Micro Economic question 2

2b Show that a minimum wage set above the market clearing wage rate causes excess supply 

of labour. Why would a government impose minimum wage despite knowing its effect on 

unemployment?

Answer

The demand for labour will be negatively sloped in all types of production for two reasons. First, a rise in the wage rate increases the costs of firms producing the commodity, forcing them to raise their selling prices. As the price of the product rises consumers will buy less of it and less output will be produced and sold. This means that less labour will be used. Second, since a rise in wages makes labour more expensive relative to capital, firms will substitute capital for labour. This means that less labour will be used to produce whatever output the firms in the industry sell.

If the wage is free to adjust in response to market forces it will move to  We,  where the demand for labour equals the supply. When the wage is above  We,  more labour will be presented for employment than firms in the industry can profitably hire. It will pay workers to lower their wages to obtain employment in the industry. And when the wage is below  We,  firms will find it profitable to hire more labour than is presenting itself for employment. They will offer a higher wage to obtain additional workers.