Clause 61: The Pushback Blog

Because ideas have consequences

Minimum Wage Laws: I Regret the Necessity

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Earlier this year, when delivering the State of the Union address, President Obama called for an increase in the federal minimum wage from $7.25/hour to $9/hour. This provoked a fresh round of public debate on the minimum wage:,0,6070933.story

For purposes of this discussion, I am going to infer that the labor involved is unskilled, since skilled labor is sufficiently scarce to command a wage rate greater than minimum. I will equate unskilled with poor because the unskilled typically are the least wealthy of workers.

The classic economic argument against having a minimum wage is that it distorts the market and actually creates unemployment among unskilled people. Let’s examine.

The Economic Theory

Absent other constraints, the market sets wages by supply and demand. The theory says that the market allows participants to respond to conditions through the price mechanism. When prices of a good go up, more of that good is made available, but demand for it will fall off. When prices of a good go down, less of that good is made available, but demand for it will increase.

At some point the supply and demand curves. That is the equilibrium, the place where supply and demand are in balance. The amount of the good available at the price equals the amount of the good desired at the price.

Unskilled Labor Market in Theory

Unskilled Labor Market in Theory

This is a picture of a market for unskilled labor. Unskilled labor is a good; there positive value in having an additional incremental unit of it. The horizontal axis represents a number of people, and the vertical axis represents a wage rate, which is a price for labor. I have drawn the traditional supply curve Slabor and demand curve Dlabor.

The market for unskilled labor is, in theory, just like the market for any other good. Left to its own, the market would sort itself out so that the equilibrium employment level QE and wage level WE would be reached.

Introducing a minimum wage distorts the market. The minimum wage must be above the equilibrium wage, or minimum wage laws would be irrelevant. Here, Wmin is the minimum wage. The minimum wage acts as a price floor, driving demand down and supply up an artificial amount. Demand for labor is reduced to Q1 at the minimum wage. Furthermore, price signals draw additional people into the market, so that the supply of labor is increased to Q2. Thus we have (Q2 — Q1) people who are involuntarily unemployed as a result of the minimum wage.

Follow all that? Excellent. Now let’s take it out in the real world and shoot it full of holes.

Price Signals?

The supply of unskilled labor consists of people who are unskilled. They don’t have a lot of alternatives to the unskilled labor market. Do they really get to respond to price signals?

The way I have drawn the previous diagram, as the wage rate goes down, some people who are unskilled withdraw from the market. Where would they go? How would they feed themselves? They typically do not have stored wealth to draw down while they are out of the market. Do they go on public assistance? That’s not OK; we want them working!

So the supply of unskilled labor cannot respond to price signals. There is only one allowable quantity of unskilled labor that can be available to the market: all of it. Thus the labor supply curve really looks like this:

Unskilled Labor Market with Everyone Seeking Work

Unskilled Labor Market with Everyone Seeking Work

Here, I have redrawn the supply curve so that all the unskilled labor, Q0, is available for work at any wage the market will allow. Where the supply meets the demand, there is still the equilibrium wage WE. At the minimum wage Wmin, demand for labor is reduced to Q1, just as before. Now the unemployment effect of the minimum wage is reduced to (Q0 — Q1).

Notice that the labor supply is not only forbidden to respond to price signals, but also to send them. If the sellers of labor are unsatisfied with the price, they are not allowed to communicate that by withdrawing supply. They have to take whatever the buyers of labor want to dish out to them.

I have called this a market, but it is not much of a market. There is no feedback loop between buyers and sellers. The buyers dictate what they are collectively willing to pay, and the sellers take it or leave it. Except it is not OK for the sellers to leave it, because they are not working. We would call them layabouts. We would challenge them for passing up the opportunity to earn anything. For the sellers, the terms are really take it or take it.

Here we have a group of people, the poor and unskilled, with a weak negotiating position. Most of them did not deliberately choose to be this way. Even those who made bad choices in the past may regret them now. We the People would be morally irresponsible to allow them to be trampled in the marketplace.

We are not done revising the model yet.

Buyer Behavior

The demand curve doesn’t look quite right, either. The buyers of labor are typically small businesspersons and low-level managers in larger enterprises. They have their own notions of what they ought to be paying for unskilled labor: not very much. That gracefully sloping demand curve doesn’t really exist. Instead, the picture should look like this:

Unskilled Labor Market with Typical Demand

Unskilled Labor Market with Typical Demand

This is not the result of a deliberate conspiracy. Many of people buying unskilled labor just don’t think that unskilled labor deserves very much in the way of compensation. I know this because I have sat across from them at the lunch table and listened to them. They aren’t particularly mean-spirited; it’s just their worldview. They believe that unskilled people deserve about 35 cents an hour, a cup of coffee and a pat on the head. It is a consequence of outlook, similar to the New England mill owners of the mid-1800s who said it was immoral to pay high wages to workers because the workers would just dissipate the additional wages on booze.

The picture doesn’t change structurally from the previous picture. The big change is the outcomes. Without government intervention, the amount of labor employed would not be that much more, but the equilibrium wage WE is far below the minimum wage.

Never ask the accountants a question until you’ve told them what the answer should be.
— Business proverb

I know there are going to be readers who object to this because “the unskilled people don’t produce sufficient value to earn a higher wage.” I am not buying that argument. A compensation structure is a social system, an expression of whom we value and how much more or less than anyone else. In thirty years of working, including some time managing, I have not seen a scientific ability to relate how much someone is valued to how much value someone produces. I have not seen any significant ability to objectively measure how much value any employee produces for the firm. There is no more factual merit to this objection than there was to the assertion of the New England mill owners that laborers would drink any increment above subsistence wages. It is a rationalization for doing what people are already predisposed to do.

The Unnecessary Minimum Wage

It would be great if buyers of unskilled labor would leave something on the table, so that these workers would have more incentive to work. After all, these are poor people and they’re working. That’s what you want poor people to be doing, isn’t it?

Unskilled Labor Market under Ideal Conditions

Unskilled Labor Market under Ideal Conditions

I have not altered the supply or demand curves; I have just shifted demand such that buyers are prepared to pay more for unskilled labor. In this idealized alternative, the equilibrium wage WE is above the minimum wage and renders the latter irrelevant. All the available labor is absorbed by demand and there is no involuntary unemployment. All the unskilled labor that can work is making itself available for work and is working.

However, we are not there and have no prospect of getting there anytime soon. The labor supply has no ability to send price signals and influence buyer behavior to move the demand curve into this position. And I see no reasonable likelihood of buyers changing their behavior out of the goodness of their hearts. As such, it is unfortunately necessary to have a public policy so that we may protect the weak from being pushed to the wall.

The remedy for the evils of competition is found in the moderation and magnaminity of the strong and the successful, and not in any sickly sentimentalizing over the underdog. The mood of unrest and insurgency is so rife today as to suggest that our leaders, instead of thus controlling themselves, are guilty of an extreme psychic unrestraint.
— Irving Babbit, Democracy and Leadership (1924), p. 231.

Reality trumps theory. It is time for orthodox economics to recognize that the traditional analysis of minimum wage policy is wrong. It is based on assumptions that are inconsistent and beliefs that are not sustainable in the real world.


Written by srojak

May 4, 2013 at 2:55 pm

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