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Significance And Evidence Of The Spill Over Economics Essay

1.0 Introduction

The minimum wage puts a good sense of equality back into employee’s relationship with the employer. Wages are considered to be a fair reflection of a worker’s efforts, but in the past wages seemed to be a point of exploitation— what an employer would possibly get away with. In more simple terms, this puts a pressure to keep low-paid wages low. This downward pressure is partially removed with the help of minimum wage (BBC News, 2005). In practice, minimum wage regulations are a common mode of government intervention in the labour market. This can be contributed to the public’s huge support for the policy and the government’s great efforts to avoid being labelled as “anti-labour”, which can be politically costly. The minimum wage has become a “symbol of decency and fairness” (Tony Blair as quoted by BBC News 2005) and multilateral institutions such as International Labour Organisation (ILO) have also supported the minimum wage policy as a tool to address income inequality and to improve workers’ living standards. This explains the great importance of studying the very interesting topic of the minimum wage. The distributional consequences of minimum wage have been pointed in the literature (Stigler, 1946), but the effect of minimum wages on the shape of the wage distribution received comparatively less empirical attention than the effect on employment, which is the subject of extensive empirical investigation in many countries (Stewart, 2009). The continuous debate on minimum wage is whether this increase has effects on the wages previously below the new minimum and how extensive are such “spill-over” effects (Stewart, 2009).

Considering the case of a blue collar and a white collar employee and assuming that white collar is paid higher than the blue collar employee, what effect does the increase in minimum wage has on the salaries of both employees? In the paper, the research tries to answer this question by data from a Portuguese firm. Observing the salaries in subsequent years of 2007 and 2008, the research finds evidence for wage compression. In the case of this firm, the research observes the salary of white collar being lowered in most cases in the next year when the rise in minimum wage has taken place but the salary of the blue collar worker shifts up with the rise in minimum wage. The Portuguese firm seems to be apparently cutting down on hours in the year 1999 and 2004. These are also the years when wages also fall and there is also a large percentage of wages that are below the minimum wage. There is also further evidence of employees being displaced as approximately 18% workers were displaced in the period 1986-2010. Stevens et al. (1994) in their paper find that current components of data do not support the accurate prediction of unfavourable circumstances associated with displacement relative to earnings discontinuities accompanying causal definitions of unemployment.

However, the evidence on spill-over is mixed and wage spill-over occurs in many countries but, the spill-over is highest in developing countries that had invested domestically in improving the skill levels of the employees (Spero and Hart, 2010). Categorically speaking, wage spill-over tends to be greater for skilled than for unskilled workers (Spero and Hart, 2010). But, why do spill-over really occurs and why this spill-over is important?

2.0 Why Spill-over occurs?

Spill-over effects on the wage distribution can occur for different reasons such as the increase in the minimum wage. This increase in minimum wage will increase the price of low skilled labour and the demand for skilled labour would subsequently increase. This would eventually lead to a rise in wage rates (Stewart, 2009). Alternatively, it could lead to a rise in wages for specific employees above the minimum in order to preserve wage differentials. Wage differentials are significant for employees and productivity of employees may be affected. Martins (2004) in a matched employer-employee panel data during 1991-99 considered difference-in-differences (DID) method and found negligible wage differentials. The increase in minimum wages could also increase the reservation wages of employees searching for work in selected sectors. This would further increase the wages which the employers need to pay for recruitment. From the employer’s perspective, firms could be led to reorganise the use of their workforce to realign the marginal products of their minimum wage workers with the new minimum wage. This could affect the marginal products of other workers (Stewart, 2009). In a laboratory experiment, the minimum wages have an important effect on subjects’ reservation wages (Falk et al., 2006). Falk et al. (2006) in their article suggest that the minimum wage affects subjects’ fairness perceptions and speculate that any observed spill-over effects could be left over. Flinn (2006) in their research provide evidence that minimum wages could also affect workers’ reservation wages in search and matching models with wage bargaining.

2.1 Significance and Evidence of the spill-over

Spill-over is important in the evaluation of the impact on the wage distribution because wages are an important constituent for welfare and incomes. This spill-over could also be vital in the investigation of the wage inequality and the evolution of wage inequality over time (Stewart, 2009). The spill-over cannot be neglected as this may result in a misleading estimation of the effect of increase in the minimum wage (Stewart, 2004).

