Minimum Wage Matters
Skip to content
Podcast | Insight Unpacked Season 1: Extraordinary Brands and How to Build Them
Policy Strategy Economics Jun 1, 2010

Minimum Wage Matters

Increasing the minimum wage may not help low-wage workers

Based on the research of

Ohad Kadan

Jeroen Swinkels

The impact of increases in the minimum wage has long caused controversy in political and management circles. Supporters of regular increases argue that those raises are necessary to keep working people from falling below the poverty line. Opponents contend that the increases actually prevent less qualified workers from entering the labor pool because employers can no longer afford to hire them.

Unfortunately, little data existed to support either side, until now. Recently, a Kellogg professor helped to build a model that gives an unexpected answer to the question in one particular type of situation: the service sector that employs minimum-wage workers who depend on incentive payments as part of their earnings, such as servers who receive tips and retail employees and sales staff who work on commission. In these cases, the model strongly suggests that everyone—employers, customers, employees who lose their jobs, and even those who stay—ends up in a worse situation when the minimum wage increases.

“We show the increase will reduce the level of service, hurting customers,” says Jeroen Swinkels, a professor of Management and Strategy at the Kellogg School of Management, who developed the model in collaboration with Ohad Kadan, an associate professor at Washington University, St. Louis. “You end up with a smaller number of workers, and even those workers who keep their jobs are less happy, because they’re forced to work harder for less attractive incentive pay. The surprise is that it’s a lose-lose-lose situation—even for people who keep their jobs.”

Swinkels is quick to point out that the result is not an excuse to ignore the plight of the working poor, but that raising the minimum wage may not be the best way to affect change. Swinkels suggests that individual incomes can be lifted by helping workers find new, higher paying jobs, not by legislating higher pay. There are several ways to accomplish this, he says, from improving employer demand, to creating job-training programs, to improving labor market mobility. All help workers advance while insulating them from adverse market changes. As workers climb the ladder, Swinkels’ model shows their movements can also help the well-being of those who remain in their current jobs.

Unanswered Questions
Swinkels developed the model intending to answer a few longstanding questions: How does a firm choose to change incentives in response to a change in the minimum wage? Do the resultant incentives lead workers to work harder than before? What happens to employment? And are workers, even if they keep their job, better off? “The power of the model,” Swinkels says, “is in the way it tells how it’s going to come out in the wash.”

Swinkels and Kadan base their model on the so-called “moral hazard issue,” which itself stems from the “principal-agent problem.” This deals with situations in which the worker who undertakes specific actions—such as selling items in a department store or serving customers in a restaurant—has incentives that are different from those of the employer. In addition, what the worker does is not directly observable. “As an employer, I can’t see whether you work hard as a salesperson,” Swinkels explains. “I can see the sales you make, but I can’t directly observe whether you are doing the right things at the right moments. So the problem is one of how to provide incentives in this world.”

The new model emerged as part of a project to understand incentive pay in the context of a lower limit on what an employer can pay. “We haven’t had a good model for thinking about this before,” Swinkels says. “The standard model doesn’t allow the latitude to answer the question of how many workers the employer should spread the work among.”

To expand on the standard model, the two theorists relied on a couple of technical advances and a different mathematical approach. They also included recognition of the risks that employees experience when they operate in an environment of high incentives, such as working very hard for a sale that can’t be made for various reasons unrelated to the employee’s effort and ability. “The model incorporates thinking through what these contacts look like in the case of the minimum wage, or limited liability, or legal constraints,” Swinkels notes. “Finally, the model incorporates the ability of the firm to decide not only how hard individuals are working, but also to adjust the number of employees.”

That factor recognizes that employers have some flexibility in the face of an increase in the minimum wage. While the increase inevitably causes employees’ total effort to fall, because the minimized cost of the effort rises with the minimum wage, employers can deal with that decrease in effort in more than one way. For example, they can fire some workers and require everyone who remains to work harder. Or, they can continue to employ all their workers but, in order to maintain minimum overall costs, reduce (costly) incentives for extra effort—in effect, asking the employees to put forth a little less effort. Whichever path they choose, the employers have one end in mind. “It does not matter whether the word processing pool of a firm is typing up the notes of auto body claims adjusters or medical researchers,” Swinkels and Kadan write. “The right thing to do is to minimize the cost per page typed accurately.”

A Series of Trade-offs
For many positions, such as rental car clerks or restaurant servers, firms face the issue of finding enough qualified employees for the total pay package of wages and incentive pay that they offer. Raising the minimum wage would make it a little easier for those firms to recruit the right people. But then, Swinkels and Kadan observe, the firms would reshuffle their incentive pay because they are no longer as worried about recruitment.

This is just one of the possible outcomes of the new model. Overall, Swinkels continues, “We show increases in the minimum wage will reduce the level of service, hurting customers. The surprise is that you end up with a smaller number of workers, and even those workers who keep their jobs are less happy, because they’re forced to work harder for lower incentives. Once the firm has adjusted the number of workers and the market in which it operates has balanced, you end up with harder working, more miserable workers.”

