The dissipation of minimum wage gains for workers through labor-labor substitution: evidence from the Los Angeles living wage ordinance.

• Author: Fairris, David
• Position: Statistical table

1. Introduction

   Economic theory suggests that firms will replace low-skill workers with high-skill workers if the two are substitutes in production and the wages of low-skill workers increase as the result of a minimum wage. Labor-labor substitution may also take place along dimensions other than skill if, for example, employers have a "taste for discrimination" and the minimum wage reduces the wage premium they must pay for favored personal characteristics of workers. If affected firms replace low-skill workers with high-skill workers following enactment of a wage minimum, the initial benefits of the regulation for workers at these firms will be dissipated over time as the wage gains for new hires are less than for members of the original workforce. A similar dissipation of wage gains will occur if employers replace workers that are discriminated against in the labor market with those that are not.

   Most theoretical depictions of labor-labor substitution focus on employer-initiated causes: It may result from changes in firms' demand for worker skills, from employer efforts to dissipate worker minimum wage rents by requiring greater work effort or less absenteeism from workers (and by seeking workers that better match these new employer goals), or from employers invoking their "taste for discrimination." However, successful labor substitution rests on workers' supply decisions as well. Indeed, such substitution could result solely from labor supply effects if, for example, firms were to hire nonselectively from an altered more highly skilled or otherwise favored applicant pool, which is brought on by the higher wage.

   The empirical literature on the employment effects of wage minimums has found little employment loss among affected jobs or more highly impacted worker populations, such as teenagers (Brown 1999). This suggests that there may be little labor-labor substitution across broad skill/occupational categories--for example, adults for teenagers, workers with some college experience for high-school graduates, or backhoe operators for ditch diggers. (1) However, labor-labor substitution may still take place along more refined dimensions of workers' skills (Abowd and Kilingsworth 1981). For example, Neumark and Wascher (1996) find evidence that minimum wages lead firms to substitute away from younger teenagers and toward older, more experienced teenagers.

   Labor substitution following a minimum wage may dissipate the initial wage gains for workers. Empirical evidence suggests, however, that, just as in the case of unions (Card 1996), the rent dissipation is by no means complete. It is now well established empirically that a "spike" exists in the wage distribution around the relevant minimum wage (Card and Krueger 1995; DiNardo, Fortin, and Lemieux 1996), suggesting that the wages of low-skill workers are indeed affected by wage mandates. (2) Moreover, job queues exist for minimum wage jobs, suggesting that economic rents are earned by low-wage workers in these positions (Holzer, Katz, and Krueger 1991). Although the worker rents created by minimum wage regulations may not be completely dissipated by labor substitution, the extent of such dissipation remains an open question empirically.

   Although the theory of labor-labor substitution is well-developed terrain, we are aware of no empirical tests of the proposition at the establishment level. (3) The empirical literature on this topic has mainly focused on estimates of the elasticity of substitution, typically relying on time series data on broad industry aggregates (e.g., manufacturing) to test for substitution either across broad skill categories (e.g., nonproduction for production workers) or across worker characteristics (e.g., older age for younger age, white for black, or male for female) using labor demand equations or production or cost function specifications. All approaches pose significant econometric challenges to the researcher, none are directly concerned with substitution resulting from a minimum wage increase, and none are able to discern whether the observed substitution is the result of within-firm as opposed to across-firm or across-industry adjustment.

   An exception to this basic approach is the literature on wage spillovers, which looks at the impact of minimum wage increases on the wages of workers earning more than the minimum. However, as noted by Grossman (1983), the wages of workers higher up in the wage distribution may increase as the result of internal wage norms rather than demand shifts because of substitution. Thus, the evidence on wage spillovers is difficult to directly link to labor substitution. Neumark, Schweitzer, and Wascher (2000) extend the wage spillovers approach by exploring the impact of an increase in the minimum wage on the hours of work and employment of workers earning more than the minimum. They find some evidence for a positive and statistically significant contemporaneous impact on the hours of work of these workers, but the effects do not persist over time, and there appears to be little statistically significant employment effects. None of these results is directly attributable to labor substitution at the establishment level.

   In this paper, we utilize a unique employer-employee matched dataset to explore the extent of labor-labor substitution and dissipation of wage gains for workers resulting from a significant wage mandate--a living wage ordinance within city contract establishments in Los Angeles. We capture labor substitution by comparing the skill and nonskill attributes of a sample of stayer workers with those of a sample of joiner workers following a period of adjustment to the initial minimum wage increase. The demographic and human capital characteristics of these workers allow us to test for substitution along observable demographic and skill dimensions. In addition, we also know the wages of these workers before the wage mandate, which allows us to measure the extent of substitution among unobservable skill and demographic characteristics. Exploring unobservable differences across the stayer and joiner populations is important because the skill substitution that interests us is perhaps less likely to occur across observable dimensions, such as schooling.

   The worker-firm match aspect of the data allows us to estimate within-firm measures of labor substitution and thereby gives some insight into whether firms behave as the microeconomics theory of substitution suggests. The establishment survey data offer information on the city contract firms that were affected by the ordinance. In addition to numerous establishment characteristics, the survey asked employers whether they changed hiring standards in response to the living wage, thereby allowing us some insight into the relative importance of demand-side (i.e., employer-initiated) versus supply-side (i.e., changing applicant pool) effects in the overall substitution response.

   One of the major challenges posed by these data in adequately testing the labor-labor substitution hypothesis is that we know nothing about the leavers--that is, those workers who left city contract work between the time their firm became subject to the Living Wage Ordinance and the time of the survey. A proper test of the hypothesis would compare joiners with leavers rather than joiners with stayers. However, to the extent firms actively seek to alter the skill or demographic features of the workforce, it seems reasonable to assume that stayers would be drawn disproportionately from among the more highly valued, and thus highly paid workers in the original workforce, which means that a comparison with stayers leads to an underestimate of true labor-labor substitution. The information on the hiring standards change allows us to produce some suggestive evidence on whether or not this is the case.

   Finally, estimates of the conditional average wage increase for stayers and joiners resulting from the Living Wage Ordinance are used to derive a measure of the dissipation of minimum wage gains for workers at affected firms. Specifically, we begin with the average wage gain for stayers and assume that it represents (a lower-bound estimate of) the average wage gain for the initial workforce at the time the ordinance took effect. This measure is then compared to a measure of the overall wage gain to workers following a period of adjustment and labor substitution, using a weighted average of the wage gains of stayers and joiners. The difference between the two measures provides an estimate of the dissipation of wage benefits for the workforce at affected firms due to labor-labor substitution. Note that this is not a measure of dissipation in the labor market as a whole--which, at a minimum, would require knowing something about the wages of leavers in their new positions--but rather an establishment-level measure of dissipation, grounded in the labor substitution behavior of affected firms and focused on the workers employed in those firms.

   The outline of the paper is as follows: We begin with a brief discussion of the Los Angeles Living Wage Ordinance. This is followed by a discussion of the data and empirical methodology. The results of the analysis of labor-labor substitution on observable and unobservable characteristics are then discussed. We conclude with an estimate of the wage gain for workers resulting from the Living Wage Ordinance, accounting for the impact that labor-labor substitution has had on the dissipation of worker rents. The results suggest substitution toward male, Latino, and black workers, and workers possessing prior formal training. All are characteristics that generate a wage premium in this particular segment of the low-wage labor market in Los Angeles. The results also suggest rather significant substitution on unobservable worker characteristics, as evidenced by the finding that the "before" wages of joiners are significantly higher than those...