The Minimum Wage and Market Economics
One of the easiest ways to begin to understand the implications of a minimum wage (or an increase in a minimum wage) is by applying basic economics. A minimum wage is a “price floorâ€. As I discussed above, a price floor has two results: an increase in supply, and a decrease in demand. So how exactly does this apply to labor and the minimum wage?
First, seeing the cost of staff going up, employers will have an incentive to decrease the number of staff (Some would argue that the current number of staff is essential to running the business and will not decrease; I’ll address this later). Second, more individuals who are currently not seeking employment will enter the job market, now willing to work for that higher wage. So, fewer people are employed, and even more people want to be employed. This is a double-whammy for the unemployment rate!
Furthermore, for those who do retain their jobs, the pressure on the employer will be to cut costs elsewhere. One of the first things to go is often training. This means less opportunity for unskilled workers to develop into skilled workers and escape minimum wage, and perhaps poverty. Another item frequently on the chopping block is health care. Some would say this means a zero-sum game for an employee, but the results are far worse. The worker is moved from group health-care to individual health-care programs, where the costs of health care is usually higher to the individual than the employer.
We must also be clear that an artificial price floor may be below the current market rate and have no effect. For example, at one time in my community, gas station attendants were being offered wages of $11.75/hr. An increase in the minimum wage to $7.15/hr would have no effect in this market. On the other hand, in less affluent, more rural, or lower “cost of living†areas (where wages tend to be lower), an increase in the minimum wage will have a greater effect if wages are lower there. The conclusion to be made here is that the effect of minimum wage is directly related to the current wages in a given area, which are related to the overall cost-of-living in an area. Low cost-of-living areas will be affected the most. Also those in jobs that earn the least (typically unskilled workers) will be affected the most.
Having said that the law of supply and demand demonstrates that a higher minimum wage will increase unemployment in poorer areas and for unskilled workers, the simple economic conclusion is that those who are poor and unskilled will be affected by job losses.
One must now ask what happens to all these unemployed workers. Well, they’re out there looking for employment, of course. But they don’t just look for work in the markets covered by the minimum wage. They also look in the job markets that are not covered by the minimum wage. This has the effect of increasing supply in these markets. As we know, this increase in supply results in a decrease in price. That is to say, wages in uncovered markets fall, further hurting the poor and unskilled.
Counter-claims to Market Effects of the Minimum Wage
There are a number of claims that attempt to use empirical evidence or rely on an emotional response to convince us that a minimum wage hike is a good idea. Let’s go over some of these claims.
The lowest unemployment rate in the country is Hawaii’s 2.8 percent, which somehow survives their $6.75 minimum wage.
These figures are accurate and statistics don’t lie (on their own). But some liars can sure use this one to confuse folks. As I mentioned, a minimum wage hike will have an effect in low cost-of-living areas. It so happens that Hawaii has the highest cost of living in the country. The 2nd Quarter 2006 cost of living index for Hawaii was 161.3. That’s 61% higher than the average state, and nearly twice the differential of the next highest state.
Now, let’s adjust Hawaii’s current minimum wage for the cost of living there. $6.75 / 1.613 = $4.18. That’s right, the adjusted minimum wage in Hawaii is much lower than what the average state is paying in adjusted minimum wages. No wonder unemployment is so low – their price floor is almost 20% lower than the average state! If anything, the claim above supports a decrease in the federal minimum wage!
The number of people currently working is required to maintain business operations. As such, businesses cannot decrease employment due to a minimum wage hike without adversely affecting operations.
As we see job cuts due to operational issues on a regular basis, we already know that there is a significant amount that employers can cut due to cost increases. We call this elasticity. But an additional aspect of areas employers can cut jobs is due to substitution. In many cases, the most cost effective way to operate a particular task is with human labor. However, as the cost of human labor rises (i.e., with a minimum wage hike), technologies become more and more available at a cost lower than the rate of labor.
