The Minimum Wage Debacle

Last week the Democrat led House passed a bill to raise the Federal minimum wage from $7.25 to $15 per hour, but the bill is expected to fail in the Republican led Senate. The debate on the existence of the minimum wage and perennial continuation of the debate on whether or not to raise it has tended to pit Democrats against Republicans on a socio-economic issue that lies at the heart of the capitalist economic mode of governance that we operate under.

As all policy issues are inherently political it is almost frustrating that most, if not all, debates on this issue tend to break down into strictly uncompromising political positions and rhetoric and no clear answer proceeds. However, it is important to ask whether there is a clear unambiguous answer that might be devoid of political bias, on this issue. I think there is, but it requires a fairly patient thought process, coupled with an understanding of the existing societal incentives that shape economic and political realities. So here goes…

The No-brainer Theory

Introductory and principles level courses in economics by nature of their being rudimentary are forced to keep any analysis of markets very simple. This is also true outside of academia when we read media articles or watch guest lectures or interview experts on market issues. To go beyond the principles’ explanation requires an audience that is fairly sophisticated in their understanding of what even the experts still struggle with and any lengthy treatise can very quickly alienate most audiences. So, things are kept simple, but unfortunately at great cost, as most end up leaving that setting with either reinforced positions or an unsatisfying feeling that there is some cover up at play.

Now, in many instances in economics, the simple analysis tends to be generalizable to complex situations, but this is not always true, so let’s now proceed with a look at the typical principles level analysis of the implications of having a minimum wage in place.

I call it here the no-brainer theory because it should be fairly easy to understand: if a business is currently employing say 20 low skilled workers and paying each of them a wage of $7.25 an hour but is now required by law to raise their wages to $15 an hour, what would have been a total hourly wage bill of $145.00 has now become $300. So, if revenue from business sales were say $500 (net of other costs), profits would now be reduced from $355 to $200. The business might be induced to lay off workers in order to avoid this reduction in profits. However, because a reduction in workers means less will be produced, the resulting scarcity in output would see the per unit price of the output that is produced go up, since the demand for the product assumedly still remains the same.

So the no-brainer analysis tells us that the price control measure, that is the minimum wage (or increase in it) put in place, leads unambiguously to both higher unemployment in the economy and higher product prices, which thinking a bit further about what the minimum wage was aimed at achieving – probably generating decent living wages for all low skilled workers – it not only fails but perhaps even aggravates the problem – many people lose their jobs and even those who manage to hold on to theirs find (along with those who no longer have jobs) that they have to pay more for products (and also taxes which become necessary to provide unemployment benefit support to those who now have lost their jobs, and need to be supported at livable wages). So people are worse off as the increase in their wages is merely illusory.

Critiquing the No-brainer theory

Now the no-brainer analysis does still have a few questions to answer. While we may shift graphs around in a principles class in economics to justify the foregoing analysis we may still wonder if the reactions and outcomes we have just described actually play out that way. For instance, would the business we just depicted, facing the higher hourly wage bill, actually lay off its workers? The argument here is that perhaps the profit the business was making initially was very large in the sense that workers were simply being taken advantage by being paid lower wages, because the business could do so. Laying workers off and having to produce less might not be the best profitable option, so with the business owner simply assimilating the cost of the higher wage bill and retaining her workforce, the policy helps by correcting what would be a market excess if left unchecked. Let’s hold that thought for a while and outline another concern with the no-brainer analysis.

How easy is it for businesses, facing a now higher wage bill from the policy, to raise the prices on their products? Further, assuming this is fairly easy, can the percent increase in prices actually be as high as or higher than the percent increase in wages from the policy? Here there are a few thoughts on this:

First, if it is the case, as perhaps argued successfully in the first instance, that businesses do not lay off workers, then output will not be reduced and so there will be no basis for higher prices, since this will simply result in inventory buildup and lower profits.

Second, if there is some reduction in the workforce and resulting reduction in output (note that if output does not also fall then workers are being made to work harder since they are fewer now than prior to the policy), can prices that allocate this reduced output remain the same? If the type of labor – low skilled workers – is being used to produce similar types of products and if not just one or few of the firms, but most or all of these firms do reduce their output, then there are no competitive pressures to keep price the same but rather the reduction in output will cause prices to go up. To keep prices the same when output is now lower than the existing demand would generate a shortage of the product, which would force the price of the product to eventually go up.

Now, by how much can we realistically expect prices to go up by? This is a technical question that has been investigated empirically with no clear answers. It does depend on a very interesting technical concept in economics called elasticity. Low skilled workers are employed in a range of industries across the economy but the key thing to note is that the demand for such products, being defined broadly, is going to be very, if not entirely perfectly, inelastic. Intuitively, while consumers may tend to react to higher prices on specific brand name products, they will not be able to react if the products in general across many producers are more expensive, since there are fewer or no substitutes available. This means that the induced cost from the reduced output can be passed on, almost, if not entirely, to the consumers of the product through higher product prices.