Many researchers have addressed the issue of minimum wage spill-over effects. From Gramlich (1976) onwards, some have adopted the direct approach while others have taken the indirect approach. The majority of this evidence has been for the United States as Lee (1999) examined the cross-state variation in the relative level of the United States federal minimum wage and found evidence of spill-over effects on specific percentiles of the wage distribution. The infamous book by Card and Krueger (1995) also found evidence of spill-over, but their findings are limited. Whereas, DiNardo et al. (1996) come up with results using an indirect approach that seem to be consistent with spill-over above the minimum. Neumark et al. (2004) also examine effects on the individual wage changes and conclude the evidence of significant spill-over effects. The above research had been taken mainly in United States and now we will look for evidence in the Europe, especially countries like Portugal and the United Kingdom.

As compared to United States, there has been little work in testing for spill-over effects of the minimum wage in the United Kingdom. Dickens and Manning (2004) provide evidence available on such effects for the introduction of National Minimum Wage in 1999 and find no evidence of spill-over effects. Dickens and Manning (2004) provide evidence in the form of percentile plots, but are unable in providing a test. Dickens and Manning (2004) apply a Lee (1999) type model of spill-over effects to the cross-percentile variation in data for the care homes sector. So, not surprisingly UK is referred to as the exception which may hold invalid. Butcher (2005) and Low Pay Commission (2009) analyze percentage changes in hourly pay percentiles for longer time spans. Low Pay Commission (2009) provides evidence of spill-over in the period 1998-2004. No standard errors were presented, but inspection of the figure in the Low Pay Commission report in the light of errors suggests that the spill-over they estimate for the period 1998-2004 are significant up to about the 12th percentile, while those for 2004-2008 are insignificant at all percentiles above the National Minimum Wage (Stewart, 2009).

2.2 Critical Analysis of Spill-over

The conclusions from empirical studies on wage spill-over from Foreign Direct Investment are mixed. Some studies suggest that wages in domestic firms are improved by the presence of Foreign Direct Investment (Lipsey and Sjoholm, 2004; Driffield and Girma, 2003). Other researchers find negative effects of foreign presence on wage levels of domestic firms (Barry et al., 2005). Finally, some studies find that FDI has no significant impact on the wages of local firms (Aitken et al., 1996). The existing literature has several shortcomings which would explain the failure to detect significant wage spill-over effects on the domestic firms. Most research has examined the horizontal wage spill-over, relating the wage level of a domestic firm to the presence of the foreign firm. It can be the case that the foreign firms pay higher wages than domestic firms, even after controlling for size and other characteristics (Girma et al., 2001; Lipsey and Sjoholm, 2004).

3.0 Literature Review

The aim of the minimum wage increases is perhaps to change the distribution of the wage and it is well established in the literature that minimum wage compresses the wage distribution but, there is no consensus on the direction or size of the effect on employment (Lemos et al., 2004). Card and Krueger (1994) have looked at the effect of minimum wage on employment through a case study of the food industry in Pennsylvania and New Jersey. They are unable to come up with evidence that the increase in minimum wage reduced employment at food restaurants. This is coherent with recent studies that are based on comparisons of time-series of affected / unaffected markets but, it is opposite to the textbook model of the minimum wage (Card and Krueger, 1994). Neumark and Wascher (2002) in their article present evidence on the effects of minimum wages on family incomes. Their results indicate that minimum wage increases the probability of the poor families escaping poverty and the probability of previously non-poor families falling into poverty. The approximate rise in the flow into poverty is higher. They also found that minimum wages have a boosting effect on the incomes of poor families. The different trade-offs created by the minimum wage increases reflect income redistribution among low-income families than income redistribution from upper to lower income families (Neumark and Wascher, 2002). Portugal and Cardoso (2006) in their article discuss the changes in the legislation in Portugal during 1980s which provided good conditions for the examination of employment effects of minimum wage, as the minimum wage increased sharply for selected employees. Portugal and Cardoso (2006) count on an employer–employee panel data set for modelling gross worker flows in new, continuing and firms that were going out of business (Portugal and Cardoso, 2006). They have used a count regression model. Employment patterns for teenager which is the affected group are compared to that of the other group such as the aged employees. The effect of the increased minimum wage has been the cutting down of separations from the employer that during the period of analysis counter balances for the reduction of accessions to new firms (Portugal and Cardoso, 2006).

