ECO/107/14

OGUTU ANN MILDRED

MOI UNIVERSITY
SCHOOL OF BUSINESS AND ECONOMICS
DEPARTMENT OF ECONOMICS
ECO 418
LABOUR ECONOMICS
OGUTU ANN MILDRED
ECO/107/14
LECTURER TUIGONG
9TH OCTOBER 2017
RELATIONSHIP BETWEEN MINIMUM WAGE RATE AND EMPLOYMENT
IN KENYA
ABSTRACT

This study has been conducted to determine the relationship between Minimum Wage

and Employment in Kenya. The arguments about the impact of minimum wage

introduction reflect back to the two most prominent theories; Neo-classical and Keynesian

hypotheses. While the advocates of Neo-classical postulation emphasize that introduction

of minimum-wage results into loss of jobs, Keynesians provide in-depth discussions as to

why the former’s view is not actually the case. Further debate involving monopsonistic

market structure and concept of covered versus uncovered sectors emerged to advance

the two sides. OLS model have been used to estimate the dataset of Kenya. The results

showed that minimum-wage reduces employment. In relation to this, working hours were

observed to increase in response of minimum wage increase.

Key words: Labour, economy, minimum wages, employment, working hours

INTRODUCTION

Minimum wage is the lowest amount of pay per hour a worker is legally entitled, this excludes

self-employed, and voluntary worker (Bazen and Skurious, 1997). It is also known as pay floor.

It is the price floor below which workers may not sell their labour. Minimum wage was first

introduced by New Zealand in 1894, followed by Australia in 1896 that of USA in 1938, France

in 1950 while Netherland in 1974. The movement for minimum wages was first motivated as a

way to stop the exploitation of workers in sweatshops by employers who were thought to have

unfair bargaining power over them.

The objective of the minimum wage settings was to protect the lowest earners in a wage

distribution with a long term view of reducing income inequality, as well as poverty alleviation

(Stewart, 1999; Stewart, 2000). Most countries had introduced minimum wage legislation by

the end of the 20th century.

According to Vandemoortele (1984), minimum wage has had two fold objectives in Kenya; First,

it formed part of the high wage policy pursued by the government in the early 1970s. High

wages, by stabilizing labour force, increasing productivity and enhancing capital intensity of

production, were expected to accelerate the pace of industrialization, the major avenue

towards economic growth. Secondly, and perhaps more important, has been to protect the

workers welfare, in particular low-income earners especially those not involved in the collective

bargaining processes.
With the onset of the Structural Adjustment Programmes, especially in the early 1990s, the

labour market in Kenya underwent through considerable liberalizations. The minimum wage

laws however were left intact in spite of the removal of price controls in the product market.

Over the years, adjustments of the minimum wage legislation have traditionally been

undertaken virtually every Labour Day with an aim of compensating workers for the erosion of

their purchasing powers since the last revision of the wage. The adjustment takes into account

the effect of changes in the entire economy and performance of various sectors (Manda, 2002).

The review of minimum wage is done through three party agreements involving ministry of

labour, Federation of Kenya Employers and Central Organisation of Trade Unions with the

support of independent members like industrialists and academicians (Manda, 2002). The

increase in minimum wage is usually set differently for agricultural workers (in the Agricultural

Wage Order) and for urban and other workers (in the General Wages Order).

There was an 18% increment on minimum wage announced by the President of Kenya on

Labour Day 2017. The primary rationale was to cushion workers against the effects of the

current state of the economy. This increase affects those paid an hourly, daily and monthly

wage. Workers are reasonably happy whereas employers have stated categorically that the

increment is too high and businesses will most likely to have to take steps to cushion

themselves against this additional expense, this may be through job cuts or increase in products

prices.

Those for minimum wage say it increases the standards of living of workers, reduces poverty,

reduces inequality and boosts morale. In contrast, the opponents say it increases poverty,
increases unemployment particularly among unskilled workers and is damaging to business,

because excessively high minimum wages require businesses to raise the prices of their product

or service to accommodate the extra expense of paying a higher wage.

BACKGROUND AND LITERATURE

Empirical Studies

Literature findings about the effect of minimum wage on employment have been divided into

three categories; those which spotted the evidences of Keynesian and neoclassical hypotheses

as well as studies which noted a positive employment effect.

Giuliano (2009) using regression analysis and panel data of the large selected retail sector in

U.S. noticed a contradictory results to the ones predicted by the theories mentioned before.

The findings of the study indicated that not only the level but also the composition of

employment in the retail sector increased. The study therefore dwelled into the argument of

market frictions as an underlying reason of the findings obtained.