For example, at $5.15 it may be cost effective to have 10 people hand-drying cars at a car wash. Lets say this effectively costs the car wash $139,259 per year for wages and employment taxes (direct costs – we’re ignoring indirect costs like supervision). At a rate of $7.25 the employer must now pay $196,040 – an increase of $56,781. Now let’s say this employer can cut staff in half by using power-assisted drying mechanisms. This equipment, with maintenance, installation, power, and all other expenses factored in, costs $400,000 and has an expected life of 5 years.
At $5.15, cutting half the staff saves $348,147 over 5 years – less than the cost of the equipment, so the power drying equipment isn’t such a good idea. In fact, that’s why we don’t have it at the moment. On the other hand, at $7.25, cutting staff in half saves $490,100, so installing the equipment is a pretty good idea. I guess our employer will be cutting half those jobs in favor of automation!
Essentially, a higher minimum wage encourages the use of automation over labor.
Let me preface my comment. I have almost no knowledge of economics. I have never studied it. My copy of The Wealth of Nations is gathering dust on my bookshelf.
But isn’t the notion of the “invisible hand” more or less discredited at this point? I was under the impression that it was.
Tom,
Like every concept ever invented, the “invisible hand” has its critics, but in my research I’ve found it still to be generally accepted, especially at the level of economic theory my article is discussing.
What you may be referring to is the fact that the invisible hand is not considered to always be a “good thing”. Even Adam Smith himself stated that it could have horrible outcomes. That doesn’t negate it’s existence, however.
The invisible hand is, if I understand correctly, just a handy (har har) way to refer to the effects of a gigantic and ridiculously complex constraint satisfaction problem settling into dynamic equilibria. Looked at that way, it’s no more mysterious or unpredictable than weather patterns. 😉
That’s a good way of putting it Funky. If I’m not mistaken, it should also be noted that this contempory use/context of the phrase by economists was not the meaning Smith intended.
I have no intense knowledge on this subject (though I suspect a great majority of people with opinions on the minimum wage are in the same boat), but if the case is so clear cut, how can headlines like this exist:
5 Nobel-prize winning economists call for minimum wage hike
It probably has something to do with your suggestion about looking at cost-of-living-adjusted (as opposed to inflation-adjusted) minimum wage analysis. For a lot of places, cost of living numbers would justify a hike; one glaring reason why a legislated hike is necessary in such areas is the artificial depression of wages by cheaper (often undocumented) labor sources.
If businesses were to be deprived of this economic escape hatch, I suspect artificial measures in the opposite direction wouldn’t be necessary at all.
The mantra the business lobby often trots out in response to this is that there are some jobs Americans won’t do, which is a lie. If the employers were subjected to the same market forces under which they expect laborers to operate, they would be forced to raise wages on their own (without the need for government intrusion).
But this all assumes the invisible hand as a true integral entity in our labor market, which it is not – and has not been for a long time.
Howard,
Let me respond to each topic you presented:
If you google “economist minimum wage”, you’ll find plenty of economists on both sides of the table, so I don’t think “economists call for minimum wage hike” has any meaning without support. Your article only discusses inflation, which I’ve addressed.
Why? Even if you can claim that real wages have been decreasing, that’s not justification for an increase. You’d first have to support that there is a good reason to hold wage rates steady. Is it to help the impoverished? If so, then it’s better to compare to the federal poverty line, and to look at how many of those are earning the minimum wage. Since it is a tiny minority, better to target those folks with something that helps them directly (like the EITC I mentioned).
You’re right about that, but the context is typically: There are some jobs Americans won’t do at a pay rate of (X). This is true. An increase in wages here results in an increase cost of goods sold (COGS) and therefore price. As I demonstrated, higher price means lower demand. Lower demand means less need for production, and less jobs. Additionally, higher labor costs means more automation and less jobs.
From a macroeconomic perspective this also tends to increase inflation, further depressing the value of the increase you hope to achieve. For these reasons, I’m not sure this equation really helps anyone.
Please explain this. The alternative is a centrally controlled economy, which we certainly do not have. While the government meddles quite a bit, and some monopolies (and other imperfections) still exist, I think it is generally accepted that the market is largely controlling itself in determining production and prices…hence the invisible hand.
