Guest Post: Minimum Wage Laws and the Labor Market: What Have We Learned Since Card and Krueger’s Book Myth and Measurement?

Because of Alan Krueger’s appointment to the CEA, I figured there would be a lot of interest in his previous work on the minimum wage.  In order to figure out how that body of work has aged, I reached out to friend-of-the-blog Arindrajit Dube.  Dube is an Assistant Professor in the Department of Economics at the University of Massachusetts Amherst who has also done similar studies on the minimum wages, including the major 2010 work Minimum Wage Effects Across State Boundaries.  Dube was kind enough to write the following guest post, examining Krueger’s work 15 years later.

Originally Posted At New Deal 2.0.

Alan Krueger’s recent appointment to head the Council of Economic Advisers has led to renewed interest in his book on minimum wages, coauthored with David Card, called Myth and Measurement. In that book, published in 1995, the authors forcefully argued that the evidence showing minimum wage increases killed jobs was fragile. Their own case study comparing fast food restaurants in New Jersey and Pennsylvania after a minimum wage increase in New Jersey showed that if anything, employment rose in New Jersey following the legislated hike.

Myth and Measurement went on to argue that the totality of evidence pointed towards the inadequacy of the simple supply-and-demand model for understanding the labor market for low-wage workers. Instead, they argued employers have some power to choose wage polices: paying a little bit more would attract more workers to a company and reduce the number leaving the company because of a better offer, but would mean higher labor costs due to paying more to those who would have stayed at the firm anyway — the “inframarginal” workers. Card and Krueger called this the “dynamic monopsony” model, and they argued that it accorded with the data much better than the canonical supply and demand model.

The reaction to the book was unforgettable, even for those of us who were mere undergraduates at the time. Mixed in with praise for the authors’ clear-headed (if brave) analysis was scathing commentary from established labor economists who considered Myth and Measurement nothing short of heresy. In his 1995 review of the book inIndustrial and Labor Relations Review, Daniel Hammermesh scolded the authors that “[a] wonderful world of reduced inequality through higher wage minima with no loss of jobs is regrettably not an option.” It has been an eventful 16 years since the publication of that book, so it seems a good time to take stock of how the authors’ central theses have stood the test of time. Writing a retrospective review of Myth and Measurement is particularly tempting, since I just finished a review of the more recently published book Minimum Wages by David Neumark and William Wascher for the Journal of Economic Literature, which should be coming out in September. (For the uninitiated, Neumark and Wascher have staked out a position in the minimum wage debate arguing that minimum wages reduce jobs and increase poverty, and therefore implementing them is generally an undesirable policy.)

So what have we learned from — and since — Myth and Measurement? Let me highlight three things. First, it is useful to understand the methodological contribution of Card and Krueger’s work. The idea of using “natural experiments” — where there is a sudden change in policy — was a hallmark of their work and since then has become a standard device in the empirical economist’s toolkit. Additionally, the idea that geographical proximity is a good way to construct a control group has been strongly vindicated by many studies, including ones looking at minimum wage impacts. Indeed, today there is a plethora of studies using border discontinuity designs. While there were problems with their case study when it came to properly accounting for statistical power (something that I take up below), overall Card and Krueger’s work has made a lasting (and positive) methodological contribution.

Second, Card and Krueger’s own follow-up work (Card and Krueger 2000), as well as subsequent studies, largely validated the claim that fast food employment does not drop in any meaningful way in response to the kind of minimum wage increases that we have seen in this country. While critics typically focused on the fact that they found sizeable positive effects on jobs in some cases, the more policy relevant point of the book was that minimum wages do not seem to “kill jobs” while they raise wages at the bottom. This point has been firmly borne out by careful follow up research.

And finally, the idea that search frictions may mediate minimum wage impacts has been taken up by numerous papers since Myth and Measurement — and has become much less controversial than at the time it was proposed. All in all, I would consider that a pretty good track record for any book in economics.

Findings on Employment

Let’s begin with the book’s core empirical findings about the impact of minimum wages on jobs in the fast food industry. What most stirred up the profession was that in some of Card and Krueger’s specifications, employment in New Jersey actually rose in response to the mandated wage increase in a statistically significant fashion. The positive effect was inconsistent with the competitive model, but was consistent with a monopsonistic model where employers have some wage setting power.

However, the authors pointed out that in other specifications (especially those that were not weighted by firm size), the estimates were much less precise. They argued that “at a minimum, we believe that our estimates call into question the prediction that an increase in the minimum wage will lead to significant employment losses at affected firms. In particular, even our least precise estimates reject the hypothesis that the elasticity of demand for labor by fast-food employers is greater than 0.3 in absolute value.”

