firm and in the economy to fall. However since the equilibrium wage rises, the question now becomes, what is the effect on average earnings and what segment of the population is losing jobs? The usual response is that average earnings rise because the employment effect is fairly small and that many workers from the lowest paid segment of the population become unemployed. However, the evidence of this is varied.