Friday, November 14, 2008

Wages, unemployment and formal employment

Take a look at these charts:
Here's how I read them. First, (A) and (B) show a strong association between real minimum wages and overall (average) employee wages. The relation was most obvious between 1999-2003. This shows that minimum wage has become an arena of collective bargaining. Wage negotiation happens not in the private sphere (within company) but in the public sphere (policy). This indicates an institutional failure in the labor market: bipartite negotiation. Since 2003, real minimum wage has been relatively stagnant, so has the overall wages.

Second, (B) and (C) can be divided into three periods. Prior to the crisis (1998), all went well in the sense that wage was growing, and so was formal sector employment. From 1999-2003, when wages was increasing rapidly, share formal sector employment declined significantly. After 2003, wages has been relatively stagnant. It is no coincidence that formal sector employment started to expand.

Note: 1) you won't see the relations as significant if you just simply take one point of time and compare it to another (say, 1999 vs. 2008). 2) a colleague of mine did an econometric estimation and confirmed that every 10% increase in average regional minimum wages is associated with 1 percentage point decline in the share of formal sector employment a year later.

Third, I didn't put it on the picture -- but apparently there is an obvious relations between wages and unemployment. Our friend Suahasil Nazara and his co-author Iyanatul Islam might be right (like Card and Krueger). But I second Prof. Aris Ananta that unemployment rate may not be the best labor market indicator, as it doesn't tell much about job quality and welfare. In such case, formal sector employment should be a better indicator.

Now the question is who wins and who loses if the minimum wage is increased?


  1. Shouldnt it be Bird and Manning's paper?

  2. I was referring to Sua and Iyan's (and Card/Krueger's) paper regarding no detrimental impact of minimum wage increase on overall unemployment. They may be correct.

    But you're right -- Bird and Manning's highlighted the distribution impact of MW policy, which is not pro-poor. As they argued, "among the poor, a minimum wages increase boosts net incomes for 21% of the households, while it results in net losses to 79% of the households." Thanks for pointing that out, whoever you are... :-)

    This is parallel to my argument that increasing MW is associated with fewer workers in the formal sector (they are forced to take worse jobs in the informal sector.

  3. Pe,
    i'm not sure that MW is the main driver of slowing employment growth in the formal sector ( i get this sense from your post). I think that technical change also contributes in the employment growth particularly after the 1998 economic crisis. But the change happened before the crisis and rapid increase in MW. i suspect that other labour regulations instead of MW are the main reason for this.

    i wrote this on our blog.

  4. Yudo,
    for sure different composition of growth matters too. But see the graph again, look at the pattern in 1999-03 and after 03. The wage-formal employment trade off is apparent. If growth composition is the main issue, then we should see formal sector continues to decline.

    Yes, other Employment Protection Legislations (EPL) is another problem and my other hypothesis. But apparently the effect is not as strong as MW as compliance rate is low. Besides, again, the Labor Law is ratified in 2003. It means EPL should still be a problem up to now. Instead, since 2003 we see that formal sector employment started to grow.

  5. Pe,
    "The wage-formal employment trade off is apparent" is not always the case. I found something paradox in the textile industry (one of the largest source of the formal employment creation).

    I wrote my argument

    it is better for me to say that i don't know exactly which one is the main obstacle (MW or EPL) on employment. But based on my study in the textile industry, employers are concerned much more on the latter (EPL) rather than the former (MW).

  6. Yudo,
    I think we are not disagreeing on anything. I agree with you, as you wrote on Ruang 413, that the impact of MW and EPL may vary across sector. I haven't been able to confirm but perhaps EPL matters more in the textile industry.

    I also don't reject that many employers state their concern over EPL (subjective indicator). A note -- when you said employers concern more on EPL, did they say which EPL in specific? The most repeated ones, based on my several interviews, are severance pay. Then there are two things: 1) the hiring/firing tax index, and indicator that was used to measure the impact of severance payment (read Armida Alisjahbana's paper), basically it has been constant lately; 2) compliance rate is low.

    So, although EPL has been stated as a big concern, it doesn't seem to be a binding constraint in reality. Also remember that, and I think this is true especially for textile industry, when employers concern over EPL, their reactions could be employing more contract and outsourced workers instead. This means, formal employment may not be affected that much.

    Meanwhile, if they face higher MW, contracting out/outsourcing will not be an effective strategy since they must pay MW anyway. They will either not complying or 'go informal'.

    But there are more devils in the detail. I am not defending that the methodology I've been using was the best one. We can elaborate this in the Cafe Salemba-Ruang 413 next off air session... :-)