Optimal Minimum Wage Policy with Voluntary Participation

Abstract

This paper considers optimal minimum wage policy in a low-ability labor market in the presence of a subsistence allowance and a participation externality. In a market with heterogenous workers and homogeneous low-skilled jobs, a low ability worker's participation decision has a chilling effect on job creation which the worker does not internalize. Absent a minimum wage, subsistence allowance sets both a lower bound on individual incomes and a threshold ability level for labor market participation. A binding minimum wage acquires the latter role. It helps to address the externality by excluding the least able from the market while the subsistence allowance continues to meet minimal nutritional requirements. Quantitatively, while the externality is shown to be important, the minimum wage is not a very effective means of addressing it.