Subsequent research that built on Myth and Measurement has found that while the sizeable positive effects in some of their specifications were likely due to chance, the lack of job loss was very much a robust finding. Card and Krueger’s own subsequent analysis in 2000 using Unemployment Insurance filings by firms (which was closer to the universe of firms in the two states than their original sample) over a longer period already moved towards this view, as the employment elasticities, while still positive, were smaller in magnitude and not statistically distinguishable from zero.(1) My own work with William Lester and Michael Reich (2010) demonstrated this point by comparing contiguous counties across state borders and pooling over 64 different border segments with minimum wage differences over a 17-year period (1990-2006). It’s like doing 64 different NJ-PA “experiments” and pooling them together. In the figure below, the dark line shows the distribution of the measured employment elasticity across the 64 “experiments.” The four vertical lines are four different published estimates from individual case studies in the literature.

Local areas are buffeted by all kinds of economic shocks, and even if these are not correlated with minimum wage increases on average, they lead to clustering in the data, leaving us with less statistical variation than may be apparent at first glance. Such clustering was not accounted for in Card and Krueger’s work or virtually in any work during that time, which explains why a sizeable positive effect could be found by chance alone. Since then, we have learned that computing standard errors without accounting for such clustering can lead to false precision. At the end of the day, however, our key conclusions were similar to Card and Krueger’s, as the implied labor demand elasticity was effectively zero, and “statistical bounds (at the 95% confidence level) around our contiguous county estimates of the labor demand elasticity as identified from a change in the minimum wage rule out anything above 0.48 in magnitude.” (The labor demand elasticitity measures the proportional change in employment for a group of workers in response to a proportional change in their wages.) Importantly, although one of the common criticisms of Myth and Measurementwas that it only considered short-run responses, we also showed that was not a fatal flaw. Even when we considered long-term effects using a 17-year panel, the finding of no disemployment effect remained.

What about other research since Myth and Measurement that has looked at the effect of minimum wages on jobs in the U.S.? The most common since the 1990s has been the “state panel” approach pioneered by David Neumark and William Wascher. Like the individual case study, it uses only differences in minimum wages across states to form inference. However, instead of comparing two areas that may be similar based on, say, proximity, the “state panel” studies effectively compare all states to all states, while accounting for possible differences by including statistical controls. The state panel approach has tended to find negative effects, especially when considering a high impact demographic group such as teenagers.(2) For example, in their 2008 book titled Minimum Wages, Neumark and Wascher review 10 state panel studies following up on the initial controversy; nine out of 10 of these studies find evidence for jobs loss.

There are some obvious virtues for the state panel approach, since it uses a lot more variation than an individual case study. However, it also assumes that we can find enough control variables to include in our regression that will make Texas look like Massachusetts. As it turns out, this is a heroic assumption that badly biases the results.

In a series of papers (Allegretto Dube Reich 2009, 2010; Dube Lester and Reich 2010, 2011) we show the nature of bias in the state panel studies. The kind of states that have tended to have higher minimum wage in the past 20 years have been quite different from those who have tended to have lower minimum wages. As an example, today 11 states plus DChave a local minimum wage of at least $0.25 above the federally mandated minimum of $0.25/hour. Eight of these 11 states are either in New England or on the West Coast. (The remaining three are Illinois, New Mexico, and Nevada.)

In other words, there is a very strong regional component to the minimum wage variation. This can lead to very misleading inference if we compare teen employment growth in, say, Texas and Massachusetts. Given factors such as climate, proximity to Mexico, and others that are usually not fully accounted for in state panel approaches, we might expect very different trends in employment in those states quite apart from minimum wages. Similarly, the growth rate in low-wage jobs has been quite different in states like Texas, North Dakota, and Indiana even thought these states have had the same binding minimum wage (i.e., the federal) over the past two decades. Unless one controls for the “unobserved” (or more accurately “not directly observed”) sources of heterogeneity in the growth prospects across areas, conclusions may be badly flawed. A telltale sign of this flaw that our studies revealed is that in the state panel model, the job losses occur substantially prior to the actual change in policy.

So what are some ways of correcting the deficiencies of the state panel approach? One fruitful way is to recognize the core insight of Card and Krueger’s research design that compared areas across the NJ-PA border. When comparing places directly across a border, many other (potentially unobservable) confounding factors are roughly similar. We implemented this strategy in numerous papers using a variety of data sets (QCEW, QWI, CPS, Census). The results were unambiguous: whatever group we considered — restaurant workers, teenagers, teenagers of disadvantaged backgrounds — the state panel approach always produced an erroneous negative estimate when it came to employment. Once we accounted for the regional heterogeneity, there was no employment loss to speak of. Other authors who have accounted for such heterogeneity largely confirm that employment effects from minimum wage increases in the US have been close to zero or even positive (e.g., Addison et al., 2009, 2011).

Inadequacy of the Simple Supply and Demand Model of the Labor Market

Another important part of Myth and Measurement argued for the inadequacy of the simple supply-and-demand model in thinking about the low-wage labor market. Card and Krueger’s primary evidence for this view was that employment didn’t fall, and may have risen, in response to a minimum wage increase. A simple model of “monopsony” is a firm that has some wage setting power due to search frictions. Employees say to themselves, “If my employer doesn’t give me the raise I was promised I might look for other jobs, but there is no guarantee I’ll find one to my liking immediately.” Conversely, raising the wages a little won’t immediately lead to a crush of workers outside the office, since only a fraction of potential workers may find out about it.

