Question

Critics of welfare assistance programs argue that they are inefficient as they might incentivize people to reduce their hours of work. Often, an alternative strategy to help those in need is to increase the minimum wage, since workers in low income families tend to hold jobs that pay the minimum wage. Using a graph that includes a budget constraint and a map of indifference curves, show and explain how increasing the minimum wage would be a better policy in terms of incentivizing working more hours than welfare assistance. Additionally, mention one way in which a higher minimum wage would not be the most effective policy in providing assistance to low income families.

Answer 1

Answer: The minimum wage is a policy set by the government to primarily improve the pay conditions of labours working in low-income jobs. With increase in wages, workers tend to work more as long as their substitution effect dominates over the income effect. Substitution effect gives workers the incentive to work moke replacing leisure while the Income effect induces workers to work less and enjoy more leisure since they can afford their original consumption bundle by working less. Since workers in low income families tend to hold jobs that pay the minimum wage; it is safe to assume that the increase in the minimum wage is not substantial enough to induce workers to work even lesser than their current working conditons.

The following diagram shows the effect of minimum wage with respect to leisure and income earned from working. With the increase in the minimum wage, the original budget line shifts upwards to M₃Q from M₁Q indicating workers would earn even higher than before. This change in the workers income produces two kinds of effects: Substitution and Income. The original leisure is given by 19 hours a day (which implies, 5 hours worked in a day) at point R where the IC₁ is tangent to the initial budget line. The high minimum wage shifts the budget line and places the labours at a higher indifference curve IC₂. A hypothetical budget line M₂Q' is drawn tangent to IC₁ parallel downward to M₃Q to show the income and the substitution effect. It is clear from the diagram that with minimum wage, under only substitution effect hours worked increases from 5 hours (19 hours of leisure as of point H) to 12 hours (12 hours of leisure as of point S); while with income effect reduces the total hours worked to 8 hours (16 hours of leisure as of point R) from 12 hours worked (12 hours of leisure as of point S). Hence, minimum wage incentivizes the workers to work 3 hours more (8 hours - 5 hours).

One way in which a higher minimum wage would not be the most effective policy in providing assistance to low income families: higher minimum wage raises the cost to the companies, hence the companies would hire less (and seek only skilled labours) and the unemployment would rise for (unskilled) low income families.