A discussion of minimum wage

Here’s a quick argument for the effects of minimum wage on job growth. Essentially I will argue two points:

(1) The effect on minimum wage on the job market is mixed: it will eliminate a number of jobs that would otherwise be extremely low paying jobs, and it will cause some improvement for those workers whose jobs are close to minimum wage.

(2) Confounding effects in the job market will often mask these results; as the cost of labor increases employers will seek to use gains in productivity to compensate.

It is worth noting that most micro- and macro-economics work by fundamentally assuming that all markets are auction markets: meaning that all markets seek to find an optimal price point through a dynamic give and take between suppliers and consumers. This is clearly not true, by the way–and the fact that incomplete information, economic stickiness (which is in a sense a polite way of saying “stubborn people”), and cultural biases tend to confound the entire microeconomic model.

Meaning that while I may argue that minimum wage tends to be a destroyer of jobs I do not believe eliminating minimum wage is a reasonable way to go, if only because there are always abusive employers and employees who do not stand up for themselves–and labor laws (including minimum wage) exist in part to provide a minimum standard of reasonable interaction.

On the other hand, I would say that anyone who seeks to just increase minimum wage should consider the potential economic impact: you just cannot raise minimum wage up to (for example) $100,000 a year. In other words, raising minimum wage works only so far as the minimum wage is set so that it’s effects are essentially statistical noise.

(Which may be unsatisfactory for those seeking to raise minimum wage for social justice purposes–but it does go to explain why economists are mixed on the effects of current minimum wage laws.)

So let’s start with a graph showing the value of work to an employer, and the salary the employer pays for that work. (The concept of the “value of work” is a bit nebulous, as I will explore further below. But just to visualize this in a concrete way, suppose the work is making 10 hamburgers an hour at a restaurant; the hamburgers sell for $5 each, and the overhead to make those hamburgers minus the worker (cost of goods, equipment, etc) is $4 each. The work, therefore, is worth $10/hour–ten hamburgers at $1–meaning for the employer to profitably make hamburgers he can pay up to $10/hour for the cook to make them. And yes, I know; the numbers are arbitrary and flexible, yadda yadda; I’ll get there later.)

Notice the red line doesn’t quite go up at a 45 degree angle. This is because an employer will, ideally, want to make a profit:

Now let’s assume we impose a minimum wage: this will be a floor on the minimum salary paid for work.

For most people making well above minimum wage, there really is no change in the salary: if your job as a software developer pays $100,000/year, bumping minimum wage from $4.85 to $5.25 isn’t going to make a difference.

For those getting paid close to or below minimum wage, on the other hand, things get more interesting. If the value of your work is too low–and falls way below the minimum wage bar–then you’re out of luck. In fact, the original purpose of the minimum wage laws were to shift manufacturing jobs back from (largely black, cheaper) southern workers to (more expensive, white) northern workers. (The Davis-Bacon Act: Let’s Bring Jim Crow to an End)

There has, in fact, been over the past few decades a steady decline in employment rates for those 16 to 24, traditionally those who make minimum wage (or close to it). However, it is unclear why–if this is a cultural change as more and more in the 16 to 24 age range go to college, or if it is due to a lack of opportunities–or both: the perception that there is a lack of jobs are causing more high schoolers to consider college and, consequently, never enter the job market in the first place. As I note above, the data is inconclusive.

(And to be very clear, for every paper that suggests there is a correlation between minimum wage and teen unemployment, such as this one or this one or this one, there is another which suggests there is no correlation or the data is inconclusive, such as this one.)

When wages are close to minimum wage, however, things get really interesting. I would argue–though again, data is inconclusive and economists, as far as I can figure, tend to bicker over the data gathering methodology, and further, the effects will undoubtedly be masked through other effects (see below)–that you will see an upward bend in salaries as employers choose to take fewer and fewer profits from a single worker in order to continue doing business. In some cases an employer may choose to take a loss on a subset of employees for business continuity purposes.

(For example, in our hamburger example above, suppose the overall business is a bar: the bar may choose to take a loss on making hamburgers as it makes a profit on selling alcohol, and the hamburgers become essentially a “loss leader” to get customers through the door.)