Obviously undocumented workers are illegal and a political hot potato. However, in economic terms, they’re just another part of the big equation. The economy of Mexico sucks badly enough that they’re willing to come here to work for what we’d consider peanuts. These illegal workers lower the market price for the work they do, causing some legal workers to quit and search for a better paying job. This is a legitimate market effect, Howard. To counteract this effect, a new market force must be added – legal consequences. If businesses faced sufficient legal ramifications for hiring cheap illegal labor, wages should rise “naturally”. Even then, there’s no guarantee that legal workers will be helped much because rising wages might lead to a smaller job market. Right, Lightwave?
Right Funky. I’d go even further and say that a raise in the minimum wage is likely to encourage an increase not only in automation, but in illegal immigration, since there will now be employers willing to pay $5.15, but unable to find legal workers at that rate.
Doing nothing to stop the flow of illegal immigrants into this country doesn’t sit right with me. I’d like to see quotas softened or lifted and/or better inforcement of current employment laws. Of course, there’d be economic consequences to any actions taken, but lacking a background in economics, I don’t know what they’d be or how bad they’d be. What solution(s) would you suggest, Lightwave?
Aside from changing the balance of wealth between the countries, the only other economic way to reduce demand for illegal work in this country would be to put a heavy economic burden on those who use the labor or those who perform the labor. The size of the burden would have to take into account the risk of being caught (in terms of a multiplication effect). At least that’s all that immediately comes to mind.
I’ll forgo any more on immigration in the hopes of steming a full fledged imigration debate within this thread 🙂
Why stick with just an economic burden on employers of illegal immigrants? It strikes me that the best way to reduce demand for illegal labor is by legislating that employers pay all laborers an equal wage, be the laborer a citizen, legal alien, or illegal alien. If employers had to pay illegals the same wage, there’d be no demand for the labor of illegal immigrants. Wouldn’t this be more effective and dabble less in economics, which can be pretty unpredictable?
Lightwave, your set of assumptions are glaringly flawed. Firstoff, the idea that an increase in wage cost will result in layoffs is predicated on some false assumptions. Firstly it assumes that there are unneccessary employees at companies, and the current cultural and economic climate is not one that allows for that. Also, to look at it from a mathematical standpoint, that only makes sense if the marginal profit associated with each employee is on the same scale as that employees wage. That is not true. Most companies make fantastically more money from each employee’s labor than they pay him/her.
It’s also obscenely callous to site the fact that people who had dropped out of the job market might return as a reason against raising the minimum wage. You’re focusing on indices rather than the actual condition of people in the country.
Most importantly, you forgot an influence that far outweighs any of the ones you mentioned. People living in bottom income brackets are almost all working multiple jobs. If you raise the minimum wage enough that they can get by working 40 hours a week, they’ll go down to one job and free up far more jobs than any of the effects that you were talking about would remove.
If you go back to what you were saying, you’ll note that minimum wage was put in during the Depression. That’s because they wanted to make more jobs by ensuring that any individual would only have to work one job. If you’d like I can find you pictures from a hundred years ago of grimy miners walking picket lines with signs saying “a four hour work day would end unemployment.” And, while I don’t agree that it would be a good idea, their reasoning is sound.
But a legislated hike will result in an increase in undocumented labor sources, which raises the theoretical possibility of a wage spiral.
Let me start by saying that I enjoy every bit of feedback I’m getting. That said, let me move on to the recent comments:
Tom,
So you think that employers who are willing to break the law and hire undocumented workers will obey a law that says “if you use illegal workers, you still have to pay them minimum wage.”?
John,
Let me address your points:
I’ve already addressed this. Automation is one aspect that makes a lower employee count acceptable at a higher wage rate (see my article). Additionally, every organization I have worked with has some current operations that they would cease if they had to pay more for it. So it is true that at least some organizations, if not most, will reduce employment.
This is a fallacy. Many well run organizations will have a high gross revenue per employee, but this has nothing to do with profit. Particularly with regard to low wage workers, there is a heavy set of other cost of goods sold (COGS) that factor in.
