Labour Economics | Minimum Wage vs. Reservation Wage | Why Does the Minimum Wage Exists | Pro and Contra of the Minimum Wage

Minimum Wage as a Labour Market Institution

Minimum Wage in Labour Economics

Minimum Wage vs. Reservation Wage 

Minimum wage is a price-based labour market institution which acts as a wage floor above the equilibrium wage. It is different from the reservation wage which is the lowest wage at which the worker is willing to work. The reservation wage corresponds to the marginal rate of substitution between leisure and consumption.

Reservation Wage with and without Hour Restrictions

If the equilibrium wage is lower than the reservation wage, the individual will choose not to work. With no time restrictions the worker will be indifferent between no work and some work, whereas in the fixed hour case, he has choice between no work at all and working some fixed amount of time. The reservation wage in the fixed hour case is higher than in the flexible case.

Static vs. Dynamic Reservation Wage

The static reservation wage is the lowest wage at which the worker is indifferent between being in and out of the labour force. The dynamic reservation wage is a threshold at which the individual who is already in the labour force chooses to accept the job instead of seeking a more beneficial one.

Minimum Wage vs. Efficient Wage and Compensating Wage Differentials

Minimum wage represents a lower bound to the wage which can be possibly paid. Efficient wage (or Efficiency wage) is a wage above the reservation wage and the minimum wage paid to workers to induce them to be more productive. Workers are also paid more than their reservation wages or minimum wages when they are compensated for risks, bad working conditions or long hours. In that case we are talking about compensating wage differentials.

Minimum Wage vs. Minimum Guaranteed Income

The notion of the Minimum Guaranteed Income (MGI) is close to that of the minimum wage. The MGI is a welfare programme aimed at helping the unemployed which very often presupposes the so-called 'take-it-or-leave-it' cash grants and other incentives which basically increase the static reservation wage and reduce the participation the participation rate. The strange philosophy of such programmes goes back to Beveridgian times when it was popular to think that those who do not want to work are still eligible to be paid. By working taxpayers.

Reasons of Existence of the Minimum Wage

While it is more than clear that the minimum wage on all levels (governmental, union bargaining and industrial) prevents both the competitive and non-competitive labour market from controlling itself and imposes a large burden on firms as well as causing unemployment which may result in increased poverty incidence, certan factors are cited as pros of the minimum wage and even as the reasons of its existence:

• the minimum wage may improve market efficiency by reducing the monopsony power of employers, externalities and informational assymetries
• the minimum wage is supposed to increase productivity: on the demand side - the minimum wage produces an increased number of high-productivity jobs; on the supply side: workers are motivated to acquire more education
• the minimum wage produces a lighthouse effect: positive effects on wages in the informal sector
• the minimum wage may reduce poverty rate (but increase poverty incidence - see above)
• equity: the minimum wage reduces earnings inequality by supporting incomes of low-earning workers.

On balance, it is clear that the minimum wage while increasing the welfare of some individuals, also creates unemployment.