What happens if wage rate increases

An increased wage means a higher income, and since leisure is a normal good, the quantity of leisure demanded will go up. And that means a reduction in the quantity of labor supplied. For labor supply problems, then, the substitution effect is always positive; a higher wage induces a greater quantity of labor supplied. But the income effect is always negative; a higher wage implies a higher income, and a higher income implies a greater demand for leisure, and more leisure means a lower quantity of labor supplied.

With the substitution and income effects working in opposite directions, it is not clear whether a wage increase will increase or decrease the quantity of labor supplied—or leave it unchanged. Figure Now suppose Ms. As shown in Figure But she is richer now; she can afford more leisure. She could earn that same amount at the higher wage in just 28 hours. With her higher income, she can certainly afford more leisure time. The income effect of the wage change is thus negative; the quantity of labor supplied falls.

The effect of the wage increase on the quantity of labor Ms. Wilson actually supplies depends on the relative strength of the substitution and income effects of the wage change. We will see what Ms. Wilson decides to do in the next section. One possibility is that over some range of labor hours supplied, the substitution effect will dominate. Because the marginal utility of leisure is relatively low when little labor is supplied that is, when most time is devoted to leisure , it takes only a small increase in wages to induce the individual to substitute more labor for less leisure.

Further, because few hours are worked, the income effect of those wage changes will be small. The substitution effect thus dominates the income effect of a higher wage. Between points A and B, the positive substitution effect of the wage increase outweighs the negative income effect. It is possible that beyond some wage rate, the negative income effect of a wage increase could just offset the positive substitution effect; over that range, a higher wage would have no effect on the quantity of labor supplied.

That possibility is illustrated between points B and C on the supply curve in Figure As wages continue to rise, the income effect becomes even stronger, and additional increases in the wage reduce the quantity of labor she supplies. The supply curve illustrated here bends backward beyond point C and thus assumes a negative slope.

The supply curve for labor can thus slope upward over part of its range, become vertical, and then bend backward as the income effect of higher wages begins to dominate the substitution effect. It is quite likely that some individuals have backward-bending supply curves for labor—beyond some point, a higher wage induces those individuals to work less, not more.

In contrast to goods and services markets, price ceilings are rare in labor markets, because rules that prevent people from earning income are not politically popular. There is one exception: sometimes limits are proposed on the high incomes of top business executives. The labor market, however, presents some prominent examples of price floors, which are often used as an attempt to increase the wages of low-paid workers.

The U. In mid, the U. Local political movements in a number of U. Promoters of living wage laws maintain that the minimum wage is too low to ensure a reasonable standard of living. A family with two adults earning minimum wage and two young children will find it more cost efficient for one parent to provide childcare while the other works for income.

Supporters of the living wage argue that full-time workers should be assured a high enough wage so that they can afford the essentials of life: food, clothing, shelter, and healthcare. Since Baltimore passed the first living wage law in , several dozen cities enacted similar laws in the late s and the s.

The living wage ordinances do not apply to all employers, but they have specified that all employees of the city or employees of firms that are hired by the city be paid at least a certain wage that is usually a few dollars per hour above the U.

Figure 3 illustrates the situation of a city considering a living wage law. For simplicity, we assume that there is no federal minimum wage. The wage appears on the vertical axis, because the wage is the price in the labor market. In response to the higher wage, 1, workers look for jobs with the city. At this higher wage, the city, as an employer, is willing to hire only workers. At the price floor, the quantity supplied exceeds the quantity demanded, and a surplus of labor exists in this market.

For workers who continue to have a job at a higher salary, life has improved. For those who were willing to work at the old wage rate but lost their jobs with the wage increase, life has not improved.

Table 4 shows the differences in supply and demand at different wages. In other words, the vast majority of the U.

But for workers with low skills and little experience, like those without a high school diploma or teenagers, the minimum wage is quite important. In many cities, the federal minimum wage is apparently below the market price for unskilled labor, because employers offer more than the minimum wage to checkout clerks and other low-skill workers without any government prodding.

Economists have attempted to estimate how much the minimum wage reduces the quantity demanded of low-skill labor. In fact, some studies have even found no effect of a higher minimum wage on employment at certain times and places—although these studies are controversial. Wages could fluctuate according to market forces above this price floor, but they would not be allowed to move beneath the floor.

