Optimal minimum wage policy in competitive labor markets

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 minimum wage induced unemployment 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 low skilled labor which 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, and therefore, the co-existence 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 or without optimal taxes) as a function of the elasticities of labor supply and demand and the redistributive tastes of the government and present some illustrative numerical simulations. ∗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 Daron Acemoglu, Marios Angeletos, John Bound, Pierre Cahuc, David Card, Kenneth Judd, Guy Laroque, Etienne Lehmann, and numerous seminar participants for useful discussions and comments.