The Behavioral Effects of
Minimum Wages
Armin Falk (University of Bonn)
Ernst Fehr (University of Zurich
Christian Zehnder (University of Lausanne)
Why studying Minimum Wages?

Minimum wage laws are an important labor
market instrument


25 of 29 OECD countries have some form of
minimum wage legislation
The behavioral effects of minimum wages are
still not fully understood

Anomalously low utilization of opportunities to pay
subminimum wages for certain categories of
workers (Katz and Krueger 1991, 1992)


Spillover effect: firms often raise wages of workers
who earned less than the new minimum wage
above the level of the new minimum wage (Katz
and Krueger 1992, Card and Krueger 1994)
Contested employment effects of minimum wages
Card (1992), Card & Krueger (1994), Machin &
Manning (1994)


Important for policy evaluation
Important for the question whether labor markets are
imperfectly competitive or approximate the competitive
ideal.
Main Message I

Minimum wages have a direct impact on
worker‘s perception of what constitutes a fair
wage and thus affect reservation wages


Introducing a MW increases reservation wages
Therefore, a sizeable share of workers who earned
less than the MW before the introduction is paid
more than the MW after the introduction

Explains the spillover effect
Main Message II

The introduction and the removal of MW has
asymmetric effects on reservation wages



Introduction: strong rise in reservation wages
Removal: Small decrease in reservation wages
 Asymmetric effects on actual wages

Actual wages strongly increase after introduction of
MW but only weakly decrease after removal of MW

Explains the low utilization of opportunities to pay
subminimum wages
Main Message III

 Asymmetric effects on employment

Actual employment increases after
introduction but does not decrease after
removal of the MW

Sheds light on the sources of positive
employment effects
Minimum Wage & Reservation Wages

For some time economists speculated that
minimum wages might affect reservation
wages


„The minimum wage becomes a focal point,
representing the going, or acceptable wage. ....
workers perceive the minimum as the 'fair‘ wage.
In this way the minimum wage might influence
workers‘ reservation wages.“ (Card and Krueger
95)
However, reservation wages are difficult to
measure in field data
Why a laboratory experiment?

Empirical evidence for zero or positive employment effects
highly contested (e.g. Neumark and Wascher).


Important determinants of employment and wages are
unobservable or very difficult to observe.




marginal revenue product of labor (labor demand)
workers’ reservation wages (labor supply)
wage setting mechanism
Information conditions unknown in the field


Measurement errors regarding employment and wages.
what do firms and workers know about marginal revenue product,
average product, profits and reservations wages.
Unknown interactions between MW, labor demand or supply
may occur.
In a Laboratory Experiment




no measurement error with regard to
wages and employment
perfect knowledge of marginal revenue
product
precise measurement of reservation
wages possible
control over information conditions.
Experimental Game

Market Participants



Exogenous Matching


At the beginning of a period each firm is randomly matched with
three workers
Stage 1 of a period


6 Firms
18 Workers
Firms can offer the same wage to 0, 1, 2 or 3 workers,
w  [0, 1000]
Stage 2 of a period

Workers simultaneously accept or reject the offer they received
Design continued

Two Treatments:




Without minimum wage (NO)
With minimum wage (MW)
Each treatment lasts 15 periods
Two Treatment Orders:


Introduction of MW (NO/MW) [5 Sessions]
Elimination of MW (MW/NO) [5 Sessions]
Design continued
Employed Workers
0
1
2
3
Revenue
0
390
740
1000
Marginal Revenue
Product
390
350
260
Design continued

Firms’ payoff


Revenue – wage  employed workers
Workers‘ payoff

Wage if employed, zero otherwise

Minimum wage equals 220 < MRP of third employed
worker

Information conditions



MRP, payoff functions, number of workers and firms and the
matching technology are common knowledge
Firms are informed about how many workers accepted their
offer
Workers are informed about firms’ profits
Elicitation of reservation wages



Ask workers for their acceptance
thresholds r before they know the wage
offer
If w > r the offer is accepted, if w < r it is
rejected
 Supply Schedule observable
Matching technology


If acceptance thresholds are heterogeneous firms
face – on average - upwards sloping labor supply
schedules
However, with perfectly random matching the
distribution of reservation wages a firm faces may
not be very representative of the overall labor supply
schedule



May generate a lot of randomness at the firm level
Needs many periods to converge to whatever the behavioral
equilibrium is in this setting
Solution

Each firm gets matched with one worker from each third of
the distribution of acceptance thresholds
Standard Predictions

Assumptions



Firms and workers are rational and selfish
Firms know that workers are selfish
Implications



Workers accept every positive wage offer
Labor supply is horizontal at a wage of one
Firms offer always the smallest acceptable wage to all their workers



NO-Treatment: w = 1
MW-Treatment: w = 220 (Minimum Wage)
There is full employment in both treatments

The minimum wage does not change employment but has strong
distributive effects
Predictions with fairness
preferences

Workers‘ have heterogenous acceptance thresholds

Firms face an upward sloping supply schedule

Wages are much higher than predicted by the self-interest
model

Minimum wage may increase employment because more
workers accept the wage offer

Example 1




Reservation wages of 0, 10, 100
Marginal cost of hiring 3 instead of 2 workers are
3*100 – 2*10 = 280 > 260 (= MRP of 3rd worker)
Third worker is not employed without the MW
With the MW law the third worker will be employed because the
marginal cost of the 3rd worker is 220

