Well, It’s Complicated (#1): The Dose Makes the Poison

Minimum wages are a rather contentious subject in American politics.  On the one side, those in favor tout their benefits to low-income labor, such as increased purchasing power (see, for example, the current “living wage” movement pushing for a federal $15/hour minimum). On the other, those opposed cite “basic economics” to argue that increased wages lead to increased unemployment and inflation, thus resulting in no real-income benefit while simultaneously hurting those laid off or unable to find a job as hiring decreases.  The problem, of course, is that both arguments are hugely oversimplified and thus easy for the opposing sides to attack and “debunk.”  So it’s hard to tell who’s right and who’s wrong without a good foundation in economic theory and empirical research.  In order to figure it out, let’s take a closer look at each argument, and see where that theory and empirical evidence leads us.

First, let’s examine the pro-minimum wage camp.  There are several arguments, but in general they boil down to a couple main points.  One, increased wages lead to increased purchasing power, which in turn benefits not only the workers with higher real wages, but the economy as a whole as their spending has a multiplier effect.  Essentially, this means they get more money for the same labor, so they spend more money, which increases demand across the market, increasing supply, and everyone is wealthier.  It’s essentially the same argument as that in favor of tax cuts, just focused slightly differently: increased income results in increased spending, making everyone richer in real terms.  Two, paying workers a “living wage” decreases the need to subsidize them through government assistance, freeing up that money to be spent elsewhere (either by cutting taxes or by redirecting the funds to other projects).  Basically, if workers can support themselves without government subsidies, it benefits everyone.  And three, it’s morally the right thing to do, as we have a social imperative to lift the poorest members of our society out of the struggles of poverty.

Perhaps surprisingly to those who cite “basic economics” to refute these claims, there’s actually some decent economic support for them.  In fact, theorists and empirical researchers have both found evidence in favor of the benefits of low-level minimum wages.  To understand why, I’m going to take a second to briefly explain where minimum wages fit into conventional economic theory, because there are a few concepts that we need to clarify.

Wages, despite the way most people think of them, are to economists nothing more than another word for a price.  Specifically, they’re the price of labor: the worker plays the role of producer and seller, the employer plays the role of buyer and consumer, and the product is the worker’s labor, which is just a service like any other.  Thus, the worker owns the “supply curve” and the employer owns the “demand curve,” and the equilibrium price of labor—the wage—is the meeting point between the two, just like everyone sees in the standard supply-demand curves in their introductory economics courses in high school and college.

But there’s a key part that those introductory econ teachers often leave out when explaining supply-demand curves and equilibrium prices.  Namely, how we actually determine what that price is in the real world—given that we can’t see the supply and demand on a handy graph when trying to buy or sell a product or a service, how do prices actually get set?  The answer is, generally speaking, in one of two ways.  Either the seller sets a price, and potential buyers decide whether that price is lower than the maximum they would each be willing to pay for the good or service in question (and sellers adjust up or down according to the feedback they get from how many people are buying), or the buyer makes an offer, and the seller decides whether that offer is higher than the lowest they’d be willing to accept to provide the good or service (and buyers, then, adjust up or down according to the feedback they get from whether sellers will sell to them or not).  Sometimes this is rather abstract, like at a grocery store, where there’s no direct interaction over prices except the choice whether or not to buy at a given price point.  Sometimes it’s a real-time interaction, like haggling at a flea market.  But whether it’s a negotiation or a simple binary purchase decision, in the absence of major shocks to either supply or demand, the price generally reflects a stable attractor that we model as an “equilibrium.”  (Of course, in reality the price is almost never at a true equilibrium, and that attractor can sometimes shift unexpectedly despite no major shocks, but we can get into the details of sticky pricing and status quo biases and endowment effects and complexity and all those other fun quirks another time.  The standard equilibrium model is a good enough generalization for our purposes here.)

And here’s another key concept stemming from that—as I mentioned, whether the seller or the buyer is setting the price, those choosing whether to make the transaction are weighing that price against the highest they’d pay (if the buyer is choosing) or the lowest they’d accept (if the seller is choosing).  That difference, between the agreed upon price and each party’s “reservation price,” is called the surplus.  The difference between the lowest amount the seller would accept and the actual transaction price is the “producer’s surplus.”  The difference between the highest amount the buyer would pay and the actual transaction price is the “consumer’s surplus.”  The two combined is the “total surplus” of the transaction—how much everyone is better off for having completed the deal.  If no one gets a surplus—if no one gains value from the trade—there’s no reason for anyone to make the trade.  Generally, freely made transactions are a win-win for everyone involved, or at least a win for someone and a loss for nobody.  Simple enough, right?

Wages typically are set in the latter manner I described: the buyer (employer) makes an offer, and the seller (worker) chooses whether it’s high enough for them to accept.  Sometimes there’s room for negotiation, sometimes not, but regardless of the final offer, it will never be higher than the value the employer places on the potential labor of that particular worker in that particular job, and the worker’s choice to accept or keep looking elsewhere depends on whether it’s higher than the lowest they’re willing to accept to do the job in question.  Thus, just like with any other price, there’s a surplus for both the producer and the consumer, and that’s the net benefit of the transaction.

