Trade and minimum wages in general equilibrium: Theory and evidence

Journal: Journal of International Economics

This paper in the Journal of International Economics (Bai et al. 2021) is truly international in collaboration and scope. This is Dr. Arpita Chatterjee’s joint work with Xue Bai (Brock University, Canada), Kala Krishna (Penn State University, USA) and Hong Ma (Tsinghua University, China).

In this paper, the authors derive a novel prediction regarding the effect of minimum wages on selection, namely that a binding minimum wage will raise (or lower) TFP at the firm and industry level depending on whether the capital intensity of entry costs exceeds (falls short of) that of production and find robust, causal evidence in support of their theoretical prediction using rich regional variation in minimum wages across Chinese counties and firm level production data.

Minimum wages are clearly highly relevant for policy, especially today with growing inequality being a concern in most countries, particularly those without a strong redistribution policy in place. There is extensive work on the impact of minimum wages on the labour market. However, the impact of minimum wage on the producers is poorly understood. The general concern is that a rising minimum wage raises cost of production which leads to increase in price and fall in demand, and hence is generally harmful for the producers in labour-intensive industries. However, this simplistic analysis overlooks the richness of productivity heterogeneity, both within and across firms, which is a well-established empirical fact in international trade and industrial organisation.

The authors build on a standard two-factor neoclassical model, but with endogenous entry of heterogeneous firms with upward sloping supply curves. These curves arise from firms having a finite number of units of capacity, each with a (possibly) different marginal cost of production. Selection here essentially refers to the firms’ choice of unit capacities to use in production given prevailing cost and demand conditions. Total factor productivity (TFP) rises when high-cost capacity is shut down by a firm and/or low productivity firms exit.

The authors show that a higher minimum wage makes selection stricter, and hence TFP at the firm

and industry level higher when entry costs are more capital intensive than production costs. This is more so the higher is the gap in capital intensity in entry and production costs, and the lower is overall capital intensity. To put things simply, in a setup with only two goods with different capital intensities of production and firms utilising both goods for entry, labour intensive industries will experience a higher growth in TFP following a rise in minimum wage. This is essentially because rising cost of labour is more binding for the labour-intensive producers forcing them to be more selective regarding their choice of unit capacities.

The authors use firm survey data from China, where different counties set and frequently change minimum wages, to test the predictions of the model. They exploit the nature of institutional setup of minimum wages in China to establish the causal evidence and construct a novel measure of capital intensity of entry cost relative to production based on firm-age specific distribution of factor intensity to find support in favour of their mechanism.

There is strong evidence in the data in support of their mechanism. For example, an increase of 500 Chinese Yuan a year, a roughly 10% increase in the minimum wage, leads to a roughly 4:4% increase in firm total factor productivity (TFP). Their theoretical argument regarding the impact on firm exit is more nuanced, combining both the selection and demand effects, but in the short run the probability of exit rises by 2.8 percentage points following a 10% increase in minimum wage.

A similar result regarding firm exit is observed in the restaurant industry in the San Francisco Bay Area in Luca and Luca (2019). However, with a focus on the within-firm (and not just across firm) heterogeneity and a mechanism relying on differential factor intensities in the cost of entry and production, the authors are able to establish robust evidence of the impact of minimum wages on the firm-level TFP of surviving firms. This shows that the impact of minimum wages on the production side is more nuanced in the presence of complex patterns of heterogeneity and we need to look beyond the effects on price and demand to understand its impact.

A perfectly competitive setting is clearly not the right one to study optimal minimum wage policy since it abstracts away from all types of labour market distortions (such as search and matching frictions and monopsony power in the labour market) that are the rationale for such policies. Incorporating selection effects of minimum wage in a model with labour market power is an exciting agenda for future research.

References:

Bai, X., Chatterjee, A., Krishna, K. and Ma, H., 2021. Trade and minimum wages in general equilibrium: Theory and evidence. Journal of International Economics, 133, p.103535.

Luca, D.L. and Luca, M., 2019. Survival of the fittest: the impact of the minimum wage on firm exit (No. w25806). National Bureau of Economic Research.