Example 2




Reservation wages of 30, 80, 130
Marginal cost of hiring 3 instead of 2
workers are
3*130 – 2*80 = 230 < 260
Third worker is employed without the MW
MW law has no employment effect
The effect of MW on actual wages
(increase and spillover effect)
0.6
MW
relative frequencyffg
0.5
NO-MW sequence
0.4
NO
0.3
MW
0.2
0
10
20
30
40
50
60
70
80
90
100
110
120
130
140
150
160
170
180
190
200
210
220
230
240
250
260
270
>=280
0.1
wage interval
Why do firms pay non-minimal wages in NO and more than the minimum in MW?
The effect of MW on reservation wages
(heterogeneity, fairness, increase)
0.6
NO_MW sequence
0.4
NO
MW
0.3
0.2
0.1
0
0
10
20
30
40
50
60
70
80
90
100
110
120
130
140
150
160
170
180
190
200
210
220
230
240
250
260
270
280
290
>=300
relative frequencysd
0.5
reservation wages
Employment effects
Without MW employment is inefficiently low?
Average Employment per Firm
NO
3.0
2.6
2.2
1.8
1.4
1
2
3
4
Session Number
MW have the chance to raise employment
5
Average


If reservation wages were constant
across conditions average employment
per firm should approximate 3 in the
MW treatment
However, the MW increases reservation
wages
Minimum wage leads to a small but significant
increase in employment
3.0
Employmentdf
2.5
2.0
NO
1.5
MW
1.0
0.5
0.0
1
2
3
4
Session
5
Total average
Do firms chose profit maximizing
wages?
S1
Optimal
wage
Actual
wage
NO condition
S2 S3 S4
S5
1-5
S1
MW condition
S2 S3 S4 S5
1-5
177 183 151 189 184 177 233 227 237 238 232 233
165 172 154 189 200 176 234 228 237 238 243 236
Employment effect is the result of profit maximizing firm behavior
A temporary MW has permanent effects – preand post-MW economy exhibit different wages
260
220
NO_MW
MW_NO
200
180
160
period
13
10
7
4
1
13
10
7
4
140
1
mean wage
240
Distribution of wages in the pre- and
the post-MW economy
0.4
0.3
NO_MW
0.25
MW_NO
0.2
0.15
0.1
0.05
0
10
20
30
40
50
60
70
80
90
100
110
120
130
140
150
160
170
180
190
200
210
220
230
240
250
260
270
>=280
relative frequencyffg
0.35
wage interval
Why are wages in the post-MW economy so high?
Why do employers‘ not take more
advantage of the elimination of the MW?


Related to the underutilization of
subminimum wage opportunities in the field
In Katz & Krueger 92, 62% of restaurant
managers believed that they could not
„attract qualified teenage workers at the
subminimum wage“


Suggests that employers are labor supply
constrained
But why could they fill their ranks before the
increase in the MW?
Reservation wages in the preand the post-MW economy
relative frequencysd
0.25
0.2
NO_MW
Post-MW median = 200
MW_NO
0.15
Pre-MW median = 150
0.1
0.05
0
10
20
30
40
50
60
70
80
90
100
110
120
130
140
150
160
170
180
190
200
210
220
230
240
250
260
270
280
290
>=300
0
reservation wages
Given these distributions, was it optimal to pay higher wages in the postMW economy?
Distribution of profit maximizing wages in the
No condition across sequences
0.45
0.4
0.3
NO_MW
MW_NO
0.25
0.2
0.15
0.1
0.05
0
0
10
20
30
40
50
60
70
80
90
100
110
120
130
140
150
160
170
180
190
200
210
220
230
240
250
260
270
280
290
300
relative frequencysss
0.35
profit-maximizing wage offer
Difference in reservation wages between
pre and post-MW economy is significant
Table 8: Effects of introduction versus removal of minimum wage on
reservation wages
Reservation wage
MW-dummy (Impact of MW in
NO-MW sequence)
85.74***
(5.44)
MW_NO-dummy (impact of
treatment order on NO-treatment)
12.46**
(4.70)
MW-dummy*MW_NO-dummy
-12.47
(9.41)
Constant (omitted category is NOtreatment in NO-MW sequence)
144.51***
(2.72)
Number of obs.
5400
Prob > F
.0000
R-squared
. 345
Note: The regression controls for session fixed effects. Robust standard errors clustered on sessions in
parentheses, *** indicates significance at the 1-percent level., ** indicates significance at the 5-percent
level.
Removal of MW has no employment
effect
3
Employmentdf
2.5
2
NO
1.5
MW
1
0.5
0
1
2
3
4
Session
5
Total average
Summary


Economists focus on how economic policy
changes the incentives for private agents
Economic policies have effects that go far
beyond changing incentives

Results suggest that minimum wages affect the
perception of what constitutes a fair wage


Minimum wage increases reservation wages
Results suggest that minimum wage creates a
kind of entitlement effect that is not fully
reversible

Explains asymmetric response of reservation wages

This effect on reservation wages gives rise to
important wage & employment effects





Firms pay on average more than the minimum wage after
the introduction of the MW
Wages in the pre-MW economy are much lower than in a
post-MW economy
Employment rises less after the introduction compared to a
situation with stable reservation wages
Employment does not fall after the removal of the MW
Our results lend support to the idea that the spillover
effect and the under utilization of opportunities to
pay subminimum wages in field data are driven by
the impact of minimum wages on reservation wages