Nearly 100 cities in the United States have enacted “living wage” ordinances. These laws typically set minimum wages that are far above the federal minimum and cover municipal employees or workers in firms that have business dealings with the city. As of December 2002, the living wage was $8.70 (per hour) in Ann Arbor, MI; $10.25 in Boston, MA;
$10.86 in New Haven, CT; and $10.36 in San Jose, CA.
Although the living wage ordinances are relatively recent, a number of studies have already attempted to measure the impact of this type of minimum wage on wages and employment in the affected localities. 36 Few workers are covered by this type of legislation, so one might suspect that it would be difficult to detect any economic impact of the higher local minimum wage. Moreover, it is difficult to evaluate the impact of a living wage ordi- nance in a particular locality since it is unclear what the “control group” should be. Perhaps localities that choose to enact living wage ordinances are localities that have employment and economic conditions that are quite different from those of other localities.
One recent study does a particularly good job at trying to estimate the impact of living wages by defining the control group as the sample of cities that attempted to pass living wage ordinances, but where the attempt failed due to legal constraints. 37 Baton Rouge and Salt Lake City, for instance, passed living wages ordinances, but state law blocked each city’s efforts. Similarly, a judge ruled that the St. Louis living wage ordinance was unconstitutional.
The comparison of employment trends in cities where the living wage ordinance was suc- cessful with those in cities where the ordinance eventually failed or was derailed shows that living wages do indeed raise the average wage level in the city, but they have adverse employ- ment effects. An analysis of nearly 100 living wage ordinances indicated that the presence of a living wage ordinance in a locality reduced the probability of employment for persons in the bottom decile of the wage distribution, with the employment elasticity being around 0.1.
3-11 Adjustment Costs and Labor Demand
The model of labor demand derived in this chapter assumes that firms instantly adjust their employment when the economic environment changes. A firm wishing to adjust the size of its workforce, however, will typically find that it is costly to make quick changes. A firm laying off a large number of workers, for instance, will certainly incur substantial costs when the experience and knowledge of those workers vanish from the production line.
A firm wishing to expand employment will find that hiring additional workers might be equally costly: the firm will have to process the job applicants through the personnel office
36 The literature is surveyed by Scott Adams and David Neumark, “The Economic Effects of Living Wage Laws: A Provisional Review,” Urban Affairs Review 40 (November 2004): 210–245. A nice exam- ple of is given by Larry D. Singell Jr. and James R. Terborg, “Employment Effects of Two Northwest Minimum Wage Initiatives,” Economic Inquiry 45 (January 2007): 40–55.
37 Scott Adams and David Neumark, “The Effects of Living Wage Laws: Evidence from Failed and Derailed Living Wage Campaigns,” Journal of Urban Economics 58 (September 2005): 177–202.
and train the new workers. The expenditures that firms incur as they adjust the size of their workforce are called adjustment costs .
There are two types of adjustment costs: variable adjustment costs and fixed adjustment costs. Variable adjustment costs depend on the number of workers that the firm is going to hire or fire. For example, the costs of training new workers obviously depend on whether the firm hires 1 or 10 workers. In contrast, fixed adjustment costs do not depend on how many workers the firm is going to hire or fire. Some of the expenses incurred in running a personnel office are independent of the number of job applicants or of the number of pink slips that the office might be processing.
Let’s initially consider the firm’s employment decisions in the presence of variable adjustment costs. Figure 3-21 illustrates one possible shape for the firm’s variable adjust- ment cost curve. It costs the firm C 0 dollars to hire an additional 50 workers. It also costs the firm C 0 dollars to fire 25 workers. As drawn, it costs more to fire than to hire. This asymmetry might arise because of government policies that mandate employers to provide severance pay for workers who are laid off.
The variable adjustment cost curve illustrated in Figure 3-21 also incorporates the impor- tant assumption that the adjustment costs rise at an increasing rate, regardless of whether the firm is contracting or expanding. In other words, the marginal cost of adjustment (that is, the costs associated with hiring or firing an additional worker) is higher for the 50th worker hired than for the 25th worker hired. Similarly, the costs associated with handing out the 25th pink slip are lower than the costs associated with handing out the 50th pink slip.