Thus, for a range of people, they will see a larger paycheck, even if the value of their work to their employer remains the same.

Part of the problem here is that there are a large number of confounding effects. For example, automation may help push up the value of an individual’s work up the value curve. (As a concrete example, the use of pneumatic nailers in the construction industry has made nailing together boards or nailing gypsum board onto a wall considerably faster.) An employee, fearing a tight job market, may also try to increase productivity–our hamburger maker may try to make 12 hamburgers an hour instead of 10. An employer may also try to push increased costs upwards–though often there are limits on how far this can be done, given that in all industries there is considerable pressure to drive prices down.

All of this has the net effect of pushing the value of the work upwards in the value curve:

Now, overall gains in productivity has been shrinking the job market; we’ve seen this especially in the past few years where salaries have remained flat while corporate profits have grown.

(As an aside, politics clearly plays into economic research, as you can see by noting that generally those who argue minimum wage has no effect on the size of the labor market also simultaneously complain about corporations taking advantage of productivity gains to pad their bottom line at the cost of employees–while on the other side of the political aisle those who argue that minimum wage laws reduce the number of jobs also seem to argue that productivity gains are not a problem in the overall job market.

Sorry, but if minimum wage encourages productivity gains through greater efficient use of workers, and productivity gains shrinks the size of the labor market, well–you see where I’m going here. Likewise, if productivity gains don’t affect the size of the labor market, then one argument against minimum wage increases–that increased productivity will cost minimum wage gobs–well, that goes away, right?)

Employee gains in productivity is also encouraged by a tight labor market, simply because employers must make due with fewer available employees, and pay more for those employees. A tight labor market is similar to a minimum wage in that it puts upward pressure on salaries, and thus puts pressure on employers to create greater efficiencies.

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As I noted above, however, this entire argument may be crap for the very simple reason that microeconomic theory presupposes all markets are essentially auction markets with a dynamic give-and-take which allows for price discovery, and they clearly are not. Instead, most employers start a business to make money–and given the inputs available to them they figure out a way to make money, or they go bankrupt.

That fact alone is the biggest reason why, so long as the minimum wage increases are kept relatively low, the data will be inconclusive: because the markets are not engaged in price discovery (and even the very action of engaging in price discovery creates a non-trivial cost in terms of effort to find optimal prices and in terms of risk of business failure due to jerking prices around), the data will inherently be too “lumpy” even if we had perfect information on the salary trends of every one of the hundreds of millions of workers in this country.

But, in my opinion, it’s probably fairly well reasoned crap.

And in my opinion, minimum wage does three things:

(1) It reduces the number of jobs, especially to those workers who are at the bottom of the wage scale–both through pricing out very low paid workers, and through encouraging productivity gains.

(2) For some workers at minimum wage, increasing the minimum wage will increase salaries.

(3) For those workers near minimum wage, increasing minimum wage encourages gains in productivity–either through automation or through internal job pressures encouraging greater worker effort.

Again, though, we will never see these effects raise beyond the background noise unless we were to drastically increase minimum wage to (for example) $30/hour or $50/hour.

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To be very clear I do not support eliminating minimum wage, simply because markets are not engaged in price discovery. If they were, then hypothetically if one employer were to raise wages by a penny a year, then they should drain all the employees from another employer who keeps wages the same–but who quits their job over a penny?

But because they’re not engaged in price discovery, this creates all sorts of opportunities for abuse that labor laws are designed to prevent: for example, an employee may continue to work for less wages in a sweat-shop job because they are emotionally abused by their employer, despite the fact that there is a much better paying job just down the street.

(If we used the same arguments economists use on labor markets and apply them to marriage interactions, then we’d have to conclude there are no abused women, since there are no gains to be had from staying around and being abused.)

And because the market is not engaged in price discovery, minimum wage laws (and other labor laws) protect employees by demanding a certain minimum level of treatment by employers–which is, I would argue, the real reason why we should keep labor laws in place, and not because of some sort of “social justice” or “living wage” argument.