Question

Assume that the labor market is competitive, where the labor demand curve is strictly downward sloping and the labor supply curve is strictly upward sloping.

(a) Suppose the government imposes a minimum wage on this labor market. Why would the minimum wage cause a deadweight loss (welfare loss)? In what sense is it a loss?

(b) How does the deadweight loss depend on the elasticities of the demand and supply curves? Explain.

(c) If the minimum wage created a deadweight loss, why would the government impose it? Discuss.

Answer 1

a) The first panel shows equilibrium in competitive labor market. The second panel shows scenario when minimum wage is imposed in the market.

When the government imposes a minimum wage, firms are not allowed to pay less than the amount that the government mandates. The firm is the buyer in the labor market. The total buyer surplus is the profit that firms obtain by hiring workers; it is the difference between the cost of hiring these workers and the revenues that they generate. Graphically, it is the area below the labor demand curve and above the market wage. The total sellers surplus is the benefit that accrues to workers from selling labor time. Sellers of labor (workers) receive surplus equal to the area below the market wage and above the supply curve. The higher wage reduces employment (the unemployed labor has been marked in the diagram). In other words, fewer transactions occur so the total surplus in the market is reduced.The lost surplus is known as the deadweight loss from the minimum wage policy. Minimum wage and living wage laws can create a deadweight loss by causing employers to overpay for employees and preventing low-skilled workers from securing jobs.

b) The deadweight loss depends on elasticities of demand and supply curves as follows:

When either demand or supply is inelastic, then the deadweight loss is smaller, because the quantity bought or sold varies less with price. With perfect inelasticity, there is no deadweight loss. However, deadweight loss increases proportionately to the elasticity of either supply or demand. This is so because a more elastic market a price change causes a greater decrease in quantity therefore a policy in a more elastic market will cause a greater deadweight loss. Four instances have been shown in the diargram.

c)The rationale behind governments imposing a minimum wage is to raise the wages of workers who are earning very little. A minimum wage is very similar to a price floor, because it is set above the market wage. Although unemployment increases when minimum wages are imposed, the main case for a minimum wage is that it helps poor and low-income families earn enough income.