In a market economy it is difficult for any company to make “fantastic” profits for any long duration. Any company making “fantastic” profits will see other companies enter the market, increase supply and competition, and drive down prices and profits. Imperfect markets can screw with this a bit, but this is largely true even for our economy.
Erm, no I didn’t…I specifically raised this point in my article!
That proposition is not supported by any generally accepted economic law or theory that I’m aware of. In a market economy, an increased potential for profit (in this case, it’s in the form of wages), results in increased entrants, not abandonment of the market. Supply/Demand says that far more will keep their multiple jobs. It also leads to the conclusion that those currently not working will enter the market, and those already working will be now willing to take on additional jobs.
I don’t accept picketers as evidence of sound economic thought. Okay, so maybe everyone ends up employed, but making half as much money. More likely everyone takes two jobs to make the same amount of money, so all this does is add expensive overhead. I don’t see how that helps.
Ontario Emperor,
I think I can assume what you mean, but can you tell us who’s wages you’re talking about, and in which direction they’re spiraling.
Rephrasing Lightwave, I’d say that the notion of legislating that employers pay illegals equally is ludicrous since the nature of illegal workers is that employers shouldn’t be hiring them in the first place. A better idea would be to enforce current laws better and/or increase the penalties for violation.
“So you think that employers who are willing to break the law and hire undocumented workers will obey a law that says ‘if you use illegal workers, you still have to pay them minimum wage.’?”
Definitely. Have you ever seen daytime TV commercials? If you’ve been victimized by anyone’s perceived negligence, Allen Rothenberg (*THE* injury lawyer!) is there for you. All it would take is one or two high-profile lawsuits against companies paying their illegal-immigrant laborers too little to whip the rest into shape.
“I’d say that the notion of legislating that employers pay illegals equally is ludicrous since the nature of illegal workers is that employers shouldn’t be hiring them in the first place.”
Really? It’s in the nature of illegal immigrants that they shouldn’t be hired. Hmm. Hook me up with some of the ganj you’re smoking.
Tom,
Perhaps you’re not aware that illegal imigrants regularly suffer illegal abuses from their employers, with no recourse. The bottom line is a law to pay illegal workers a higher wage will not help the economy or the poor.
Aside from that, perhaps you could defend why you think it is a good idea for employers to hire illegal workers, rather than targeting an argumentum ad hominem at commenters who have otherwise been respectful of you.
“Perhaps you’re not aware that illegal imigrants regularly suffer illegal abuses from their employers, with no recourse. The bottom line is a law to pay illegal workers a higher wage will not help the economy or the poor.”
Of course this would have to come as a package deal — it doesn’t seem to me that the government can very well instruct employers to pay decent wages to people, then turn around and not offer them the standard rights enjoyed by workers. It simply wouldn’t be right to do otherwise. Then again, the federal government isn’t known to legislate based upon what’s right…
“Aside from that, perhaps you could defend why you think it is a good idea for employers to hire illegal workers, rather than targeting an argumentum ad hominem at commenters who have otherwise been respectful of you.”
I offered no such argument. My comment to Eric was not an argumentum, and, a fortiori, not an argumentum ad hominem. I was merely attempting to get him to explain just how he figures that the “nature of illegal workers is that employers shouldn’t be hiring them in the first place,” and exactly how it is that he comes to think the suggestion I’ve made is “ludicrous.”
Lightwave,
(Please bear with me as I haven’t had much time to respond to anything on this thread since the first comment I left.)
First on the article I cited:
On whatever grounds the Nobel winners in the article support raising the minimum wage (whether it’s based on inflation, cost of living or any other factors), they obviously disagree with your position (whether they disagree with your conclusion, your premise, or both). Which isn’t to say there aren’t highly qualified economic minds who wholeheartedly support with your side; I know full well that there are.
But your post is written with an apparent tone that any competent economic analysis would bear out your conclusions; this is far from clear, given the variety of conclusions reached by highly-qualified economists on all sides of the issue.
And a point I forgot to address originally was the implication that empirical evidence is somehow inherently inferior to theory. While theory can provide a decent perspective, it doesn’t always translate to reality. Theory almost always operates in a vacuum, while reality almost never does.
