Thinking About Labour Markets: Partial Equilibrium Fallacies

I think by this time we all know that empirically, a minimum wage doesn’t seem to have the negative effect on employment that conventional economic analysis says it does. The reason for that is the Econ 101 standby of analysing policy changes based on ceteris paribus – a partial equilibrium approach. Holding everything constant and changing just one variable is a very useful way of thinking about economic issues, but it risks missing out on real world implications when you forget that economic systems are, in fact, actually systems.

For the uninitiated, here’s a look at the classical view of the impact of a minimum wage:

The labour market is in equilibrium where the supply and demand curves intersect (S1 and D1). At that point (E1), labour demanded and labour supplied are exactly balanced, and there is no unemployment. Assume the government imposes a minimum wage (MW), which is higher than the market clearing wage. Labour supply increases to X1, while labour demanded falls to X2.

We now have a market in disequilibrium, with labour supplied exceeding labour demanded (X1 - X2), which means we get unemployment, QED. That’s the partial equilibrium, ceteris paribus perspective.

But the increase in wages (even for the fewer people in employment) causes consumption and thus aggregate demand to increase, which increases firm profits and increases the demand for labour. That shifts the demand curve for labour to the right:

Now the market is in equilibrium, but at point X1, where demand and supply are balanced again, but at a higher wage level and with higher employment to boot.

In practice, whether this actually happens depends a great deal on a host of other factors such as the elasticity of labour demand and supply, the ability of production to expand, the flexibility of the labour market, as well as the pass through of wage costs into consumer prices (that’s one inevitable consequence of a minimum wage).

Either way, it’s not a foregone conclusion that unemployment rises with an increase in the minimum wage. Analysis of this sort needs to take into account the systemic nature of national economies, and the potential for positive and negative feedback loops.

The reason why I’m belabouring this point is that this mistake is fairly common, and applies to another labour market bugbear – foreign labour. Ironically, it seems as if the very same people who accept the relatively benign impact of a minimum wage, forget the systemic perspective when foreign labour is being discussed.

Here’s the partial equilibrium, ceteris paribus perspective of foreign labour:

From the E1 with wages W1, an increase in foreign labour shifts the labour supply curve to the right (S1 to S2). Labour supplied and employed increase to X1, while the wage rate drops to W2. Therefore, an increase in foreign labour causes wages of all workers to fall, QED.

But taking the systemic persepctive again, an increase in total labour employed (even at the lower wage rate), increases consumption and aggregate demand, which again increases firm profits and thus labour demand:

The labour demand therefore also shifts to the right. The new equilibrium returns wages to the initial level (W1), and the larger number of workers are absorbed into the workforce (E2). Again in practice, the impact on wages and employment depend a great deal on demand and supply elasticities, and the consumption and production functions involved.

I’m grossly oversimplifying here (especially in my paint-by-the-numbers examples), but it’s not a foregone conclusion that employing foreign labour causes domestic wages or domestic employment to fall. The latest World Bank study on the impact of immigrant labour in Malaysia suggests that wage competition largely resides within the foreign labour market itself, and marginally affects domestic wages only at the very bottom of the market. As a whole, employment is unaffected, and overall wages for domestic labour are actually slightly higher.

There are other, perhaps more relevant, considerations with employing large amounts of foreign labour, such as cultural integration and social equity (e.g. the wedge between taxes and benefits). But I don’t think wages or employment for locals are really the most important economic or social issue here. The discourse on foreign labour in Malaysia really needs to move on from fear mongering about jobs and income.