Statistically, the dispersion of wage distribution is claimed to be much lower in Europe than in United States (Bertola et al., 2001). “Wage compression” in economic terms means the difference in wages across employees or firms in Europe that does not reflect the much difference in productivity (Mourre, 2009). This mismatch may be understood in a way by comparing the level of relative wage and relative productivity. Looking at wage moderation in the Euro Zone which seems to have a crucial element of macroeconomic stability in recent years, this would partially explain the resilience of employment in the face of the economic recession (Mourre, 2009). According to Mourre (2009), there is still long way to go towards achieving Lisbon employment targets in Europe. Consideration should also then be given to the microeconomic structure of wages which could affect the macroeconomic performances.

Stewart (2004) approximates employment effects in UK with the introduction of National Minimum Wage in 1999. Difference-in-differences (DID) approach is used and the estimator is based on position in the wage distribution. An adjusted estimator is also used for the response to the change in the employment pattern. No critical employment effects are found for any of the estimators (Stewart, 2004). Stewart (2009) in a report explores whether the increase in the National Minimum Wage (NMW) have effects on wages in order to bring those previously below the new minimum and how extensive are such “spill-over” effects. Spill-over effects can be predicted for many reasons in a labour market (Stewart, 2009). Stewart’s report used 3 approaches in testing for spill-over effects. The first includes an inspection of individual wage changes and the second includes a comparison of wage quantiles. The final approach uses a comparison of estimated wage distribution functions (Stewart, 2009). The tests in each approach are applied to the introduction of Minimum Wage in 1999 using data from the Annual Survey of Hours and Earnings (ASHE). The tests were conducted under different assumptions about the counterfactual distribution (Stewart, 2009). Since the concept of minimum wage spill-over effect is based on a comparison with a counterfactual position, the approximation of the spill-over effects of the Minimum Wage were found to depend significantly on the assumptions made for the counterfactual (Stewart, 2009).

Dickens and Manning (2004) found that UK National Minimum Wage (NMW) had a lesser impact on UK wage inequality because it was laid at a moderate level and evidence suggests the presence of negligible spill-over effects. These negligible spill-over effects account for the small numbers of workers that were affected. The data collected relates to care homes where the National Minimum Wage affected nearly half of the employees. They found no evidence of large spill-over effects (Dickens and Manning, 2004). Martins (2004) evaluate the impact of Foreign Direct Investment on the Portuguese labour market. The data set used is an employer-employee panel data that covers the period 1991-99. When considering difference-in-differences (DID) method, the wage differentials are found to be negligible. With the Ordinary Least Squares (OLS) method, the multinational premium falls significantly when different characteristics of employees were added. The spill-over effects found are significantly positive.

3.1 Neoclassical Theory of Minimum Wage Effects

In Neoclassical theory, minimum wages are considered just like any other price floor. The firms reduce the quantity of labour demanded provided the wage will exceed the market-clearing wage. The magnitude of this reduction will depend upon the wage increase and the wage elasticity of labour demand (Leonard, 2000). Some employees receive the higher wage and are better off as compared to other employees. Whereas, the wage of other employees is worth less than the new minimum, will work for lesser hours or may be dismissed in the future. If the quantity of labour refers to employment, then the wage gains of those who keep their jobs must be traded off against the wage losses of those who lose their jobs (Leonard, 2000).

3.2 Current Controversy of Minimum Wage

The current minimum wage controversy derives from literature in empirical labour economics, arguing among different claims that increases in minimum wage does not lead to unfavourable employment results for low-wage workers as summarized in the famous book “Myth and Measurement: The New Economics of the Minimum Wage” by Card and Krueger (1995). The current controversy arises because “the new economics of the minimum wage” is at odds with neoclassical price theory, which predicts unemployment and with the aid of econometric research continuously finds evidence of unemployment effects (Leonard, 2000). The findings of Card and Krueger (1995) are at odds when compared to most of the labour economists in United States believe (Whaples 1996). Both, Card and Krueger understand as they comprehend of their project as a negation of neoclassical price theory’s expectations and of the econometric proof provided in its support (Card and Krueger, 1995, 396–97).

