Before beginning to write this article, I was of the opinion that minimum wage should at least be adjusted for the cost of inflation, but I had put little additional thought into the matter. Raising the minimum wage is certainly a popular idea with Americans today. Indeed, Americans overwhelmingly support an increase in the minimum wage. Sadly, however, we can not rely on the good judgment of Americans at large to determine what is a good idea (we can’t even count on them to stick to their guns….war in Iraq, anyone?).
The idea of a minimum wage was originally applied in Australia and New Zealand. The U.S. Federal minimum wage was established in 1938 at $0.25/hr and covered less than half of all jobs. The current minimum wage is $5.15 and covers more than 75% of all jobs.
I’d like to discuss some of the implications of a minimum wage hike and some of the claims that have been made about its effects. But before I delve into the details of the wage hike, I think it’s important for a brief reminder of market economic theory 101.
Market Economics – Supply and Demand
If you’re already very comfortable with market economics, it might be best to skim past this section. I also usually get a few comments from folks who think market economics are unjust, inequitable, or just plain a bad idea. Regardless of your beliefs, however, ours *is* a market economy, and we must treat it as such.
One of the essential economic theories is the law of supply and demand. The idea here is that the invisible hand of the market will adjust prices, supply, and demand into a balanced equation. There are a few basic scenarios:
- Increase Supply or Decrease Demand – With no increase in demand, the supplier(s) are left with excess stock, which costs money to maintain, and that they won’t sell. Something has to happen here to resolve this irrational market situation. Demand must be increased (and we’ll get to how that is accomplished) or Supply must be decreased (usually not possible for a single supplier to achieve in a competitive market)
- Increase Demand or Decrease Supply – With no increase in supply, shortages occur. Buyers are prepared to pay for the product but cannot obtain it. Meanwhile suppliers are earning sub-par amounts for their product. Again, something must happen here to resolve this irrational market situation. Demand must be decreased or supply must be increased.
- Increase in price – With no change in supply, the result is a decrease in demand. That is, the number of people willing to pay the higher price decreases. Therefore fewer people will buy. This is an irrational thing to do where supply/demand/price have already met. However, in a shortage situation, as described above in (2), this will decrease the demand to meet the available supply, thus resulting in a much more rational scenario.
- Decrease in price – With no change in supply, in the results are increased demand and shortages, as more folks are willing to buy at the new price. This, however, solves the scenario in (1) above where there is an oversupply in the market.
For example, say I start making widgets. I’m able to make about 100 a month. After experimenting a bit, I find out that folks will randomly buy about 100 each month if I set the price at about $2.50 each. At this point I’m feeling pretty good because I’m running a good business. That is, until you start making widgets too. Now you’re making 100 widgets and selling them for $2.50. Supply has just doubled. There are still 100 people willing to buy at $2.50, so I only sell about half my widgets, and you sell about half. Neither of us is too happy about that – after all, what are we going to do with all of our extra widgets? So, I decrease my price to $2.00. Consequently, I sell all my widgets, and you only sell about 30. The average price has just gone down, so demand in turn went up. Given that our products are exactly the same, the two of us will keep adjusting pricing until we find the point where we’re both selling all our widgets.
Odd things can happen in market economics, however. Monopolies, oligopolies, price ceilings, price floors, and other imperfect markets can force the invisible hand of the market into knocking the balanced supply and demand equation out of, well, balance. Here I’ll discuss price floors because they specifically relate to the minimum wage.
A price floor is an artificial price level set such that a particular good cannot be sold below that price. Price floors have the effect of item 3 in “Supply and Demand” above. It causes demand to drop for a product without regard to the current supply in the market. It also causes the supply to the market to increase independent of the drop in demand. This leaves sellers with excess supply.
A good example of this might be a price floor on milk. Lets say a law is passed to help “protect” dairy farmers from falling milk prices. Imagine that milk has been priced at $0.75 per gallon until the government sets a price floor at $1.50. Now, the market had already determined that $0.75 was the price at which customers would buy the amount of Milk being supplied, so what happens? A number of folks stop buying milk. Something else happens. Now that the price of milk is $1.50, a lot more suppliers are willing to enter the market to sell milk at $1.50, being a much more lucrative market.
The result of the price floor is both a decrease in demand and an increase in supply. This is the worst of both worlds! Perhaps now the dairy farmers we were trying to protect are making twice as much for each gallon of Milk, but are only selling one quarter the number of gallons. That means they’ve just lost half their income overall!
As an aside, perhaps there are other good reasons to set this price floor for Milk. It may be that an overcapacity in a particular food market is useful for strategic planning purposes. It may be acceptable to us to be dependent on foreign oil, but entirely unacceptable to be dependent on foreign food. As such, the government can take steps to fix the broken economic equation, say, by offering to pay for the unsold milk.
Now that we are armed with a basic understanding of supply, demand, price, and price floors, let’s move on to discussing the minimum wage.