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Optimal Minimum Wage Policy in Competitive Labor Markets

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  • David Lee

    (Princeton University and NBER)

  • Emmanuel Saez

    (University of California, Berkeley and NBER)

Abstract

This paper provides a theoretical analysis of optimal minimum wage policy in a perfectly competitive labor market. We show that a binding minimum wage, while leading to unemployment, is nevertheless desirable if the government values redistribution toward low wage workers and if unemployment induced by the minimum wage hits the lowest surplus workers first. This result remains true in the presence of optimal nonlinear taxes and transfers. In that context, a minimum wage effectively rations the low skilled labor that is subsidized by the optimal tax/transfer system, and improves upon the second-best tax/transfer optimum. When labor supply responses are along the extensive margin, a minimum wage and low skill work subsidies are complementary policies; therefore, the coexistence of a minimum wage with a positive tax rate for low skill work is always (second best) Pareto inefficient. We derive formulas for the optimal minimum wage (with and without optimal taxes) as a function of labor supply and demand elasticities and the redistributive tastes of the government. We also present some illustrative numerical simulations.

Suggested Citation

  • David Lee & Emmanuel Saez, 2008. "Optimal Minimum Wage Policy in Competitive Labor Markets," Working Papers 1099, Princeton University, Department of Economics, Center for Economic Policy Studies..
    • Handle: RePEc:pri:cepsud:178
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    More about this item

    JEL classification:

    • E24 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Employment; Unemployment; Wages; Intergenerational Income Distribution; Aggregate Human Capital; Aggregate Labor Productivity
    • J24 - Labor and Demographic Economics - - Demand and Supply of Labor - - - Human Capital; Skills; Occupational Choice; Labor Productivity
    • J38 - Labor and Demographic Economics - - Wages, Compensation, and Labor Costs - - - Public Policy

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