The Two-Sector M odel

As mentioned above, the standard competitive model is suitable for the countries where minimum wage coverage is high. However, this model might not be complete for developing country cases, given a high proportion o f workers in the uncovered sector. The extension o f the standard competitive model is given by the two-sector model firstly constructed by Welch (1974) by considering incomplete coverage of minimum wage. This model basically assumes that there are two sectors in the economy, one that is covered by the minimum wage policy (the so-called covered

sector) and one that is not covered by the minimum wage policy (the so-called uncovered sector) with perfect mobility across two different sectors. In the absence o f a minimum wage, these two sectors are assumed to be paid at the same wage level Wo.

Suppose there is an imposition o f a minimum wage in the covered sector that is higher than the equilibrium wage rate Wo. The covered sector jobs then become preferable to the uncovered sector jobs, suggesting that more people become willing to work in the covered sector. In other words, an imposition o f a minimum wage potentially creates an excess supply o f labour in the covered sector. According to Welch (1974), the probability o f finding a job in the covered sector (P ) is therefore given by:

^ D cQVm) SQVm)

where Dc(Wm) is the demand for covered sector jobs and S(Wm) is the aggregate supply o f labour.

Based on the two-sector model, this excess supply o f labour in the covered sector potentially generates a displacement effect for employment in the covered sector into the uncovered sector or withdrawal from the labour market. Specifically, this effect not only shifts or affects workers who were previously in the covered sector but also moves people who were previously not in the covered sector and have been encouraged to enter the covered sector by the minimum wage imposition. This evidence is illustrated by the shift in the supply curve o f the uncovered sector outward from So to Si in figure 4.2.

Following Welch (1974), the supply o f labour in the uncovered sector (Su(Wo)) after the minimum wage imposition in the covered sector can be specified in general form as follows:

S UQV0) = S Q V )(}-P ) (4.4)

where S(W) is the total supply o f labour. In consequence, the uncovered sector employment will increase (from Eo to Ei in figure 4.2) and wages paid to the workers in the uncovered sector will decrease below the original equilibrium level (from Wo to Wi in figure 4.2). At the new equilibrium wage level, Wj, demand in the uncovered sector at Wi (D U(W/)) is then given by:

D u{W,) = Du(W ,){\ + r,co) (4.5)

where Du(Wo) is the demand o f labour in the uncovered sector before the minimum wage imposition, 77 is the elasticity o f labour demand, which is presumed the same as for the covered sector, andco is the proportionate wage reduction (or given as co = ( Wj- W0)/W0).

On the other hand, the supply o f labour in the uncovered sector, at the new equilibrium wage (SU(W/)), is given by:

S u(W1) = S(W )(l + s c o )(l-P ) (4.6)

where s is the elasticity supply o f workers in the uncovered sector. Equating the sum o f the demand and supply changes related with the co proportionate wage reduction and the supply shifts induced by the minimum wage imposition in the covered sector gives:

~ ° V - (4.7)

l - c + ewm

where c is the proportion o f workers employed in the covered sector and wm is the proportion by which wage changes as the minimum wage imposition in the covered sector.

W

w,

E0 Ei

Figure 4.2

Minimum Wages Effects in the Uncovered Sector

In Indonesia, the distinction between the covered and uncovered sectors depends on the category (status) o f employment. As mentioned above, in Indonesia, paid employment is the category o f employment legally covered by the minimum wage policy, while self-employed and unpaid family workers are the category of employment not covered by the minimum wage policy. Although the proportion has been increasing, paid employment in Indonesia is only 39% o f total employment with more than 60% o f them in urban areas. Given that there are no unemployment benefits provided by the Indonesian government, if there is some decline in the covered sector, it can be predicted that workers are likely to be displaced to the uncovered sector. In addition, Feridhanusetyawan and Gaduh (2000) argued that the labour market in

Indonesia is flexible enough in supporting labour mobility from one sector to the other sector if there is a contraction in the covered sector. One o f the examples o f flexible labour mobility in Indonesia is the role o f the urban informal sector as a “safety valve”

for employment during the crisis o f 1997-1998.

In addition, Mincer (1976) and Gramlich (1976) extend the standard two-sector model by considering that workers displaced from the covered sector will not automatically enter the uncovered sector when the wage rates offered in the uncovered sector are lower than their reservation (expected) wages (the so-called two-sector model with queuing for covered-sector jobs). These workers, specifically, will wait (queue) for the covered sector (as unemployed) because this sector generally has a higher expected wage than the uncovered sector. However, the probability o f getting a job in the covered sector in practice is lower than the probability o f getting a job in the uncovered sector. In this case, Gramlich (1976) specified the expected wage as follows:

E(W) = (P + r ( l - P ) W tn) (4.8)

where P is the probability o f being employed in the covered sector, r is income replacement rate for unemployment benefits, and Wm is the wages in the covered sector. Specifically, P depends on the number o f unemployed queuing for the covered sector jobs (U) relative to the covered sector employment as follows:

/> =

X -r r -

1 +

+ DC(W„)

According to this model, the total supply o f labour therefore consists o f covered and uncovered sectors employment and unemployed, which is given by:

S(W)=Dc(Wm) + Du{Wi) + U (4.10)

Assuming demand elasticities in covered and uncovered sectors are equal, total employment will be a function o f proportion o f workers employed in the covered sector (c), elasticity o f demand for labour (rj), elasticity o f supply for labour (s), unemployed parameter (a), and the wages in the covered sector ( Wm), which is given by:

c{s + —)r}

In E = --- 2 --- In Wm (4.11)

£ H (1 - ^{C ) l )} a

Solving for the unemployment rate (the ratio o f unemployed to supply o f labour), this is given by:

U c {E -r j)

S(WU) s a + c - «(1 - c)rjIn Wm (4.12)

The limitation o f this two-sector model with queuing for covered sector jobs developed by Gramlich (1976) and Mincer (1976) is that it assumes workers cannot search for covered sector jobs when they are employed in the uncovered sector (Brown et al, 1982). If covered and uncovered sectors are separated geographically, workers in uncovered sectors are unlikely to search for covered sector employment.

However, the covered and uncovered sectors are usually separated based on their employment category (employment status), such as in Indonesia, suggesting that uncovered sector employment (those who are interested in entering covered sector employment) are likely to search for covered sector employment when they are employed in the uncovered sector. Therefore, the unemployment rate (from the queuing for covered sector jobs) might be less than predicted. In addition, this model assumes the availability o f unemployment benefits, which is not the case o f Indonesia.

As a result, the simple two-sector model developed by Welch (1974) might be more relevant for Indonesia than the two-sector model with queuing for covered sector jobs developed by Mincer (1976) and Gramlich (1976).