What this means is that everyone will face higher prices – those who are not low skilled workers, and whose wages may not have changed; business owners who also purchase those products, who now have to pay higher wages to their low-skilled workers; and the low skilled workers who are earning higher wages (also those who have lost their jobs and are supported through assumedly generous unemployment benefits). So, in terms of what economists call real wages or the purchasing power of one’s income, we have a scenario where it generally falls for most people, but for low skilled workers with jobs it may fall, remain the same, or at best increase by only a little, depending on the tax they face as part of their unemployment benefit contribution.

The Layoff choice

Now what seems clear is that if businesses do indeed lay off workers and reduce output that we will see higher product prices that simply reflect no real benefit from the policy since we have at best only marginally increased the wellbeing of the low-skilled workers who retain their jobs, but have reduced the wellbeing of everyone else in the economy. So, let’s revisit that issue I requested earlier that we hold the thought on for a while. Will businesses actually follow through to lay off workers and reduce output?

The analytical answer to this question is one that involves the structure of the market in question. The no-brainer analysis assumes that the market is perfectly competitive. This is an analytical convenience but sometimes generalizes to many real-world scenarios. Is a generalization to the low skilled labor market apt? Without getting too technical the assumption of perfect competition means there are many participants on the demand and supply side of the market, that the market item is homogeneous in its attributes, and that there are no unduly high barriers to keep participants from entering or exiting this market by choice.

The presumption of many participants on the demand side in the low skilled labor market therefore means that there are many businesses, which by virtue of being many, find it costly to coordinate their activities but instead compete against each other for the assumedly homogeneous resource – in this case, low skilled workers. To make this idea concrete consider that in some local city say Toledo Ohio that Walmart and a few other retail stores are hiring low skilled workers and paying them $6.75 an hour. If these low skilled workers believe that their contribution on the job per hour is more than that, then the presumption is that they will vote with their feet to a different job. The question then becomes whether there are any other jobs that will pay them more than the $6.75 an hour. When the pool of potential workers at that skill level far outstrips the available jobs for such skills, it is not clear that workers may find such jobs that will pay them that, even if their true contribution per hour is more than $6.75.

Now even if you have say McDonalds and several other fast food restaurants also hiring the same type of workers and perhaps paying them $9 an hour, while there will be more applicants wanting to work in the fast food industry as opposed to the retail stores, at some point there will be no more openings in the fast food industry and the remaining still abundantly supplied low-skilled workers might find themselves having to accept the jobs paying them $6.75 an hour.

The point being made is that the low-skilled labor market is full of potential workers that far outstrips the demand for them, so wages need not converge due to competition to some true value of each worker’s contribution. Wage differentials may persist and even all those wages may still fall short of what each worker’s true contribution on the job is.

Why is this important? It is because when there is some degree of market power in the low-skilled labor market, in this case where employers of labor can unilaterally choose what they pay their workers, it is very likely that workers are being paid a wage that is lower than their actual contribution on the job per hour. This is the case because market power, if it exists within a capitalist setting, will be exercised. However, if businesses are required to pay workers wages above what they paid previously but below or up to what their actual contribution on the job per hour is, then it turns out that it is actually optimal for these businesses to increase the number of workers employed and not reduce them. As a result, output actually increases, not falls!

OK this is a very important claim and it needs to be justified since it might not seem to make immediate intuitive sense. I provide a back-of-envelope illustration of this claim here and summarize the result in what follows below:

To illustrate, suppose we have a low skilled labor market with the presence of market power, then if wages are kept at $4 an hour at which 10 million people are employed, the total hourly wage bill is $40 million. If the total productive value of this workforce per hour is $225 million, then business profits will be the difference, or $185 million.

With the imposition of a minimum wage at $12 an hour. If the businesses keep the total number of workers the same, i.e. 10 million, their profits now fall to just $105 million. If the businesses reduce their total hires to below 10 million, they get even smaller profits. However, if they increase their workforce to a higher, argued to be optimal, level of 14 million, then their profits will be $126 million.

It is optimal to hire more workers because each additional worker above 10 million provides production of greater value than what has to be paid to that worker up to the 14 millionth worker. It was not optimal for the business to hire more than 10 million workers if the business could pay wages of $4 an hour, but having to pay the higher wage under the minimum wage law, it turns out to be optimal for the business to hire more workers.

Intuitively, market power allowed businesses to pay workers a wage below what their true hourly contribution was, resulting in an inefficiently low number of hires. The minimum wage policy set at the higher wage that reflects each worker’s true hourly contribution, corrects this labor market failure.