Swinkels emphasizes that the model’s results have implications beyond service area firms and their employees. “Many of these factors will apply to relationships between a firm and its suppliers, involving penalties for suppliers’ poor performance,” he explains. “It can also apply to boards of directors’ treatment of CEOs. And the same piece of mathematics says how a firm will adjust when its employees have more attractive outside options.”

So far, the model remains a theoretical pursuit. “It screams for empirical testing,” Swinkels says. “We hope that it will excite empirical activity by people better qualified at that than ourselves.” Nevertheless, he continues, the project carries a strong message. “The implication is that if you want to help the working poor, this is not the way. There are smarter ways of doing so than by raising wages in the service sector.”

Featured Faculty

Richard M. Paget Professor of Management Policy; Professor of Strategy; Chair of Personnel Committee

About the Writer
Peter Gwynne is a freelance writer based in Sandwich, Mass.
About the Research

Ohad Kadan and Jeroen Swinkels. 2010. Minimum Payments, Incentives, and Markets. Working paper, Kellogg School of Management.

Read the original

Most Popular This Week
  1. Your Team Doesn’t Need You to Be the Hero
    Too many leaders instinctively try to fix a crisis themselves. A U.S. Army colonel explains how to curb this tendency in yourself and allow your teams to flourish.
    person with red cape trying to put out fire while firefighters stand by.
  2. How Experts Make Complex Decisions
    By studying 200 million chess moves, researchers shed light on what gives players an advantage—and what trips them up.
    two people playing chess
  3. What Went Wrong with FTX—and What’s Next for Crypto?
    One key issue will be introducing regulation without strangling innovation, a fintech expert explains.
    stock trader surrounded by computer monitors
  4. What Triggers a Career Hot Streak?
    New research reveals a recipe for success.
    Collage of sculptor's work culminating in Artist of the Year recognition
  5. How Much Do Campaign Ads Matter?
    Tone is key, according to new research, which found that a change in TV ad strategy could have altered the results of the 2000 presidential election.
    Political advertisements on television next to polling place
  6. What’s the Secret to Successful Innovation?
    Hint: it’s not the product itself.
    standing woman speaking with man seated on stool
  7. Which Form of Government Is Best?
    Democracies may not outlast dictatorships, but they adapt better.
    Is democracy the best form of government?
  8. Immigrants to the U.S. Create More Jobs than They Take
    A new study finds that immigrants are far more likely to found companies—both large and small—than native-born Americans.
    Immigrant CEO welcomes new hires
  9. How Are Black–White Biracial People Perceived in Terms of Race?
    Understanding the answer—and why black and white Americans may percieve biracial people differently—is increasingly important in a multiracial society.
    How are biracial people perceived in terms of race
  10. Yes, Consumers Care if Your Product Is Ethical
    New research shows that morality matters—but it’s in the eye of the beholder.
    woman chooses organic lettuce in grocery
  11. What Donors Need to Hear to Open the Checkbook
    Insights from marketing on how charities can grow by appealing to different kinds of donors.
  12. Why Well-Meaning NGOs Sometimes Do More Harm than Good
    Studies of aid groups in Ghana and Uganda show why it’s so important to coordinate with local governments and institutions.
    To succeed, foreign aid and health programs need buy-in and coordination with local partners.
  13. What Went Wrong at AIG?
    Unpacking the insurance giant's collapse during the 2008 financial crisis.
    What went wrong during the AIG financial crisis?
  14. The Complicated Logic Behind Donating to a Food Pantry Rather than Giving a Hungry Person Cash
    If we were in need, we’d likely want money. So what accounts for that difference?
    Donating food is paternalistic aid
  15. Product Q&A Forums Hold a Lot of Promise. Here’s How to Make Them Work.
    The key to these online communities, where users can ask and answer questions, is how many questions get useful answers.
    man sits at computer reading Q&A forum
  16. Podcast: What the FTX Meltdown Means for the Future of Crypto
    The implosion of the crypto exchange has sent the industry reeling. We dig into what happened and whether cryptocurrency, as a concept, can weather the storm.
  17. What the New Climate Bill Means for the U.S.—and the World
    The Inflation Reduction Act won’t reverse inflation or halt climate change, but it's still a big deal.
    energy bill with solar panels wind turbines and pipelines
  18. To Improve Fundraising, Give Donors a Local Connection
    Research offers concrete strategies for appealing to donors who want to make an impact.
    Charity appeals that frame the message around local connection tend to be more successful as a result of the proximity effect
  19. Post-War Reconstruction Is a Good Investment
    Ukraine’s European neighbors will need to make a major financial commitment to help rebuild its economy after the war. Fortunately, as the legacy of the post–World War II Marshall Plan shows, investing in Ukraine's future will also serve Europe's own long-term interests.
    two people look out over a city
More in Policy