Home / Opinion / Online-views /  Opinion | How to successfully set a minimum wage in India

Recently, there has been much discussion about the minimum wage in India following the introduction of the wage code bill, which seeks to set a legal national wage floor, and the Delhi government’s intention to revise its minimum wages. The discourse, however, lacks serious inputs based on careful evidence-based understanding of the impact of the minimum wage law.

It is commonly understood that instituting a minimum wage reduces employment levels. This theoretical outcome is founded on the crucial premise that we operate in a labour market where employers do not have wage-setting power. This means assuming that the labour markets are competitive. In competitive markets, firms take the market wage as given, and hire workers such that the revenue contributed by the last worker hired (marginal revenue product) is equal to the market wage. If a legal wage floor higher than the prevailing market wage is introduced, it would result in job losses.

However, what if individual firms have the power to set wages? And what if they are able to pay workers below their marginal revenue product? Economists call the power to set such low(er) wages monopsony power. George J. Stigler, in his seminal work in the American Economic Review in 1946, showed that when labour markets are monopsonistic, introduction of a minimum wage could, in fact, lead to an increase in jobs in specific cases.

In monopsonistic markets, the prevailing wages are not equal to but below the marginal revenue product of labour, thanks to the employer’s wage-setting power. Hence, if a minimum wage is set above this prevailing wage, firms have the ‘room’ to pay the minimum wage and simultaneously hire more workers so as to equate the minimum wage to the marginal revenue product. This is possible, however, only when the minimum wage is set below the marginal revenue product of labour. If set too high, the wage floor can result in job losses. The catch here is not that there could be employment gains, which could be small anyway, but that there may not be employment losses.

The decisive question is then whether the assumption of competitive labour markets holds. The answer is an emphatic no, particularly in low-wage segments and vulnerable sectors. Most employers, especially in low-wage markets in developing country settings, exert influence over the setting of wages in the slice of the market they control, however small that may be.

As an extreme example, think of a ‘company town’ where there is only one firm, and where workers prefer to work because of the firm’s proximity—or because they cannot easily migrate or travel to work elsewhere even if they can obtain higher wages, or if their skills are particularly developed for the jobs of this neighbourhood employer. In reality, rather than this extreme case, workers may face the company town scenario in varying and perhaps smaller degrees.

The empirical evidence on the employment responses of the minimum wage law is completely divided. Peer reviewed studies show both negative effects on employment (David Neumark and William Wascher in 1992 in the Industrial and Labor Relations Review), and positive or null effects on employment (David Card and Alan Krueger in 1994 in the American Economic Review, and Arindrajit Dube, T. William Lester, and Michael Reich in the Review of Economics and Statistics in 2010).

The literature being divided may sound like bad news. But on the contrary, it corroborates the theory that the minimum wage effects depend on the type of the underlying labour market—monopsonistic or competitive—and how high or low the minimum wage itself is. Most importantly and optimistically for us, the employment effects are all not uniformly negative.

To inform the current policy debate in India, we need solid evidence on the minimum wage impact in Indian labour markets. Unlike in developed counties, there is only a handful of studies investigating this. Rohan Gudibande and Arun Jacob, in their working paper Minimum Wage Law for Domestic Workers: Impact Evaluation of the Indian Experience, show that the introduction of the minimum wage for domestic sector workers has a strong effect on increasing wages in the short run, with no adverse impact on jobs. In a recent working paper, Minimum Wage Effects at Different Enforcement levels: Evidence from Employment Surveys in India, I show that the minimum wage for construction workers helps raise their wages and increases employment in this sector. These results are not surprising because the domestic and the construction sector in India are monopsonistic in nature.

In an article in the Economic Journal, Arnab Basu, Nancy Chau, and Ravi Kanbur note that the effectiveness of the minimum wage depends, crucially, on both the state’s enforcement capabilities and the level of the minimum wage itself. Consistent with this, I use state-level minimum wage inspections data as a proxy for enforcement to show that stricter enforcement improves the bite of the law in its effectiveness to increase wages. Further, I demonstrate that a policy maker interested in achieving a wage push along with employment gains is most likely to be able to do so with a strictly enforced but reasonably low minimum wage, rather than using other combinations of these two policy instruments.

The Delhi government, on 18 October, went ahead and restored the minimum wage hike for city government employees as planned earlier. The wage code bill is yet to be voted upon in parliament, but the effort to set a legal national floor which seeks to consolidate wage floors across multiple states and occupations is already commendable. At this stage, the relevant governments should carefully consider setting the minimum wage at the right level so as to mitigate any employment losses, and develop capabilities to enforce it effectively so that the major stakeholders, including the workers and employers, benefit from it.

Vidhya Soundarajan is an assistant professor at the Indian Institute of Management Bangalore.

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