MINIMUM WAGE AND ITS EFFECT ON EMPLOYMENT

 

If Alice has a cake business, she will need to hire people to help her bake, decorate and deliver her cakes to her clients. In the resource market, Alice becomes the demander and her workers become the suppliers. When the supply of labour is equal to the demand for labour, the market can be said to be at equilibrium at the intersection between supply and demand curves. This is the stage when wages are at the current market rate. In other words, the person hiring is willing to pay what is agreeable to the worker.

Let us assume that is £7 pounds an hour. The government then passes a law that says that there has to be minimum £8.72 an hour for these workers, as anything less than that is not sufficient to give them a good life. Minimum wage is also called the price floor in the market. One would think that having a fixed minimum wage would bring clarity in the market. Surprisingly, it doesn’t happen that way. If the minimum wage /price floor is higher than the actual clearing price, it will end up distorting the market. Employers will have to reduce the number of hours that it can hire labour as they have a fixed amount of money that they can spend on their workers.

However, the workers see the increased rate at which they can be hired and thus more of them will be willing to work. A worker who made £7 an hour and worked 40 hours a week will now feel that he is eager to work more hours, say 45 , as he will now earn nearly £9 an hour. The supply of labour will increase. What will happen now is that the demand is limited. Thus, there will be an over supply of labour. Hence, we see that before the introduction of minimum wage, there was a surplus below the demand curve and above the supply curve. The producer surplus was the benefit of the individual workers, which was above and beyond the benefit they would now get after the minimum wage. The consumer surplus was the advantage that the employer was getting before the minimum wage. Overall, the market gets dead weight loss. Minimum wage works to the advantage of those who have employment in hand. However, it works to the detriment of the employer for the labour he has employed already.

Minimum wage affects unskilled labour markets where the workers do not have specific training or relevant experience for the work they are applying for. In the labour market, demand comes from employers and not from individual consumers. Similarly, the supply is not coming from big corporations, it is coming from individual workers.

Milton Friedman, Free market economist,  had argued ,’A minimum-wage law is, in reality, a law that makes it illegal for an employer to hire a person with limited skills’. His argument was that if you were willing to hire a teenager for a dollar fifty an hour, the law won’t let you as it would be illegal to hire someone for less than minimum wage. The law would say that you must hire him at a dollar sixty. If you didn’t want to pay that, or couldn’t afford to pay that, you would just end up not hiring him. As a result, this would produce unemployment among people with low skills.

The National minimum wage rate is currently £8.72 for workers over 25 (from April 2020). The minimum wage was introduced in April 1999 (at £3.60) and is the legal minimum that employers can pay.

The Profit Maximising Rule

Janet runs a stall in the local market where she sells burgers. One assumption we can safely make for any business is that it aims to make a profit. It is the same for Janet. She is wanting her stall to do well so that it earns a tidy profit for her.

Janet knows that maximum profit is earned when the total revenue earned by the stall exceeds the total cost of running the stall by the largest possible amount. When Janet raises the price of her burgers, she starts getting less customers. When she reduces the price of her burgers, she gets a lot more customers which leads to Janet dropping the prices further. Customers further increase but at this stage, Janet realises her business is running in a loss.

Janet’s friend Barbara explains profit maximising rule to her. Barbara tells her that the marginal revenue in Janet’s Burger stall is the addition to total revenue that results from selling one additional burger, while marginal cost in her stall is the cost of making the additional burger. Her cost of burger is constant and hence her marginal revenue remains constant no matter how many burgers she sells. However, Janet’s profit would be maximised at a point where marginal cost equals marginal revenue. This is the golden rule of profit maximisation: Maximum profit occurs at a point where marginal cost is equal to marginal revenue. This is considered the optimal level of production.

Why does profit maximise when MC=MR? This is because if marginal revenue was higher than marginal cost (ie if Janet earned more per additional burger than she spent on making that additional  burger), Janet would happily decide to make more burgers as it increased her profit directly. Conversely, if marginal cost was higher than marginal revenue (ie if Janet spent more on making an extra burger than she earned by selling it), she would decrease production as expanding her output was having a negative impact on her profit. However, the optimum level of production for Janet would occur when marginal revenue equalled marginal cost, which would be the point of maximum profit.

Keeping the Profit Maximising rule in mind helps a business to set the right price for their products. Thus, if Janet chooses to maximise the profits of her burger stall, she must choose that level of output where Marginal Cost (MC) is equal to Marginal Revenue (MR), and the Marginal Cost curve is rising. In other words, she must produce at a level where MC = MR.

 

At A, Marginal Cost < Marginal Revenue, then for each additional burger made, revenue will be higher than the cost so that Janet will make more burgers.

At B, Marginal Cost > Marginal Revenue, then for each extra burger produced, the cost will be higher than revenue so that Janet will make less burgers.

Thus, Janet’s optimal quantity of burgers produced should be at MC = MR

The MC = MR rule is quite adaptable so that Janet can apply the rule to many other decisions for her business. For example, she can apply it to hours of operation. She can decide to keep the burger stall open as long as the added revenue from the additional hour exceeds the cost of remaining open another hour.

 

 

 

LAW OF DIMINISHING RETURNS

 

Alice has an acre of land where she grows courgettes. Besides the land, she needs seeds, fertiliser, water and labour to ensure a good growth of courgettes. Alice realises that if she increases the amount of fertiliser, her output of courgettes will increase. However, there will be a point where too much fertiliser will reduce her courgette crop.

At this point, the additional courgette output from additional unit of fertiliser will be smaller than the additional output of courgette from the previous increase in fertiliser. The point at which the yield of courgette is highest after which it starts to decline is the point where the law of diminishing returns has kicked in.

So, what is the law of diminishing returns? At some point, employing an additional factor of production causes a smaller increase in output than expected.

Peter’s Cafe

Diminishing returns happen in the short run when one factor is fixed (eg capital). Take the example of a busy café run by Peter. Peter decides to hire extra workers. As his capital is fixed, he cannot expand the space in the café. Although the extra workers will increase production (number of cups of coffee made in a day), they will jostle into each other’s way as space will be limited. At some stage, the marginal increase in Peter’s income will stop or reduce. All this is true only if considered in the short run as all factors become variable in the long run. Thus, law of diminishing returns applies only in the short run.

Let us assume that each worker’s wage is £10 in Peter’s café. Thus, hiring an extra worker will cost an additional wage of £10. The Marginal cost MC of a cup of coffee will be the cost of the worker divided by the number of extra cups of coffee produced. If Marginal Product MP is the output by the extra worker, as MP increases, MC will decrease. And vice versa. Let Total Product TP be the total output by the workers.

 

 

 

CAFÉ WORKERS	Total cups (TP)	MP	MC
1	5	5	2
2	11	6	1.7
3	18	7	1.4
4	26	8	1.25
5	33	7	1.4
6	38	5	2

 

We can see that, at the addition of the fifth employee, diminishing returns set in. This is because as extra employees produce less, MC increases.

A very relatable example for students would be the amount of revision hours they put in for studying for an exam. If they study for three hours a day, they will improve their knowledge considerably. If they study for six to seven hours a day, they will gain knowledge exceedingly well. However, if they study into the late hours up to early morning, sacrificing their sleep, their gain in knowledge will be hardly noticeable as their exhaustion will not let the brain work to its full capacity.