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A common assumption in the minimum-wage literature is that low-wage workers as a group benefit from an increase in their total wage income. These workers would therefore be best off when the minimum wage rate is set at a level where the aggregate demand for low-wage labour is unitary elastic, and would be made better off by increases in the minimum wage rate as long as the aggregate demand for labour is inelastic.

Accordingly, there is a close connection between the desirability of raising the minimum wage rate in order to improve the welfare of low-wage workers and the inelasticity of the demand for their labor. Indeed, the motivation for many empirical studies of the demand for low-wage labour is the desire to evaluate the efficacy of a legislated minimum wage rate for combatting poverty.

In the face of a downward-sloping demand curve for labour, however, a minimum-wage legislation that raises workers’ wages above the competitive level will inevitably lead to job losses for some of the workers. The standard analysis implicitly assumes that the workers’ income will then be reduced to zero and that their free time has no value, i.e., that workers’ reservation wage rates are zero. In reality, however, workers are likely to collect unemployment benefits, and they may value leisure and engage in home production.

Therefore, although they would be worse off than if they were employed at the minimum wage rate, they may not be as badly off as assumed. In other words, unemployed workers’ reservation wage rates are likely to be positive. The standard analysis also implicitly assumes that workers care only about their expected wage income (the income at the minimum wage rate multiplied by the employment probability) and thus are risk neutral. More realistically, however, workers are likely to be risk averse and hence be negatively affected by the uncertainty associated with whether they will earn the minimum wage rate or will have to make do with their reservation wage rates.

We first show that for each minimum wage rate there exists a critical value of the elasticity of labour demand — which is generally different from unity — such that an increase in the minimum wage rate makes workers better off if labour demand is less elastic than the critical value, but worse off if labour demand is more elastic,

Further Reading Card and Krueger (1995) question whether it is empirically true that a binding minimum wage rate always reduces employment. They suggest that low-pay firms may behave monopsonistically, in which case the minimum wage rate may have a positive effect on employment (Stigler, 1946).