3.3 Origins of Wage Compression

The wage compression effect on the wage distribution is soundly established in the literature, but there is still some debate about the direction of the effect of the minimum wage on employment (Brown, 1999). The evidence in the case of Brazil indicates that the minimum wage strongly compresses the wage distribution (Lemos, 2004; Carmignani, 2003). The economic theory offers two explanations for the origins of wage compression. The first describes wage compression as being caused by the labour market institutions like the minimum wages affecting the lower end of wage distribution, trade-unions, etc. Koeniger et al. (2005) explores the significance of labour market institutions such as associations, the laws of dismissing and the minimum wages for the unfolding of wage inequality. Their approximates for more than 10 OECD (Organisation for Economic Co-operation and Development) countries suggest that labour market establishments can account for a large part of the change in wage inequality across countries (Mourre, 2009). But, the other explanation identifies the cause for wage compression. Booth and Zoega (2002) provide foundations for wage compression by modelling wage-setting in a competitive labour market. In their model, wage compression arises quite naturally in market economies and does not depend on the existence of institutional structures such as minimum wages and unions. Shimer (2004) also comes to the conclusion of wage dispersion in equilibrium, when all employees and firms are uniform. When firms are composed of diverse elements, the more productive firms will pay higher wages and employees would for obvious reasons switch employers when they see a more productive opportunity. Large empirical evidence supports the determination of wages, suggesting firms pay different wages to similar employees allowing wages to deviate from productivity. Krueger and Summers (1988) show the evidence of few United States industries paying wages up to 20% above and below the average wage. Genre et al. (2005) show that in Europe the characteristics of employees fail to explain wage differentials across industries. This could happen only if the employers are pursuing different wage policies. The other scenario may be that more skilled workers are attracted by high paying firms.

3.4 The case of Portugal

The legal minimum wage for young employees in Portugal was raised by almost 50% in January, 1987. This major increase can be used to evaluate the impact of the minimum wage change on employment of young worker. The employment growth of young workers is compared with the employment growth of older workers using a firm-level micro data. The main findings are that the increase in the minimum wage significantly reduced employment of teenage workers, but increased employment of middle aged workers (Pereira, 2003). Cardoso (1998) analyze the level of income inequality in Portugal during 1980s and detect a high level of inequality at the start of the 1980s with a rise in wage dispersion. The explanation for this change in the wage pattern is that changes were made during 1983-92 within the economic activities (Cardoso, 1998). Dolado et al. (1996) in their research try to find out that whether the minimum wage is a curse or a cure. The rivals of minimum wages argue that jobs in Europe are damaged whereas the well-wishers claim that minimum wage helps the poor and combats labour exploitation. The minimum wages have not risen relative to the average wage for the last two decades in Europe and the minimum wage caused higher unemployment only in the cases when a required wage fall for low paid employees was to be prevented (Dolado et al., 1996). Comparatively to the United States, minimum wages for young employees in Europe are lower proportion of average wage earnings. Dolado et al. (1996) emphasize that the effect of minimum wage has been exaggerated as they are unable to find evidence that minimum wages reduced employment. Carneiro and Portugal (2010) in their paper model equations of firm closing to specify wage determination to analyze how wages respond to adverse demand shocks that will raise the risk of displacement and the extent to which the wage change affects the likelihood of exit. Their results provide evidence that the fear of job loss leads workers to accept wage concessions in a longitudinal worker-firm data set from Portugal. Their research shows that firms with a higher incidence of minimum wage earners will be vulnerable to unfavourable shocks and the minimum wage restrictions increase the failure rates (Carneiro and Portugal, 2010).

4.0 Methodology

4.1 Data

Quadros de Pessoal (QP) is a longitudinal data set that matches firms with employees in Portuguese economy. The data is collected annually by Ministry of Employment and Social Security (Ministerio do Emprego e Seguranca Social in Lisbon). Workers on short leave like holidays, medical, etc are included but long leave workers are not reported. The data reports main salary and salaries which are split into the components like salary2, salary3, salary4 and salary5. These components include overtime work, regularly and irregularly paid subsidies, etc. The amount an employee works overtime is also reported. The analysis is focused on the wages of fulltime employees. The observed data includes variables like gender, age, experience, education, tenure with the firm, NSS (Social Security Number), sales, job level, admission date, earnings, etc. However, there are problems faced by panel data sets like as oversampling or under sampling of specific groups, other sampling issues and panel attrition.

The methodology used is quantitative and software like Stata 10 and MS Excel 2007 were used to interpret and analyse the data using descriptive statistics. This econometric methodology was used to address the economic issues and in helping the analysis of the data. The analysis is based on firm level data collected in Portugal.

