When—to cover the risk of underemployment—households oversupply labor to a labor market in which demand is down, a minimum wage set below the prevailing market wage can send the market wage down and unemployment up. Unemployment benefits can, by countering some of the risk of unemployment, neutralize the inefficiencies of households' tendency to oversupply labor.
The supply behavior of labor often depends on the demand conditions prevailing in the labor market. If demand is inadequate, households may send additional household members, who otherwise would not have worked, to look for work, for fear the main income earner may lose his job.
Basu, Genicot, and Stiglitz study the theoretical consequences of this "added worker" effect. They show that it can give rise to multiple equilibria in the labor market.
Surprisingly, a minimum wage law set below the prevailing market wage can cause the market wage to fall and unemployment to rise.
Unemployment benefits, by countering some of the risk of unemployment, can neutralize the inefficiences caused by households' tendency to oversupply labor.
This paper—a product of the Office of the Senior Vice President, Development Economics—is part of a larger effort in the Bank to understand unemployment and examine alternative labor market policies. Copies of the paper are available free from the World Bank, 1818 H Street NW, Washington, DC 20433. Please contact Michelle Mason, room MC4-338, telephone 202-473-0809, fax 202-522-1158, Internet address mmason1@worldbank.org. Kaushik Basu may be contacted at kbasu@worldbank.org. (35 pages)
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