Friday, February 09, 2007

The Case Against a Minimum Wage

Many feel the minimum wage is good policy for many reasons. Usually the most compelling is that it is an effective anti-poverty tool. After all, if someone is making the minimum wage currently, they’re typically on the lowest end of the pay spectrum and therefore giving them a raise will be effectively helping those who need an income boost the most. At least, that’s what one would think.

On the surface, it looks like the working poor are getting a free lunch. However, we all know that there is no such thing. So, when they receive a raise, where does the money come from? Who is paying for this wage? To solve this, let us first look at the economics of the situation.

When a market is allowed to operate freely, prices are determined by supply and demand. The supply of employees under a fixed set of conditions is determined by the price being paid to the employee. More people are willing to work at higher wages than at lower wages. In this sense, the supply curve for employees is upward sloping, with changes along the curve being caused by changes in the price offered to the employee.

The factors affecting the demand for employees are directly dependant on the value of the marginal product of labor. That is, how much does a firm make by hiring an additional employee? At a lower wage, firms can afford to hire more workers. At a higher wage, firms must hire fewer workers. Even if you hire very productive workers, with rising wages there comes a point when hiring more is no longer profitable. This is because the value of the product of labor diminishes marginally.

The idea is that every worker you add to a business produces less for the company than the worker hired before. We can visualize this concept by picturing an apple orchard. If we only hire one apple picker, they will be extremely productive. All the fruit in the orchard will be low on the branches and easy to get down. Adding another worker means that more fruit will be picked, so it is advantageous to hire them, however with two people working the amount of “low hanging fruit” will become less and less. Eventually we reach a point where adding another worker leaves us with nothing but very high fruit which is difficult to get to. Every additional employee is marginally less productive than the one added before. Therefore, since the more employees added, the less productive each one is, eventually a firm reaches a point where the next employee hired will have their productivity reduced so much that they do not justify their wage. Thus, as you can imagine, the demand curve for employees is downward sloping; at a lower wage, the powers of diminishing marginal productivity are reduced and despite the lower productivity, more employees can be hired profitably because their wage is lower. At a higher wage, fewer employees can be hired profitably.

So we can then deduce that the number of employees hired is determined by the wage at which the supply of workers is equal to the demand for workers. At this wage, there is no surplus of workers nor excess demand for them.

What happens when we disrupt the supply and demand with a price floor, or, in our case, a minimum wage? If the floor is below the equilibrium wage, then it has no effect. However, things change if the floor is placed above the equilibrium wage, which is the case with a minimum wage. If there is a minimum wage that increases the wage above the equilibrium, then we still have our demand curve working the same way and our supply curve working the same way. Regardless of the minimum wage, at specific prices the supply of workers will still increase at higher wages and decrease at lower wages. If a minimum wage is installed, it raises the wage. At higher wages, there is a greater incentive to work; therefore, more employees will want to work. Conversely, at a higher wage, a firm can afford to profitably hire fewer workers than they could at lower wages. Therefore, when a minimum wage is installed raising the wage, firms will demand less employees. This creates a distortion; there is excess supply of workers over what firms are demanding. This “excess supply” goes by another name: unemployment.

So where does the extra money come from to pay the workers who are making the higher minimum wage? It is paid by the employees who are unemployed; either laid off or simply not hired when they otherwise would have been. It would seem that by increasing unemployment among unskilled workers a minimum wage is a poor antipoverty tool.

Obviously, since the percentage of the workforce making the minimum wage is so small, this will not result in a very large absolute increase in the overall unemployment rate. So this isn’t a bad thing, right? And, after all, as long as it helps some unskilled poor workers get a leg up, what’s the harm in punishing a few to do it? Well, let’s take a look at who is affected by this unemployment as a result of a minimum wage.

Over 50% of those earning the minimum wage are between the ages of 16 and 24. This is also the working age group with the highest unemployment rate. These are therefore those who are affected most by this minimum wage-caused unemployment. Furthermore, a minimum wage hits young workers the hardest because, being so new to the workforce, they have little-if-any experience and few skills. Therefore, they are the workers who need that first job the most if they hope to develop the skills and experience necessary to command higher wages. Indeed, the highest demographic of unemployed are young minorities, specifically Latin and African Americans. These are the employees with either language or skill barriers due to failing schools that cannot command a high enough wage to make the minimum. Their productivity is so low that firms cannot afford to hire them at such a wage.

This concept is not a secret. White labor unions in South Africa fought to increase the minimum wage during apartheid to keep the blacks in that country poor. Because, starting out, few had the skills or education necessary to warrant such a high wage they couldn’t be profitably hired by the firms. As a result, they were not able to get that crucial “foot in the door” that would allow blacks to overcome their position. The minimum wage didn’t help the poor blacks of South Africa, it served to further oppress them. The same is true for America.