In this situation, the price floor minimum wage is said to be nonbinding —that is, the price floor is not determining the market outcome. Even if the minimum wage moves just a little higher, it will still have no effect on the quantity of employment in the economy, as long as it remains below the equilibrium wage. Even if the minimum wage is increased by enough so that it rises slightly above the equilibrium wage and becomes binding, there will be only a small excess supply gap between the quantity demanded and quantity supplied.

These insights help to explain why U. Since the minimum wage has typically been set close to the equilibrium wage for low-skill labor and sometimes even below it, it has not had a large effect in creating an excess supply of labor.

However, if the minimum wage were increased dramatically—say, if it were doubled to match the living wages that some U. The following Clear It Up feature describes in greater detail some of the arguments for and against changes to minimum wage. Because of the law of demand, a higher required wage will reduce the amount of low-skill employment either in terms of employees or in terms of work hours.

Not necessarily. The answer is not clear, because job losses, even for a small group, may cause more pain than modest income gains for others. For one thing, we need to consider which minimum wage workers are losing their jobs. If those who lose their job are high school students picking up spending money over summer vacation, that is something else.

Another complexity is that many minimum wage workers do not work full-time for an entire year. Imagine a minimum wage worker who holds different part-time jobs for a few months at a time, with bouts of unemployment in between.

Of course, these arguments do not prove that raising the minimum wage is necessarily a good idea either. There may well be other, better public policy options for helping low-wage workers. The Poverty and Economic Inequality chapter discusses some possibilities. The lesson from this maze of minimum wage arguments is that complex social problems rarely have simple answers.

Even those who agree on how a proposed economic policy affects quantity demanded and quantity supplied may still disagree on whether the policy is a good idea. In the labor market, households are on the supply side of the market and firms are on the demand side. In the market for financial capital, households and firms can be on either side of the market: they are suppliers of financial capital when they save or make financial investments, and demanders of financial capital when they borrow or receive financial investments.

In the demand and supply analysis of labor markets, the price can be measured by the annual salary or hourly wage received. The quantity of labor can be measured in various ways, like number of workers or the number of hours worked.

Factors that can shift the demand curve for labor include: a change in the quantity demanded of the product that the labor produces; a change in the production process that uses more or less labor; and a change in government policy that affects the quantity of labor that firms wish to hire at a given wage. The main factors that can shift the supply curve for labor are: how desirable a job appears to workers relative to the alternatives, government policy that either restricts or encourages the quantity of workers trained for the job, the number of workers in the economy, and required education.

American Community Survey. National Center for Educational Statistics. Median Estimate Range of Likely Outcomes. Note: Where an asterisk appears for a value, it represents an amount that is not zero but would round to zero. Federal Minimum Wage: The target amount for the hourly minimum wage. Year the Specified Increase Would Be Fully Implemented: Like previous increases in the minimum wage, the options presented here would take a number of years to be fully implemented.

Further Adjustments to the Minimum Wage: Indexing the minimum wage means automatically adjusting it after it reaches the target amount. The Effects on Employment.

How would increasing the minimum wage affect employment? Raising the minimum wage would increase the cost of employing low-wage workers. As a result, some employers would employ fewer workers than they would have under a lower minimum wage. However, for certain workers or in certain circumstances, employment could increase. Changes in employment would be seen in the number of jobless, not just unemployed, workers.

Jobless workers include those who have dropped out of the labor force for example, because they believe no jobs are available for them as well as those who are searching for work. How did CBO estimate effects on employment? Effects would generally be greater if the minimum-wage change affected more workers, if it led to larger mandated increases for directly affected workers, if firms had more time to respond for example, because the change was phased in over a longer period , and if the minimum wage was indexed to inflation or wage growth.

If workers lost their jobs because of a minimum-wage increase, how long would they stay jobless? At one extreme, an increase in the minimum wage could put a small group of workers out of work indefinitely, so that they never benefited from higher wages.

At the other extreme, a large group of workers might shuffle regularly in and out of employment, experiencing joblessness for short spells but receiving higher wages during the weeks they were employed. In analyzing the effects of joblessness on poverty, CBO used its estimates of the distribution of durations of unemployment for the — period to assign directly affected workers either no joblessness or a duration of joblessness within the projection year that was randomly chosen from that distribution.

