Optimal Minimum Wage in Competitive Labor Markets∗

This paper presents a theoretical analysis of optimal minimum wage policy in a perfectly competitive labor market. Introducing a minimum wage is desirable if the government values redistribution toward low wage workers. This result remains true in the presence of optimal nonlinear taxes and transfers. In that context, a minimum wage effectively rations low skilled labor which is subsidized by the optimal tax/transfer system, and improves upon the second-best tax/transfer optimum. We derive formulas for the optimal minimum wage (with or without optimal taxes) as a function of the elasticities of labor supply and demand and the redistributive tastes of the government. The optimal minimum wage decreases with the demand elasticity for low skilled labor but increases with the supply elasticity of low skilled labor. The optimal minimum wage follows an inverted U-shape as a function of the strength of the redistributive tastes of the government. We present a number of numerical simulations to illustrate those results. When labor supply is along the extensive margin, a minimum wage should always be associated with in-work subsidies: the co-existence of minimum wages with high participation tax rates for low skilled workers is (second-best) Pareto inefficient. ∗David Lee, Department of Economics, Princeton University, Emmanuel Saez, University of California, Department of Economics, 549 Evans Hall #3880, Berkeley, CA 94720, [email protected]. We thank John Bound and David Card for useful discussions and comments.