In Card and Krueger’s dynamic monospony model, separation and recruitment rates are functions of the wage rate and so the model allows positive firm-level labor supply elasticities. They argue that empirically plausible magnitudes of the labor supply elasticities facing a firm are consistent with small positive or zero effects of a minimum wage increase on employment levels. Why? Because firms do not fully internalize the gains from paying a slightly higher wage. A higher wage reduces quits and increases recruitment among “marginal workers,” thereby increasing employment. But a higher wage also means paying more to those who would have stuck around anyway — the “inframarginal workers.” This logic means firms don’t raise wages as high as is “efficient” from a societal, as opposed to a profit maximization, perspective. When a minimum wage hike raises the bottom wage, it leads to fewer quits and more recruitment, and hence greater employment. Of course eventually, if the wage is raised enough, the firm may simply go out of business. But over a range, the effect of increasing jobs at some firms may dominate the reduction of jobs from firms not producing at all.

So how has subsequent research spoken to the issue of “dynamic monopsony” or “search friction”? One piece of evidence comes from this year’s Nobel Prize in Economics to Professors Peter Diamond, Dale Mortensen and Christopher Pissarides “for their analysis of markets with search frictions.” In other words, thinking about the labor market in terms of search frictions has become eminently respectable. Indeed, Dale Mortensen’s paper (with Kenneth Burdett) in 1998 formalized the dynamic monopsony model in an equilibrium context with search frictions and competition. Such a model can help us understand a variety of facts about the low wage labor market: why similar workers are paid differently, why there is so much job-to-job mobility, and — wait for it — why minimum wage policies could have little in the way of disemployment effects. Indeed, in some cases, by compressing the wage distribution, minimum wage increases may actually improve the functioning of the labor market.

In recent work with Michael Reich and William Lester (2011), we estimated the effect of minimum wages on separations and new hires, along with the effects on employment and wages. We find a striking pattern when we consider either a high-impact demographic group (teens) or a high-impact sector (restaurants): while the effect of minimum wages on employment is close to zero, both separations and new hires fall sharply in response to a minimum wage hike. As we then go on to show, this “trifecta” of results — strong positive wage effect, close to zero employment effect, and strong negative turnover effect — are a signature of a Burdett-Mortensen type model with a sizeable amount of search frictions. We estimate that the “labor supply elasticity” facing the firm falls in the 4 to 10 range, suggesting wages are about 10-20 percent lower due to employers’ market power. While quantitatively our estimates of labor market power are in the lower range of Card and Krueger’s suggestions, the qualitative importance of search frictions is borne out in the data with more careful work. And more recent firm-level studies, such as those surveyed by Ashenfelter, Farber and Ransom (2010) in an entire volume of the Journal of Labor Economics devoted to the issue of monopsony, have indeed found labor supply elasticities consistent with substantial wage setting power.

Today, thankfully, we do not need a large positive minimum wage effect on employment to motivate the use of more realistic models of the labor market. The importance of frictions is borne out through many other types of empirical evidence — including the extent of wage dispersion, especially for similar workers, or how turnover responds to minimum wage policies, to name a few. Many papers (e.g., Flinn 2006, Giuliano 2007 ) have looked at how minimum wage effects may vary when the labor market is characterized by search or information frictions. The fourth volume ofHandbook of Labor Economics has an entire chapter by Alan Manning on “Imperfect Competition in the Labor Market.” In that sense, Myth and Measurement was a harbinger of things to come.

Standing the test of time is a challenge for any work, but especially so for a book that has elicited such vitriol from some corners of our profession. In another review of the book in Industrial and Labor Relations Review, labor economist Finish Welch had this to say: “I question David Card and Alan Krueger’s models and how they do empirical research. Although the notoriety surrounding Myth suggests important conclusions that challenge economists’ fundamental assumptions, I am convinced that the book’s long-run impact will instead be to spur, by negative example, a much-needed consideration of standards we should institute for the collection, analysis, and release of primary data.” Sixteen years later, it is safe to say that the book’s long-run impact has not been on standards for collection, analysis and release of primary data. Instead, what has happened is that today, writing a paper arguing that moderate increases in minimum wage do not have any appreciable effect on jobs because the labor market exhibits search friction is not a conversation stopper or a career ender. On that count alone, Myth and Measurement should be considered a success.

(1) Neumark and Wascher (2000) evaluated payroll records from restaurants from a sample that was in large part collected by the lobbying organization Employment Policies Institute and found that the policy clearly reduced employment. However, as shown in Card and Krueger (2000) who used administrative UI records, this was likely driven by the selective nature of that payroll data.

(2) The reason labor economists studying minimum wages have focused so much on teens is not because we think that the impact on teens is especially important from a policy perspective. Rather, the reason is because such a high fraction of teens (around a quarter) earn the minimum wage, making them the canary in the coalmine when it comes to detecting minimum wage effects. A similar logic applies to studying restaurant workers.