Positive Effect

Bhaskar and To (1999), developed a model with two assumptions. First, production costs are

fixed and second, to the firm the labour supply is imperfectly elasticity which crop-out from

Salop (1979) model of horizontal differentiation. The authors study reveals that minimum wage

effect on employment differ for oligopsony and monopsony with a greater employment effect

per firm observed in the case of oligopsony than monopsony under free market entry

condition. The observed positive effect is true where minimum wage is set below firm’s

marginal product of labour.

Bhaskar and To (1999) developed monopsonistic competitive model with free entry. The

findings under the model put-forward three interesting findings that;

• An increase in minimum wage increases employment by each firm in the industry.

• Because of increase in minimum wage, some firm exit the market.

• Minimum wage effect might reduce or increase employment in the industry.

Under the Homogenous labour we have the price level effect, distribution and

employment. Firms are always dependent on their profit mark-up and this may change

but it is not dependent on their wage cost. Here minimum-wage can create a nominal

wage anchor and prevent the development of deflation in the goods market. But for

the case of employment, there is no direct relationship between wage change and

employment, but there is an indirect relationship because low nominal wage leads to

deflation, loss of production and employment.

Under heterogeneous condition in which we have different wage rate the following

will be the economic impact of minimum-wage. The price effect, the changes in

minimum-wage will have effect on the price level, except in extreme cases where the

effect is considered small (where minimum-wage is use as the standard for other

wages). For the employment effect, the increase in minimum-wage will change the

income distribution that is, workers income increase, the aggregate demand and

output will most likely change, but no systematic employment effect.

Some empirical findings show that, moderate increase in minimum wage shouldn’t lead to

unemployment rather increases employment as reported by Card (1992a, b), Card and Krueger

(1994, 1998), Katz & Krueger (1992), and Machin & Manning (1994). These authors’ finding

supports Keynesian view on the effect of minimum wage on employment,

Card and Krueger (2000) studied the impact of minimum wage on employment by looking at

fast food Industry in New Jersey and Pennsylvania. On April 1, 1992, New Jersey’s minimum

wage rose from $4.25 to $5.05 per hour. To evaluate the impact of the law they surveyed 410

fast-food restaurants in New Jersey and eastern Pennsylvania before and after the rise.

Comparisons of employment growth at stores in New Jersey and Pennsylvania (where the

minimum wage was constant) provide simple estimates of the effect of the higher minimum

wage. They also compared employment changes at stores in New Jersey that were initially

paying high wages (above $5) to the changes at lower-wage stores. Card and Krueger found

no indication that the rise in the minimum wage reduced employment.

An increase in the New Jersey’s minimum wage probably had no effect on total employment in

New Jersey’s fast food industry and/or might have minimal positive effect. They further stated

that, within New Jersey, hours grew more at restaurants in the lowest wage areas of the state,

where the minimum wage increase was more likely to be a binding constraint. Meanwhile, the

result has contradicted the view that total hours drop in reaction to the New Jersey minimum

wage increase.
Negative Effect

Vedder & Gallaway (2002) in their study of the effect of minimum wage on employment and

hours, using the US data set from 1959 – 1999 (41 years) and applying ordinary least square

method (OLS), the findings is, minimum wage impact on hours negatively for the full time

worker in private non-agricultural sector, with a weekly decline on average hours dropping

from 39 to 34.5. For manufacturing sector, same observation is recorded. Deere et al., (1995)

and Neumark (1999) concur with the findings. The study further added that minimum wage

effect on employment has greater negative impact on young and less skilled worker.

Inconclusive Effect

Giuliano (2009), Addison et al (2008) used retail sector in the U.S. in their analyses and showed

that there was neither negative nor positive employment effect. Equally, the study by Metcalf

(2008) findings on the effect of minimum wage on employment and working hours, by using

case study approach rather than quantitative measurement was inconclusive.

Furthermore, Zavodny (2000) used regression analysis to study the effect of minimum wage on

both employment and working hours in U.S. Both state and individual level data were used in

the analysis. The findings indicated that while hours of working were unaffected, employment

on other hand was minor affected negatively both for state and individual data.

As noted above, many literature (except Zavodny, 2000) paid more attention to specific sector

analyses in examining the behaviour of labour supply both in terms of employment and working

hours in the presence of minimum wage. Thus, either failed to assert their findings at the macro

level or such explanation bear unsound stance. This is because sectorial analytical studies do
not consider the argument of covered versus uncovered sectors which is very important to be

controlled in order to give conclusion at the aggregate level. This paper therefore uses Zavodny

(2000) approach by using aggregate rather than specific sector data to draw attention to what

might be the effect of minimum wage at macro level. However as opposed to the study by

Zavodny (2000) which focused in U.S., this paper uses Kenya economy and also excludes

individual data analysis since both data (state and individual ones) yield more or less the same

results in the earlier referred literature.

