Question

Suppose that a 5% increase in the minimum wage causes a 5% reduction in employment. How would this affect employers and how would it affect workers? In your opinion, would this be a good policy?

Short answer

Firms respond by substituting labor with physical capital or cut down the production.

Step-by-step solution

Step 1. Definition

A minimum wage, to be effective, needs to be set above the market wage level. When this happens, employers must follow minimum wage guidelines. Not all workers will actually benefit from higher wages.

Step 2. Explanation

From a macroeconomic standpoint, the reduction in employment is contributing to higher unemployment rate. The benefit of rise in minimum wage goes only to those workers who are unskilled and were working at the minimum wage level. Those who were already earning higher would not be affected by it. At the same time, 5% of workers are losing their jobs.

For employers, the rise in minimum wage would increase their cost of production. They would compensate by reducing production and reducing input used.

The policy can be considered good only if the gain from higher wages would be greater than the loss from increased unemployment.