So while theory is nice, empirical evidence is usually relevant. As of yet, at least in statewide minimum wage increases I’ve been looking into, I’ve seen none of the negative impacts you refer to. I guess what I’m saying is that I’d be far more likely to be swayed by your position if it was more heavily based on real world results rather than theory – especially since we already have sufficient (and current) real world examples to study.
And before I slip back into the offline realm, a quick thought on the invisible hand vs. centrally-controlled economy question:
To me there isn’t much doubt that, given the sheer volume of inorganic interference built into things like the tax structure, as well as the statutory and administrative codes that bolster or restrict everything from labor standards to workers’ freedom of assembly, our economy’s much more of a hybrid between central control and sheer market force than you seem to think. Whatever the balance is, I’m sure it’s far from Adam Smith’s vision.
Tom,
If I’ve understood correctly, your suggestion amounts to the government telling employers, “It’s still illegal to hire illegal immigrants, but if you should decide to break the law and hire them anyway, we’ve put a new law in place that says you must pay them legal worker rates.” How is that not ludicrous? Why would a government write laws to control behavior it has already made illegal?
Furthermore, why would a company that’s already breaking the law by hiring illegal immigrants choose to not break the law regarding how they are paid? It seems to me that the only way companies are going to stop hiring illegals is if there are stiffer penalties for and a greater likelihood of being caught doing so. The only way to improve illegals’ lives is to make them legal, i.e., lift or loosen quotas and/or remove some red tape to make legal immigration easier and more common.
Howard,
You make some very insightful points that tell me I need to clarify my comments. First, empirical evidence may be valuable in analysis, however, the use of such evidence is usually simplified to the point that it entirely ignores to complexity of the market (see my Hawaii example).
Another way of saying this is: most evidence provides correlation. Correlation is not causation (A watermelon is ~98% water, and a cloud is ~99.999% water. Yet they are nothing alike). As such, I have yet to find any empirical studies that even approach the appropriate depth necessary to be credible for this topic. Having little valid evidence on which to rely, I must turn to economic law and theory.
On the topic of the invisible hand, I think you are correct that there is some control on the market. In some markets there is heavy control. But I think you’ll find that the vast majority of markets operate in a very free way (just start thinking about things you buy on a regular basis and how price and supply are or are not controlled).
Even with the current heavy regulations on labor, outside of the minimum wage, the market largely operates freely. Employers and employees (individually or as a group) negotiate their own prices. In fact, this tends to be one area where there is more stomach for price negotiations than most other markets.
Tom,
You’re making an argument for granting illegal workers similar status to legal workers. Again, all this does is set a price floor on yet another group of workers, so the arguments in my article have even stronger application here.
“If I’ve understood correctly, your suggestion amounts to the government telling employers, ‘It’s still illegal to hire illegal immigrants, but if you should decide to break the law and hire them anyway, we’ve put a new law in place that says you must pay them legal worker rates.’ How is that not ludicrous?”
That would be silly — indeed, silly enough to safely assume that that’s not my point. Obviously, in order to legislate that illegal immigrants would be paid at the same rates, it would only make sense to legalize the hiring of illegal immigrants. Since they are to make the same wages, however, there would be no incentive to hire illegal immigrants over naturalized US citizens.
“Why would a government write laws to control behavior it has already made illegal?”
Not that I’m supporting it, but governments do this all the time — in some cities, prostitutes can take their pimps to court for mistreatment and abuse. Some city programs offer free drug needles for the purpose of stopping the spread of AIDS amongst heroin addicts.
“Furthermore, why would a company that’s already breaking the law by hiring illegal immigrants choose to not break the law regarding how they are paid?”
With the proper legal recourse for workers who immigrate illegally, there is nothing to say that companies would screw illegal-immigrant workers any more than American workers.
“You’re making an argument for granting illegal workers similar status to legal workers.”
