Effects of minimum wage on workers’ on-the-job effort and labor market outcomes

Can higher minimum wages motivate workers to work harder? If so, what are the effects of workers’ on-the-job effort responses on the labor market outcomes? To answer these questions, we apply a model with directed on-the-job search and dynamic incentive contracts in a frictional labor market. The steady-state comparison of the calibrated model shows that a higher minimum wage increases workers’ on-the-job effort. It also reduces the average hiring and layoff rates. Since the reduction in the hiring rate is higher than the reduction in the layoff rate, the un-employment rate increases, and hence lowers the aggregate output. Moreover, we find that the higher minimum wage has a spillover effect on higher-income workers. It suggests that agents’ incentive decisions can provide a new explanation of the spillover effect of the minimum wage. Lastly, shutting down the effort channel leads to greater labor market impacts. These results suggest that workers’ on-the-job effort responses have moderate offsetting effects on the cost of the higher minimum wage.