4.2 Regression Analysis

4.3 Econometric Methodology


The research uses MS Excel 2007 and Stata 10 for the analysis of minimum wages in Portugal from 1983-2010. Originally, the wages were in ‘ESCUDOS’ which was the local currency of Portugal prior to the introduction of ‘EURO’. The minimum wage is seen to be on the increasing trend across the period 1983-2010 as shown in Figure 1 (See Appendix). The sharpest increase in minimum wage from the previous year seems to be in the period 1990-91 as the slope is steepest during this interval. This sharp trend is again seen in the period 2008-2010 as depicted in Figure 1. For the purposes of comparison, the conversion rate is considered as 1 Euro = 200.482 Escudos. Figure 1 was generated in Stata 10 using the command ‘twoway connected var1 var2’, where var1 = minimum wage in Escudos and var2 = time in years. Figure 2 (See Appendix) was generated in MS Excel 2007 to provide some more insights to the relationship of minimum wage with time. We see that the trend is fairly linear and we get an equation of the form y = mx + c. In this case, m = 2884.197 and c = -5.705E06 i.e ( -5.705 * 106 ) and a large value for R-square (0.9925) is obtained. Figure 3 (See Appendix) shows the minimum wage (the ‘red worm’) compared with the increase in the minimum wage (the ‘blue worm’). The net increase is observed to remain fairly constant with a few bumps. Figure 4 is an alternative approach to show this comparison using bar charts. We see in Figure 5 that the net increase is highest in 1985, 1990-1 and this pattern is repeated in the years 2008-10.

5.0 Results & Findings

The Portuguese firm seems to be apparently cutting down on hours in the year 1999 and 2004, when wages also fall and there is also a large percentage of wages that are below the minimum wage. Looking closely to the trend in the year 1999, nearly 75% employees are under Minimum Wage and again after 5 years this pattern seems to iterate in the year 2004, when just 25% of employees are above the Minimum Wage. Perhaps, in these circumstances, an employee would be searching for a best year for employment in that particular firm. This best year for employees in the firm is 2002 when surprisingly, there is just 1 employee that is under the Minimum Wage. Over the entire period 1986-2008, there are 26% employees that are paid below the Minimum Wage. The research finds evidence of wage compression, especially for high paid employees which are paid lesser salary in the next year. Considering the case of a blue collar and a white collar employee and assuming that white collar is paid higher than the blue collar employee, what effect does the increase in minimum wage has on the salaries of both employees? In the case of this Portuguese firm, the research finds the salary of white collar being lowered in most cases in the next year when the rise in minimum wage has taken place. But, the salary of the blue collar worker shifts up with the rise in minimum wage. There is also evidence from the research that in most cases low paid employees were being paid more salary in the next year because of the increase in the minimum wage. There is also further evidence of employees being displaced as approximately 18% workers were displaced in the period 1986-2010. This result is given by the variable ‘stays’ which is a dummy variable (stays = 1 if employees stay and 0 if employee leaves/dismissed) generated in Stata 10.


5.2 Limitations

There are several drawbacks in the data because it was collected for research purposes only. I can observe only few employees earning up to a certain limit for example, 36,000 Escudos is the highest salary and 1160 Escudos is the lowest (probably this is a part-time worker) in 1982 and 41,500 Escudos is the maximum, whereas 2375 Escudos is the minimum in 1983. There could be a possibility of some censorship of highest paid salaries. There are missing values in the period 1982-85 for the variable ‘NSS’ which is the worker identifier number, perhaps because National Security Number was introduced in 1986. Although, job experience can be constructed back to 1982, information on educational attainment for some employees is not available for those starting their professional career before that time. There are also substantial values missing for the variables like age, tenure, experience and education in the year 1983 and 2008. There is no clear distinction between a part time worker and a full time worker. Moreover, for a subsample of individuals (N=5570) exact firm size is available together with additional information concerning the firm, e.g. age of the firm and the structure of employment. Results using this smaller sample will be presented below. No distinction between temporary or dismissal of employees is made.

5.3 Further Research

Wage inequality between men and female with the job security or racial inequality among employees in the labour market could be further studied in order to determine the starting point and ending point of wage convergence. The differential in the dismissal risk in Europe according to firm size can also be explored so as to study the relationship between the firm size and dismissal risk. The unemployment effect of wage compression is another interesting topic that needs further research. The impact of parental leave on the employment of women may differ with the level of wage flexibility (Kahn, 2010) and all these interesting topics could be fruitful areas of further research that would add value to the research that is already done and in some cases will fill small gaps that exist for economists to raise questions in the labour market.

6.0 Conclusion

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