OBJECTIVE

 To identify the effect of minimum wage on employment.

 To determine how minimum wage impacts working hours.

 To analyze various theories that have been developed on the relationship between

minimum wage and employment.

 To outline policy implications based on the results.

HYPOTHESIS

Most textbook treatments of the employment effects of the minimum wage rely on the simple

supply and demand model of price floors. The outcome of this is often contrasted with that

which occurs under monopsony. In recent years, the analysis of the effects of a minimum wage

in competitive labor markets has been significantly extended to include formal treatment of a

minimum wage which applies to one sector of a two-sector economy, or which has no direct

effect on some workers because they earn more than the minimum. The first three parts of this

section deal briefly with the traditional analysis, while the next two sections deal with more

recent additions to the literature.

There are different theoretical approach on the effect of minimum wage on employment. The

two main theories include: neoclassical view and Keynesian view. Traditional economic theory

involves three different approach which are supply and demand model of price flow,

monopsony model and shocked effect model.

1. SUPPLY AND DEMAND MODEL

According to the supply and demand model of the labour market, increasing the minimum

wage decreases the employment of minimum-wage workers.

The most basic model of the effect of the minimum wage on employment and unemployment

focuses on a single competitive labor market with homogeneous workers whose wage Wo

would otherwise fall below the legally set minimum wage Wm. Employers minimize costs both

before and after the minimum wage law, workers' skills and level of effort are identical and
given exogenously, and all workers in the market are covered by the minimum wage.

Adjustment to the new equilibrium is not considered. In this model, initial employment E0 is

determined by supply and demand; once the minimum wage is introduced, employment falls to

Em the level demanded at wage Wm (Figure 1). The proportional reduction in employment

(ℓnEm-ℓnE0) is equal to the proportional wage increase (ℓnWm-ℓnW0) times the elasticity of

demand.

If employment would otherwise increase, the reduction in employment predicted by the model

may take the form of a lower rate of employment growth rather than an actual decline in the

number employed. If employment actually declines, it may take the form of not replacing

workers who quit rather than discharging workers.

While the model determines an excess supply of labor at the new minimum wage, Sm-Em, this

excess supply does not correspond to the official measure of unemployment (Finis Welch, 1976,

p.8), or even to the Increase in such unemployment above some frictional level. Sm represents

the number (or work-hours) of those persons willing to work at Wm but some of the Sm-Em who

are not employed may decide that prospects of finding work are too dim to make actively

searching for work worthwhile. Those not actively looking for work are not included in the

official unemployment count.

 2. MONOPSONY MODEL

A well-known exception to the conclusion that the minimum wage reduces employment is the

monopsony case (George Stigler, 1946). Stigler’s monopsonist’s model predicts that minimum

wages can raise employment over a limited range. A Monopsony firm in this model is a price-

taker in the product market but has some degree of market power in the labour market.

Without a minimum wage, the monopsonistic employer's marginal cost of labor everywhere

exceeds the supply price; labor is hired until marginal cost and demand are equal (Figure 2). A
minimum wage makes the employer a price-taker, up to the level of employment S (Wm). Thus,

a minimum wage between W0 and W1 will increase employment (S. Charles Maurice, 1974);

choosing Wm=W1 brings employment to its competitive level, E1. Once Wm equals W1, further

increases would reduce employment below the competitive level. The monopsony model has

not motivated much recent work, perhaps because there is little evidence that it is important in

modern-day low-wage labor markets (West and McKee, 1980b).

Thus, when the firm is confronted with an increase in the minimum wage above the ongoing

wage (which is less than the workers marginal productivity in the case of a monopsony),

monopsony theory predicts that the best strategy; over a certain range, is to increase the

level of employment.

3. SHOCK EFFECTS MODEL

If employers do not minimize costs, there is the possibility that they will respond to a

minimum wage increase by raising the productivity of their operation to offset the increase

(Lloyd Reynolds and Peter Gregory, 1965, p. 193). This possibility is often labeled a “shock”

effect- the minimum “shocks” employers into greater productivity.

Such a shock effect might reduce the disemployment from a minimum wage (increase) but is

unlikely to eliminate it (West and McKee, 1980b). First, while some firms may be in a position

to take advantage of previously unrealized economies, other firms may not be so fortunate.

