Question

A manufacturing company recorded orders of 10 million products. To maintain its output volume, the company combines efforts of capital and 100, 000 workers. Suppose a new minimum wage law is imposed by the governor, leading to a higher minimum wage in the labor market. As a manager of the company, what would you do in the following situations? Please provide clear and accurate explanations to support your answer

• In the short-run, if you cannot purchase more machines (capital is fixed) and you need to maintain the company’s output volume. Would you decrease the number of workers you hired? Why?
• What would you do in the long-run if you want to maximize your profit and maintain the company’s output volume, and why?

  To help you answer this question, please draw an isoquant diagram for each question.

Answer 1

A minimum wage is the statutory minimum wage that employers can pay per hour.

Higher wages increase incomes and are likely to cause higher consumer spending. A significant increase in minimum wages could lead to higher growth. It could also contribute towards inflation for two reasons:

1. Higher costs for firms

2.Higher spending by workers.

minimum wage is only one factor that affects growth and inflation. In the real world, the UK has seen above inflation increases in the minimum wage without any negative impact on inflation or unemployment – but only negligible impact on economic growth.

Effect of higher minimum wages on economic growth

If workers receive a pay increase, then there will be a rise in consumer spending. Low-income workers are likely to have a higher marginal propensity to consume (in other words they spend high % of extra pay). This could also cause a multiplier effect, with higher spending causing knock-on effects to elsewhere in the economy; this should help boost economic growth.

However, if we assume labour markets are competitive and if we assume that a minimum wage does cause lower employment, then rising unemployment will have a negative impact on aggregate demand. People who become unemployed would spend less, leading to lower aggregate demand.

If labour markets are perfectly competitive and if there is a national minimum wage (NMW) above the equilibrium wage, you would expect a fall in demand for labour ,and therefore, there would be an excess supply of labour This is known as real wage unemployment) However, to complicate matters labour markets are often not perfectly competitive, but exhibit signs of monopsony power (where firms have market power in setting wages) If firms have monopsony power, they pay wages below the equilibrium and so min wages don’t cause unemployment.

Empirical evidence

It is debatable whether a minimum wage actually causes unemployment. In period 2010-17, UK unemployment has fallen to 4.5% – despite above-inflation increases in the minimum wage. Therefore, overall, the higher minimum wage in this period has probably had a positive impact on aggregate demand – especially given how real wage growth has been low and consumer spending weak. Even modest rises in the national minimum wage make a big difference to disposable income and contributed to higher spending.

Higher wages enable higher consumer spending and a rise in AD.

Effect on inflation

From the perspectives of firms, an increase in the minimum wage would increase their costs of production. Also, not only will firms have to increase the wage of workers on the minimum wage, but if they seek to maintain wage differentials – they may need to increase wages of more qualified workers – earning just above the minimum wage.

In this case, a minimum wage could lead to firms passing wage rises onto the consumers in the form of higher prices. This will cause SRAS to shift to the left and higher inflation. Also, if higher minimum wages leads to an increase in consumer spending, it could cause a degree of demand-pull inflation as well.

In theory, a higher minimum wage could cause inflation for two reasons:

1. Higher spending by workers (demand pull inflation)
2. Higher costs for firms, leading to wage-push inflation.

However, in reality, the inflationary impact of a rise in a minimum wage is likely to be muted.

• As a percentage of a firm’s overall costs, the minimum wage bill is only a small component.
• Also, given the low inflationary pressures, there is also a pressure for firms to absorb the wage increases without increasing prices (reduce profit margins).
• Also, in theory, firms could respond to higher minimum wages by investing in capital to raise labour productivity and so will be able to afford the higher wages – without increasing prices.

Short Run Production Function

• The short run is a time period where at least one factor of production is in fixed supply
• A business has chosen its scale of production and sticks with this in the short run
• We assume that the quantity of plant and machinery is fixed and that production can be altered by changing variable inputs such as labour, raw materials and energy.

Diminishing Returns

• In the short run, the law of diminishing returns states that as more units of a variable input are added to fixed amounts of land and capital, the change in total output will first rise and then fall
• Diminishing returns to labour occurs when marginal product of labour starts to fall. This means that total output will be increasing at a decreasing rate

What might cause marginal product to fall?

One explanation is that, beyond a certain point, new workers will not have as much capital equipment to work with so it becomes diluted among a larger workforce I.e., there is less capital per worker.

Criticisms of the Law of Diminishing Returns

• How realistic is this assumption of diminishing returns? Surely ambitious and successful businesses will do their level best to avoid such a problem emerging?

• It is now widely recognised that the effects of globalisation and the ability of trans-national businesses to source their inputs from more than one country and engage in transfers of business technology, makes diminishing returns less relevant

• Many businesses are multi-plant meaning that they operate factories in different locations – they can switch output to meet changing demand

Long-run cost curves

Cost curves appropriate for long-run analysis are more varied in shape than short-run cost curves and fall into three broad classes. In constant-cost industries, average cost is about the same at all levels of output except the very lowest. Constant costs prevail in manufacturing industries in which capacity is expanded by replicating facilities without changing the technique of production, as a cotton mill expands by increasing the number of spindles. In decreasing-cost industries, average cost declines as the rate of output grows, at least until the plant is large enough to supply an appreciable fraction of its market. Decreasing costs are characteristic of manufacturing in which heavy, automated machinery is economical for large volumes of output. Automobile and steel manufacturing are leading examples. Decreasing costs are inconsistent with competitive conditions, since they permit a few large firms to drive all smaller competitors out of business. Finally, in increasing-cost industries average costs rise with the volume of output generally because the firm cannot obtain additional fixed capacity that is as efficient as the plant it already has. The most important examples are agriculture and extractive industries.

criticism

The theory of production has been subject to much criticism. One objection is that the concept of the production function is not derived from observation or practice. Even the most sophisticated firms do not know the direct functional relationship between their basic raw inputs and their ultimate outputs. This objection can be got around by applying the recently developed techniques of linear programming, which employ observable data without recourse to the production function and lead to practically the same conclusions.