The Effects on Income. How would increasing the minimum wage affect family income? However, income would fall for some families because other workers would not be employed and because business owners would have to absorb at least some of the higher costs of labor.

For those reasons, a minimum-wage increase would cause a net reduction in average family income. How did CBO estimate effects on family income? CBO projected the distribution of family income in future years and then combined those forecasts with estimates of effects on wage rates, employment, business income, and prices.

Finally, outside forces, such as unions or government regulations, can distort pay rates. Wages and Productivity in the U.

If the economic theory were correct in the real world, wages and productivity would increase together. Some of the disconnect between performance and pay can be addressed with alternate pay schemes. While a salary or hourly pay does not directly take into account the quality of work, performance-related pay compensates workers with higher levels of productivity directly. One example is commission-based pay. In this type of pay scheme, workers receive some percentage of the profit that they generate for their company.

This may be paid on top of a baseline salary or may be the only form of compensation. This type of system is very common among car salespeople and insurance brokers. Another alternative is piece-work, in which employees are paid a fixed rate for every unit produced or action performed, regardless of the time it takes.

This is common in settings where it is easy to measure the output of piece work, such as when a garment worker is paid per each piece of cloth sewn or a telemarketer is paid for every call placed. In a perfectly competitive market, the wage rate is equal to the marginal revenue product of labor. Just as in any market, the price of labor, the wage rate, is determined by the intersection of supply and demand.

When the supply of labor increases the equilibrium price falls, and when the demand for labor increases the equilibrium price rises. In the long run the supply of labor is a simple function of the size of the population, so in order to understand changes in wage rates we focus on the demand for labor. To determine demand in the labor market we must find the marginal revenue product of labor MRPL , which is based on the marginal productivity of labor MPL and the price of output.

Conceptually, the MRPL represents the additional revenue that the firm can generate by adding one additional unit of labor recall that MPL is the additional output from the additional unit of labor. The MPL is generally decreasing: adding a th unit of labor will not increase output as much as adding a 99th.

Since competitive industries are price takers and cannot change the price of output by changing their level of production, the MRPL curve will have the same downward slope as the MPL curve. From the perspective of the firm, the MRPL is the marginal benefit to the firm of hiring an additional unit of labor. We know that a profit-maximizing firm will increase its factors of production until their marginal benefit is equal to the marginal cost.

Therefore, firms will continue to add labor hire workers until the MRPL equals the wage rate. Thus, workers earn a wage equal to the marginal revenue product of their labor. Marginal Product and Wages : The graph shows that a factor of production — in our case, labor — has a fixed supply in the long run, so the wage rate is determined by the factor demand curve — in our case, the marginal revenue product of labor.

The intersection of vertical supply and the downward sloping demand gives the wage rate. As in all competitive markets, the equilibrium price and quantity of labor is determined by supply and demand. More hours worked earn higher incomes but necessitate a cut in the amount of other things workers enjoy such as going to movies, hanging out with friends, or sleeping.

The opportunity cost of working is leisure time and vis versa. Considering this tradeoff, workers collectively offer a set of labor to the market which economists call the supply of labor. To see how changes in wages affect the supply of labor, suppose wages rise. This increases the cost of leisure and causes the supply of labor to rise — this is the substitution effect , which states that as the relative price of one good increases, consumption of that good will decrease.

However, there is also an income effect — an increased wage means higher income, and since leisure is a normal good, the quantity of leisure demanded will go up. In general, at low wage levels the substitution effect dominates the income effect and higher wages cause an increase in the supply of labor. At high incomes, however, the negative income effect could offset the positive substitution effect and higher wage levels could actually cause labor to decrease.

This creates a supply curve that bends backwards, initially increasing with the wage rate but later decreasing. Backward Bending Supply : While normally hours of labor supplied will increase with the wage rate, the income effect may produce the opposite effect at high wage levels.

People supply labor in order to increase their utility —just as they demand goods and services in order to increase their utility. The supply curve for labor will shift in response to changes in the same factors that shift demand for goods and services. These include changes in preferences, changes in income, changes in population, and changes in expectations. A change in preferences that causes people to prefer more leisure, for example, will shift the supply curve to the left, creating a lower level of employment and a higher wage rate.

An increase in the demand for labor will increase both the level of employment and the wage rate. We have already seen that the demand for labor is based on the marginal product of labor and the price of output. Thus, any factor that affects productivity or output prices will also shift labor demand.