Second, firms may have failed to minimize costs by using too much labor at the previous
wage W0; cost-cutting would then take the form of discharging (or not replacing) the extra

workers.

Presumably, the scenario most favorable to the shock argument is the employer being able to

call forth greater levels of effort in response to the minimum. A formal model consistent with

cost-minimizing employer behavior along these lines has been developed by John Petten

Gill (1981). Just as rent controls are thought to induce landlords to lower apartment quality in

response to excess demand, competitive employers may raise the required level of effort in

response to minimum-wage-induced excess supply. Higher effort levels can offset the

effective increase in the minimum wage, depending on a parameter which tells how much

workers will increase effort at Wm rather than not work at all. For what appear to be plausible

values of this parameter, effort reductions can offset much of the disemployment effect

which would otherwise occur.

4. TWO-SECTOR MODEL

Coverage under the minimum wage provisions of the Fair Labor Standards Act has increased

gradually, but even today it is not complete. Since the 1977 Amendments to the Act, roughly

84 percent of all private non-farm nonsupervisory wage and salary workers have been subject

to the minimum wage, compared with 53 percent in 1950 (Welch, 1978, p.3). Roughly 80

percent of low-wage workers (those with wages at or below the minimum) work in

establishments subject to the minimum wage (Curtis Gilroy,1981). Thus it makes sense to
consider a model in which coverage is incomplete, particularly in studying effects of the

minimum wage in earlier periods when coverage was less extensive than it is today.

In Welch's (1974) model of a partial-coverage minimum wage, the covered sector reacts to

the minimum wage as it would if coverage were universal. Workers displaced by the

minimum wage "migrate" to the un-covered sector, shifting supply there outward. As a

result, wages fall and employment increases in the uncovered sector.

Those displaced from the covered sector do not automatically become employed in the

uncovered sector. As wages in the uncovered sector fall, some of those displaced by the

minimum wage (as well as some of those originally employed in the uncovered sector) decide

not to work in the uncovered sector because the wage there is less than their reservation

wage. Therefore, the effect of the minimum wage on total employment depends on the

elasticity of labor supply and the reservation wages of those who do not obtain covered

sector work, as well as more obvious factors such as the size of the covered sector and the

elasticity of labor demand.

Let S and D denote supply and demand, let the subscripts c and u refer to covered and

uncovered industries, and let c be the proportion of employment before the minimum wage

which is in industries about to become subject to it; i.e.,

(1) c=Dc(W0)/[Dc(W0)+Du(W0)]
Before the minimum wage is introduced, wages in the two sectors are equal, and the supply

of labor in the uncovered sector, (1—c) S(W0), equals demand in the uncovered sector,

Du(W0).

Welch assumes that, after the minimum wage is introduced, each of the S(Wm) workers

willing to work at the minimum wage has the same probability of obtaining one of the Dc(Wm)

covered sector jobs. Therefore, this probability equals

(2) f=Dc(Wm)/S(Wm)

If wages are measured so that W0=1 and ln(W0)=0, the proportional increase in the wage in

the covered sector is ln(Wm). The uncovered wage Wu must now equate the new uncovered

sector supply, S'u(Wu) = S(Wu)(1-f),with demand, Du(Wu).

After solving for W, one can find the overall level of employment (covered and uncovered

sectors combined) as a function of the parameters ƞ, Ɛ, c and Wm. If we measure

employment so that E0= 1, the minimum wage elasticity of employment ƞm=ℓn(Em)/ℓn(Wm) is

equal to cƞƐ ℓn(Wm)/[1-c+Ɛℓn(Wm)]. Note that while ƞm is proportional to the demand

elasticity ƞ, it is not likely to be close to ƞ. If Ɛ=0, ƞm= 0: covered-sector employment losses

are exactly offset by uncovered sector gains. As Ɛ increases, so does ƞm approaching cƞ as Ɛ

approaches infinity. For "reasonable" values of the parameters, ƞm can be much less than ƞ;

e.g., if c=7, ℓn(Wm)=6, Ɛ=3, and ƞ=-1.0, ƞm=-26.

A more convenient but perhaps less plausible assumption is that those with the lowest

reservation wages find covered-sector employment. In this case, S'u(Wu)= S(Wu) –Dc(Wm), and

the employment elasticity ƞm equals cƞƐ/[Ɛ-(1-c)ƞ]. Thus, ƞm no longer varies with the

proportional wage increase for covered-sector workers Wm. It remains true that ƞm<-cƞ,

approaching -cƞ as Ɛ becomes larger. For the "reasonable" values used earlier, ƞm equals only

-35. As one would expect, the disemployment effect is larger as coverage c is increased.

