Question

Requirement: Answers to each of the following problems will be evaluated based on accuracy, completeness and clarity. Unsupported answers will receive no credit. Any assumptions you make in answering the questions should be clearly stated. Point allocation is given beside each question.

Condition: Suppose Oregon proposes indexing the minimum wage to inflation. In the space below, summarize what it would mean to index the minimum wage to inflation, and then describe the substitution and scale effects you anticipate with this policy? (In your response, assume that the minimum wage is an effective price floor and that both factor and product markets are perfectly competitive.)

Question: Describe the scale effect in this scenario.

Answer 1

The minimum wage is set in regards to CPI prices for example 8$ as against national average of 9$ as price ceiling.

The increase in minimum wage due to CPi inflation will now force firms to opt for mass layoffs which will then lead to rise in unemployment and hence aggregate demand reduces which will lead to sharp drop in prices because of perfectly competitive market.

The scale effects demonstrated here is by drop in prices due to minimum wages. As substitution effect, firms will replace loss of these workers due to increased wages by efficient machines to balance productivity.