It is easy to describe what happens to the firm’s employment as the firm attempts to hire or fire additional workers in the presence of variable adjustment costs. Suppose, for instance, that the price of the output increases and that the firm expects this price increase to continue indefinitely. We know that the increase in output price will induce the firm to increase its employment from, say, 100 workers to 150 workers. Because it is costly to make an immediate transition to a new equilibrium, the firm will proceed slowly in hiring
Variable Adjustment Costs
Change in Employment C0
+50
−25 0
FIGURE 3-21 Asymmetric Variable Adjustment Costs
Changing employment quickly is costly, and these costs increase at an increasing rate. If government policies prevent firms from firing workers, the costs of trimming the workforce will rise even faster than the costs of expanding the firm.
the additional workers, as illustrated by the adjustment path AB in Figure 3-22 . A profit- maximizing firm will find that it is not worthwhile to hire all the additional workers imme- diately because the costs resulting from hiring a large number of workers at the same time exceed the costs incurred when hiring just a few workers at a time.
The same kind of slow adjustment occurs if the firm faces a decrease in output price.
The firm would then like to cut employment from its initial level of 100 workers to 50 workers. Laying off too many workers at once, however, is disruptive, and the greater the number of layoffs, the higher the marginal cost of adjustment. The firm, therefore, will cut employment slowly, as illustrated by the adjustment path AC in Figure 3-22 . As drawn, the firm is much slower in cutting employment than in adding workers. This asymmetry might arise if government mandates make it difficult for firms to trim their workforce.
Consider now the case where all of the adjustment costs are fixed and suppose that the firm is now hiring 100 workers, but, in response to an increase in output price, it would like to switch to a higher employment level of 200 workers. The instant the firm makes any change in its employment (whether adding 1 or 100 workers), the firm incurs this fixed adjustment cost. The firm then has two options. It can either choose to remain at its current employment level of 100 workers or adjust its employment to 200 workers. It does not pay for the firm to adjust its employment slowly because the fixed adjustment costs will be incurred regardless of how many additional workers the firm actually hires.
If the firm is going to adjust its employment, it might as well adjust to the optimal level immediately.
FIGURE 3-22 The Slow Transition to a New Labor Equilibrium When a Firm Faces Variable Adjustment Costs Variable adjustment costs encourage the firm to adjust the employment level slowly. The expansion from 100 to 150 workers might occur more rapidly than the contraction from 100 to 50 workers if government policies “tax” firms that cut employment.
Employment
Time 50
100 150
C A
B
The firm’s decision will depend on which alternative yields higher profits. If the profits earned by maintaining the size of the workforce at 100 workers exceed the profits earned by adjusting to 200 workers (and bearing the fixed adjustment cost), the firm will shy away from adjusting its labor force. When fixed adjustment costs are sizable, therefore, employ- ment changes in the firm will be sudden and large, if they occur at all.
The two types of adjustment costs, therefore, have very different implications for the dynamics of employment in the labor market. If variable adjustment costs are important, employment changes occur slowly as firms stagger their hiring and firing decisions to avoid the high costs incurred when making large changes in the size of the workforce. If fixed adjustment costs dominate, the firm will either remain at its current employment level or switch immediately to a different employment level.
The available evidence suggests that both variable and fixed adjustment costs play an important role in determining labor demand. In particular, variable adjustment costs might account for as much as 5 percent of the total wage bill in the early 1980s. 38 Because of these adjustment costs, it might take up to six months for the firm to adjust halfway to its optimal employment level when its economic environment changes. This result suggests that firms are continuously moving toward equilibrium, and that the firm’s scale is not “what it should be”
in the long run. As a result of variable adjustment costs, it has been estimated that the firm’s output is typically off by about 2 percent from its desired output level. The evidence also indi- cates that many firms incur sizable fixed adjustment costs. A careful study of employment trends in the auto industry, for example, reveals that these firms change their employment sud- denly by very large quantities, rather than gradually as implied by variable adjustment costs. 39