5. TWO-SECTOR MODEL WITH QUEUING FOR COVERED SECTOR JOBS

This model is a sort of an extension of the preceding one. It has been formalized by Mincer

(1976) who was the first author to introduce the notion of unemployment when considering

the effect of Minimum Wage regulation on the functioning of the labour market. Mincer’s

approach aimed at seeing what would happen, not only in terms of effects on employment but

on unemployment as well, if Minimal Wage were introduced in a given economy. The basic idea

of Mincer is that in the covered sector, the existence of a Minimum Wage that is higher than

the equilibrium rate (Wm>Wc), would encourage some workers to wait for jobs, thus generating

unemployment. Here unemployment is seen as queuing for covered-sector jobs. The length of

the queue (the unemployment level) would depend on the type of the frontier separating the

formal from the informal sector.

For example, if the two sectors are geographically separate, as might be true in some

developing countries, workers are unlikely to search for covered-sector jobs while employed in
the uncovered sector. In this case, the effects of Minimum Wage on unemployment might be

lower. On the other hand, in other countries, covered and uncovered establishments may be

next door to each other (C. Brown, C. Gilroy, and A. Kohen, 1982, p. 492); In this case the

effects might be higher.

METHODOLOGY

DATA COLLECTION

Data and Sources of Data

The study makes use of time series data for the period…………. The main sources of these data

include: Government of Kenya Statistical Abstracts and Economic surveys and Time Series Data

for Kenya 2017. The data for most variables is annualized except for minimum wage which is

given on a monthly basis. This is annualized by multiplying by twelve.

Limitations of the Study

DATA ANALYSIS

Methods of Analysis

Ordinary Least Square (OLS) model is used to estimate the relationships between the variables.

Two regression equations were applied where unemployment rate and weekly working hours

were used as endogenous (dependent) variables on each case. The study adopted the model as

used by Giuliano (2009) where unemployment was estimated using minimum wage, population

growth and net migration rates. However, since Okun’s law hypothesizes the relationship

between unemployment rate and economic growth, this study incorporate GDP growth rate as

an extra exogenous variable. The two models therefore assume the following forms.
 (1)
(2)
Wh ere
Is the slope dummy, calculated as the product of minimum wage and dummy country (“1” for the UK,
“2” for France and “3” for Netherland as denoted by sub - script “ ”).

and are the coeff icients of exogenous variables and error term incorporating the effects o
 dependent variables which are not explained by the specified factors in the model respectively. E - Views

 computer software was used to estimate the relationships between the variables.

 From neo-classical and the two sector model by Harris and Todaro (1970), it is assumed

that while minimum wage, population growth and net migration rates have positive

effect to unemployment rate, Okun’s law on the other hand shows that GDP growth

rate is negatively related to unemployment.

INTERPRETATION
CONCLUSION

While low wages contribute to the dire economic strains of many poor and low-income

families, the argument that a higher minimum wage is an effective way to improve their

economic circumstances is not supported by the evidence.

First, a higher minimum wage discourages employers from using the very low-wage, low-skill

workers that minimum wages are intended to help. A large body of evidence confirms that

minimum wages reduce employment among low-wage, low-skill workers.

Second, minimum wages do a bad job of targeting poor and low-income families. Minimum

wage laws mandate high wages for low-wage workers rather than higher earnings for low-

income families. Low-income families need help to overcome poverty.

Research generally fails to find evidence that minimum wages help the poor, although some

subgroups may be helped when minimum wages are combined with a subsidy program, like a

targeted tax credit. The minimum wage is ineffective at achieving the goal of helping poor and

low-income families. More effective are policies that increase the incentives for members of

poor and low-income families to work.

CITATION
REFERENCE

Card, D. and A.B. Krueger, (1994) Minimum Wages and Employment: A Case

Study of the Fast Food Industry in New Jersey and

Pennsylvania. American Economic Review, 84(4)1772-793

Card, D and A B Krueger, (2000) Minimum Wages and Employment: A Case

Study of The Fast-Food Industry in New Jersey and

Pennsylvania: Reply. The American Economic Review, 90

(5): 1397-1420

Republic of Kenya (Various issues), Economic Survey, Government Printers

Republic of Kenya (Various Issues), Statistical Abstract, Government Printers

Vandemoortele J (1984), Wage policy in Kenya (past, present and future), IDS consultancy

paper IDS UNO.

Vandemoortele J & Ngola S M (1984), The setting of minimum wage and its

consequences on employment and earnings in the modern sector in

Kenya, IDS consultancy paper No. 6, IDS UNO.