The Effect of Minimum Wages on Employment: A Factor Model Approach

The goal of this paper is to resolve issues in the minimum wage-employment debate by using new factor model econometric methods to control for unobserved heterogeneity. Recent work has shown that traditional methods producing negative and statistically significant minimum wage-employment elasticities are sensitive to adding controls for unobserved heterogeneity, but these controls rely on assumptions that may not be supported by the data. The factor model results suggest that any negative employment effects that do exist are small. Furthermore, simulation results show that unobserved common factors can explain the different estimates across methodologies in the literature. A counterfactual experiment shows that the states that would be affected by a modest federal minimum wage increase are those that are most able to absorb minimum wage increases without experiencing decreased employment.