“Alright,” one may argue, “so a minimum wage hurts minorities, so what? I don’t care about race, just that poor people are being helped!” The fact of the matter is, a minimum wage doesn’t specifically help poor people. Over half of the people making a minimum are 16 – 24 years old; rarely the age where one is supporting a family. Of the remaining on minimum wage, a large percentage are non-breadwinners, or, of a family, the member not making the highest income. The minimum wage is poorly targeted to helping those who actually need higher incomes.

As Harvard economist Greg Mankiw points out, the sheer notion of a minimum wage being used as an anti-poverty tool is illogical. He states,

“Consider this policy aimed to help workers at the bottom of the income distribution:

1. A wage subsidy for unskilled workers, paid for by

2. A tax on employers who hire unskilled workers.

Now, if you think like an economist, you might wonder about the logic of part 2 of this proposal. You might say, "A tax on the hiring of unskilled workers would discourage their employment, offsetting some of the benefits they would get from the wage subsidy. It would be better to finance the wage subsidy with a more general tax, rather than with a tax targeted specifically on employers of unskilled workers."

I agree. So why did I bring up this proposal? Because a policy essentially the same looks likely to become law, having been advocated by Congressional leaders and, recently at his news conference, President Bush. Haven't heard of it? It is called an increase in the minimum wage.”

It makes sense. If you were trying to subsidize unskilled workers, why would you then want to punish those that hire unskilled workers? Perhaps giving those earning the minimum wage a raise could help; but when you pay for that raise by punishing those who hire the people you intend to help, it works counter to the goal of helping them.

A minimum wage creates a market failure. A market failure is a situation where a buyer and a seller both want to make a transaction at a given price, but due to some circumstance cannot. There are situations where employers want to hire an employee with a low VMPL at a low wage, because at that low wage they are still profitable. There are also situations where people want to work for a low wage, simply because working a low wage is better than not working at all.

Take a sixteen year-old Latin American, for example. She may not speak English. She has little schooling, no prior work experience and cannot read or write. There is very little this employee can contribute profitably to a company. There are, however, some positions where this example person can be hired profitably. She knows that if she gets her foot in the door, she can gain some experience and possibly learn some English on the job that will give her opportunities down the road. However, because of a minimum wage, an effective ban on low wage jobs, no employer can profitably hire this girl. She wants to work; the employer wants to hire her. You have two parties voluntarily agreeing to a transaction that does not occur due to legalities. One begins to wonder how the minimum wage helped this person. Indeed, it seems illogical that a way to help low wage workers would be to ban low wage jobs. If they aren’t able to be profitably hired at higher wages, what are their options?

I have illustrated above how a minimum wage creates unemployment and how this unemployment affects those who need employment the most: unskilled, young minorities. The increased wage of some is paid for by the lack of wage for others. Furthermore, I have illustrated the contradictory nature of a minimum wage as an anti-poverty measure due to the fact that of those earning the minimum wage, few are actually in poverty. Because those who make the minimum wage are most often not those in poverty, the minimum wage is a poorly-targeted anti-poverty tool. Also, the minimum wage creates disincentives for employers to hire unskilled workers by taxing them to do so. Lastly, banning low wage jobs destroys opportunities for the unskilled employees who would be working them. A more targeted and effective anti-poverty tool would be a negative income tax.

The case against the minimum wage is clear. We would be wise not to adopt it.


A.J. said...

Thanks for the longest post in The Western Right's history. Jeez!

Anonymous said...

I believe the growing tension with Iran should be brought to the forefront of political debate. minimum wage? PALES in comparison.

sign the petition.

Anonymous said...

Absolutely! War with Iran! It's the only way. Look what it did for us after Iraq. It doesn't matter if we screw it up either. See, what liberals don't get is that the war is a brilliant waste of money because it consolidates conservatives and spends money liberals want for their entitlement programs. It's genius! Bankrupt the government and then those liberals will be screwed. So yes, we must support war with Iran.

Anonymous said...

Careful Matt. Mankiw has called for increased taxes on gas. He was fired as Bush's chief economic advisor for a reason. He's a liberal at heart and not one we should be quoting. Bush knows what's best and so we should be quoting Heritage. Screw those Ivy League economists and their data.

Matthew said...

Does anyone want to talk about my article?

Anonymous said...

wow, "bush knows best" you conservatives are nothing of the sort. You are lost aren't you?

Anonymous said...

William! That Bush knows best stuff was sarcasm! Can you not tell?

LibertaRyan said...

This is a very well written argument. It condenses many of the complexities as they pertain to economics and the minimum wage, and break it down so that the average reader inclined can formulate an informed opinion on the matter. Well done.