Academic journal article Atlantic Economic Journal

Synergies in Labour Market Institutions: The Nonlinear Effect of Minimum Wages on Youth Employment

Academic journal article Atlantic Economic Journal

Synergies in Labour Market Institutions: The Nonlinear Effect of Minimum Wages on Youth Employment

Article excerpt

Introduction

Minimum wages have seen a remarkable return to the spotlight in 2015/2016, with the introduction of minimum wages in Germany and announcements of substantial minimum wage hikes in the UK and Japan. In this context, two questions become ever more relevant to policymakers: What are the benefits and costs of minimum wages? The first question produced a plethora of papers that agree that minimum wages decrease inequality but disagree on the size of this effect (e.g. Neumark and Wascher 2006; Manning 2003).

In contrast, the discussion of minimum wage costs yields strong disagreement. Empirical papers point to negative, positive or insignificant minimum wage effects on employment. The following analysis aims to tackle this question, where the focus is youth employment. The reason for the restriction to the younger age class is twofold. Firstly, the soaring youth unemployment in post-crisis Europe has become a pressing issue to policymakers. Secondly, minimum wages should have a more pronounced impact on young workers, since they are more likely to work in low-skill sectors (Manning 2003).

The present paper employs a fixed-effects panel data model covering 19 Organisation for Economic Cooperation and Development (OECD) member countries in order to estimate a nonlinear relationship between minimum wages and youth employment. In particular, it will be shown that the minimum wage effect on youth employment varies with labour market institutions. The motivation for considering nonlinearities follows Coe and Snower's (1997) hypothesis that institutions form synergies in their interactions.

In the context of minimum wages, this hypothesis has only been thoroughly examined by Neumark and Wascher (2004). However, Neumark and Wascher's paper suffers from the low quality of institutional variables. The present research paper employs better institutional and control variables as well as a larger number of observations. In doing so, significant negative synergies are estimated between minimum wages and institutions that enforce labour market rigidity such as unemployment benefits and union density, while a positive synergy is found with active labour market policies that constitute training for the unemployed.

Two key conclusions follow. Firstly, many minimum wage panel data models are misspecified as they omit the interactive term with labour market institutions, which might account for some of the discrepancy in empirical evidence. Secondly, policymakers need to consider the institutional setting faced before adjusting minimum wages. This paper suggests that minimum wage raises in rigid markets will depress youth employment particularly strongly.

Theoretical Background and Empirical Evidence

Economic Theory

Basic neoclassical theory suggests that, in a competitive labour market, minimum wages (MWs) above the efficient level will depress employment by decreasing labour demand. This effect will be more detrimental in low-skill sectors where MWs are binding. Given that young workers tend to work in such sectors, MWs lead to higher youth unemployment following this theory (Neumark and Wascher 2008).

However, more recent models dispute the validity of the neoclassical prediction. For instance, job search costs can engender monopsonistic markets in which firms can set wages below the competitive level without losing workers (Burdett and Mortensen 1998). In such a setting MWs can increase employment by limiting employers' bargaining power (Manning 2003).

The implicit theoretical foundation of the following analysis diverges from both these theories. Firstly, it builds upon the distinction between supply and demand side effects as proposed by Brown et al. (2014). The authors argue that MWs raise labour supply by increasing the return on working, but depress labour demand through elevating costs faced by firms. Hence, the overall effect is ambiguous, but can potentially be investigated in greater detail by examining labour market institutions, broadly defined as the policies and conventions that determine the costs, flexibility and incentives of employment (Betcherman 2012). …

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