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Minimum Wage, Selection and Welfare: A General Equilibrium Analysis

by Hashmi, Aamir

I study the effects of a permanent increase in minimum wage on unemployment, income and welfare in a general equilibrium setting. The increase in minimum wage affects the demand for labor on both intensive and extensive margins. On the intensive margin, individual firms respond to the increase by reducing their demand for low-wage workers. One the extensive margin, the increase affects the equilibrium number of firms by altering their incentives to enter and exit. I build on the general equilibrium model in Hopenhayn and Rogerson (Journal of Political Economy, October 1993, volume 102, issue 5, pp. 915--938) to quantify these effects. There are three types of consumers in my model: type 1 are the minimum-wage earners; type 2 are other workers; and type 3 are entrepreneurs who own firms and consume profits. Firms are heterogenous with respect to productivity and produce according to a labor-only decreasing-returns-to-scale constant-elasticity-of-substitution production function. The model features entry and exit, and the cost of entry is positively related to the mass of entrants. I calibrate the model to US data and use it to quantify the effects of a counterfactual 25% permanent increase in minimum wage. In my preferred post-increase scenario, in which the wages of other workers are downward rigid, overall unemployment increases by 3.2%, and income and welfare decrease by 2.1% and 1.5%, respectively. On the intensive margin, the average firm size (as measured by the number of workers) is 1.4% smaller. On the extensive margin, there are 1.7% fewer firms in the new equilibrium.

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