The Minimum Wage Determination

Now consider the illustration where $12 an hour reflected the true valuation of hourly work contributed, if we had put in place instead a $15 an hour wage rate as required by the law for low skilled workers, we would have had instead a situation where more people would be attracted to the work force (more teenagers, college students etc.) such that there would be an excess supply of such workers but in our illustration, the demand for workers at that wage would be the same 10 million as were hired under the $4 wage. Again, for the same reasons as before, it is optimal for total number of hires to be no less than 10 million. Only at wages higher than $15 an hour would we see a reduction in the demand for workers fall below 10 million, though again it would create higher unemployment due to the increase in the number of new job market entrants seeking to work at that relatively lucrative hourly wage.

The point to this hypothetical illustration is to show that if the presence of market power is strong enough to keep wages for low skilled workers very low then policies that force businesses to pay higher wages, such as minimum wage policies, may actually not lead to unemployment but rather increases in the number of hires up to the point where the minimum wage captures the true hourly contribution of workers. Any increase in the minimum wage above this would reduce workers hired and create unemployment in the sense of some of the influx of new job market entrants are not finding work, while the quantity of workers that would be hired also gradually falls, but unless that minimum wage is prohibitively high, employment and output can still remain at levels similar to what they were prior to the policy.

So, what the real issue is should be how to determine the true value of each worker’s hourly contribution. Unfortunately, this can be a difficult, nearly elusive quest and politics tends to get in the way of this and politicians turn instead to some “livable wage” number. If this number or what is proposed is actually higher than the true contribution of the worker per hour, then the no-brainer theory kicks in. This may therefore explain why empirical results on the impacts of raising the minimum wage have tended to find conflicting results (assuming nothing else is wrong with the data analysis process and assumptions).

Efficiency meets Social Justice

Now back to our introductory comments. The question of the minimum wage is one that has often traditionally pit notions of allocative criteria against each other. With efficiency being an advocation that we avoid waste, and social justice advocating instead for some form of equity in the allocation. It turns out that in the presence of market power, the labor market allocation is inefficient, and the wages paid are socially unjust.

Apparently in such a setting a minimum wage set at the true value of the worker’s hourly contribution does achieve labor market efficiency by increasing the number of workers hired. Further, by raising wages, coupled with the follow-up effects of resulting lower product prices due to the increased output produced, this policy does move society toward some notion of social justice, by reducing income inequality.

But to address the elephant in the room – it is a highly redistributive policy. It is obvious that any talk of increasing the minimum wage tends to get business owners up in arms. The specter of job losses, and price increases is raised, i.e. the no-brainer theory is immediately set up, easy to understand, and is trumped up. The debate gets political and minimum wage advocates become painted as socialists seeking to rob business owners of the rewards of their creativity and entrepreneurial endeavors and to reward perhaps lazy workers who want to earn a big paycheck for doing nothing. Perhaps not knowing how else to respond these advocates play the social justice card and highlight the huge disparity in incomes between business owners, often select ones like the large corporation executives, and the minimum wage workers.

If you lean right on the political spectrum then the minimum wage (and increases to it) is a bad idea, because you are pro-markets and true to the capitalist spirit that seeks to reward enterprise. If you lean left, then the minimum wage (and increases to it) is great, as it addresses income inequality and protects workers from undue exploitation.

The point of this discourse is to inform. To inform that economics has long established the underpinnings of why capitalism is a good mode of economic governance: It achieves efficiency by linking rational human behavior to incentives in the market place. Those incentives work under well-defined market environments. However, those environments do not exist all the time and especially not, in particular markets. This is why economists generally agree that government has a role to play to either ensure that the environment does exist, or where it cannot do so readily, to search out alternative policies to foster the efficiency that capitalism promises. The low skilled labor market is one such market where the presence of market power generates a market inefficiency.

The minimum wage can actually help correct the environment failure in this market. There are of course other policies that could be put in place – essentially those that are aimed at directly reducing the market power present in this market. Those would be preferred, but the minimum wage (and increases in it), if correctly determined, can be considered to be a second-best sound policy, if those policies are not politically feasible.

The Issue of Elusiveness

Given the peculiarities of the low skilled labor market, correctly determining the true hourly contribution of a worker is perhaps elusive and the wage paid really just follows a historic precedence that dates back to the feudal system. However, should there be a minimum wage simply on the basis that we know that, otherwise, market power would restrict wages to a lower than optimal level, it should not be set to the point where it induces incentives for workers to want to increase their skills through education and on the job training opportunities. Similarly, it should provide incentives for continued entrepreneurial opportunities through the promise of relatively higher incomes (that account also for assumed risks) that could be earned in such endeavors. Requiring then that the minimum wage be a livable wage at some poverty threshold might therefore be a good approximation.