No, I’m making an argument for allowing illegal immigrants to work legally. Illegal workers would still be illegal workers, but simply because one is an illegal immigrant does not make one, ipso facto, an illegal worker. I suppose I haven’t made myself clear. Above, when I said “illegal worker/laborer,” what I should’ve said was “worker who is also an illegal immigrant.”
“Again, all this does is set a price floor on yet another group of workers, so the arguments in my article have even stronger application here.”
Again, I really have no idea what the heck economics is all about, so I can’t really offer a counter-argument here. But the whole reason I wrote the above comment about forcing companies to pay illegal immigrants the same wages as legal immigrants had not a thing to do with price floors or any of that mumbo-jumbo, but with undercutting companies’ desire to hire them. Someone said that the best way to stop companies from doing this would be via certain economic pressures, incentives, or something. I merely suggested that a more effective way to achieve the same end might be to consider putting in place laws requiring equal wages for illegal immigrants.
The existing labor laws cover illegals just the same as they cover citizens, it’s just that there’s no means of enforcement. In general there’s very little proactive enforcement of these laws. If you refuse to pay someone minimum wage, they can seek redress from the government, but the government does not generally seek out infractions.
Also, to return to the central argument that a minimum wage increase would result in an increase in unemployment, a simpler way to seek out data would be to look at places where minimum wage hikes have occurred, and then se if that has historically precipitated spikes in unemployment. To within my knowledge, that is not in fact the case.
Also, to look at a macroeconomic view, any increase in pay to minimum wage workers is almost all going to get spent. If you increase wages at the bottom, the long term benefit from an expanding consumer base will be greater than any negative impact. We can look again at the depression and see that one of the contributing factors was that most of the people in the country didn’t make enough to buy the fancy industrial goods that were coming out. If minimum wage workers now could afford to buy computers, that’d be a boon for the economy.
Tom,
I think John makes my point for me.
You can’t make any effective laws that protect an illegal immigrant, because they’re unenforceable. Any illegal immigrant making a claim would feel threatened with deportation. The fact is, the power held by anyone who could threaten INS action trumps any fines the government can levy.
Regardless of your laws, I’ll state again this concept only serves as a vast minimum wage hike, so my original argument applies even more.
John,
In response:
True, but that doesn’t make it a good thing by definition. For example, taxes are going to get spent anyway, but they still sap economic resources from some economic areas to distribute them to other areas. We know that heavy taxes have had devastating effects on economies, so putting a wage increase in the same category does not help your argument.
Again, you must look much farther than simple wages/unemployment. As I’ve said, my article responds directly to this argument with the Hawaii scenario.
I’ve stayed out of this one because I am ambivalent, or rather believe in both sides rather strongly. Lightwave is right on one (as far as I see) account: it is incoherent to establish a federal minimum wage, the cost of living being highly variable. States can and do impose minimum wages. Let them continue to do so. This is reason alone to opposed this particular legislation.
For the rest of the analysis however, I care not at all, not least because most people already know about supply and demand (if not intuitively then from high school), and anyone can fabricate examples to illustrate points. But mostly because a man’s labor is not merely a commodity. It may be seen as that by economists and the “modern” economy they created. And if this is so, then surely the problem with the economy and economists and not with man who labors with inherent dignity. Now the minimum wage has been around for longer than any of us has been alive. And it has been raised surely at least a dozen or so times. Probably far more, I don’t know. So in support of the thesis that raising the minimum wage is, because of potential unemployment or whatever, bad for the working poor, I’d like to see studies that show this is exactly what happens most of the time. Or that raising the minimum wage widens the gap between rich and poor. I suspect the reason these studies were not presented is because this doesn’t always (if ever) happen.
I’ve worked for or only slightly above minimum wage for at least 8 years of my life. And, even tho’ I now make over an order of magnitude more than that, I still know how I felt about raising the minimum wage not so long ago: absolutely in favor. Mechanization has already squeezed out almost all the unskilled labor it can. Outsourcing has set its sights now on the professional classes (like me for instance). Those jobs that remain at minimum wage are jobs that mostly are not automatable and not outsourcible. And I’m sure they’d appreciate a raise. But again, the states should do it, not the federal government.
Lightwave & Co.,
Point conceded.