With this concept of wages as just another price, then, we can see that minimum wages are a governmentally-imposed price control, specifically a price “floor” (meaning prices cannot go below the established minimum, regardless of supply and demand dynamics).  So what does that do to our standard model of equilibrium pricing and surplus?  Well, it depends where the floor is relative to the equilibrium price.  If market wages for a given worker in a given position with a given skill set are already higher than the new minimum, it has little to no effect at all.  But as the minimum increases, it starts to have very significant effects.

Once a price floor passes above the theoretical equilibrium price, it starts cutting into demand—consumers are no longer willing to purchase as much for the product at that price point, because now they’re getting less of a “consumer surplus.”  Because they’re no longer selling as much, producers can lose surplus, too—they get more from each sale, but they make fewer sales.  If the price floor continues increasing, the extra benefit from each individual sale gets drowned out by the lower and lower number of sales.  This lost surplus—the amount by which everyone in the transaction is worse off—is called “deadweight loss.”  It’s an inefficiency, which in economic terms means the market is no longer making everyone as well off as it theoretically could.

This inefficiency is the base of the argument against minimum wages.  Opponents point to that inefficiency, saying “Look, you’re just making everyone worse off!”  But what they’re missing, and why I say there’s some decent economic support for low-level minimum wages, is that the deadweight loss isn’t the whole picture.  They ignore that part of the producer surplus that *grows* as the price floor increases.  Since in our model producers are workers, what the whole picture tells us is that yes, unemployment will increase for minimum wage employees, but also those who now get such jobs will be better off than they would be otherwise.  And that’s exactly what the empirical evidence shows as well.  The overwhelming bulk of studies about the effects of minimum wages have found that unemployment among minimum wage workers increases as minimum wages rise, but also that those with jobs see a higher real income that results in an improved standard of living.  So the pro-minimum wage camp’s claims aren’t as easily refuted by “basic economics” as the opposition often claims.  Those workers DO have higher real incomes.  We DO see a multiplier effect as their purchasing boosts local markets.  We DO see a reduced need for subsidies among such workers (assuming they aren’t in that subset with skewed real incomes from the so-called “welfare cliff,” but that’s a side product of a poorly designed subsidy system and a topic for another time).  So it would seem the evidence is in favor of minimum wages after all, right?

This is where it gets, well, complicated.  Because remember how I said “low-level minimum wages”?  That’s the part proponents often seem to forget or misunderstand.  As I mentioned, as a price floor continues increasing, the amount of surplus added from each individual sale is rapidly drowned out by the amount of surplus lost as sales decrease.  For labor markets, this means that low level minimum wages can boost unskilled workers’ real incomes and standards of living, at the cost of small increases in unemployment.  Small increases in unemployment can be effectively mitigated with various social support programs (like those subsidies we mentioned), so overall most everyone still wins.  But as minimum wages continue increasing higher and higher above the theoretical equilibrium, the positive effects apply to fewer and fewer workers and unemployment increases and increases, and soon the minimum wage’s negative effects have swamped its positives and everyone is worse off than they started.

Soon, employers are dealing with higher labor costs, so they cut back new hires and cut costs elsewhere, maybe even laying off current employees or cancelling planned investments that would have provided jobs elsewhere.  The unemployment rate among low skilled and unskilled workers skyrockets.  Those workers who CAN find a minimum wage job may have some increased real income, but they have to wait much longer for raises and often see cutbacks in benefits.  Additionally, since standard of living is highly dependent on one’s community, in many cases that increased real income doesn’t lead to much improvement in quality of life given the high unemployment and low business investment around them.

The dose makes the poison.  At a low level, minimum wages can help far more than they hurt.  They can increase real incomes for the vast majority of unskilled workers, they can boost productivity, and they can even fuel economic growth through multiplier effects of the added spending in the market.  But seeing those good effects, well intentioned but misguided advocates push for higher and higher minimums, following the “more is better” theory, not realizing that the negatives will quickly overwhelm the positives and the minimum wage will hurt the very workers it was intended to help.  If one is going to implement a minimum wage, it needs to be carefully watched to ensure it stays in the sweet spot where it does good, but doesn’t creep up so high above the market equilibrium that the medicine turns to poison.

So who’s right in the minimum wage debate?  Well, that goes back to the third point raised by minimum wage advocates–that we have a moral responsibility to help lift the poorest members of our society from the struggles of poverty.  I’m not going to pretend to know whether that’s true, as it depends entirely on your own values and your own political philosophy.  But, as explained above, if you happen to value government intervention to help the poor, a minimum wage CAN be an effective tool in that effort.  But only if those implementing it remember that the medicine can just as easily become a poison if not used cautiously and monitored carefully to ensure it keeps pace with natural market dynamics.  So neither side is truly right or wrong, at least in terms of the economics.  It depends entirely on the context and circumstances, and what you value.  As the title of the feature says, it’s complicated.

________________________
Sources for claims of empirical evidence:

Neumark, David. “The Effects of Minimum Wages on Employment.” 2015

Liu, Shanshan et al. “Impact of the Minimum Wage on Youth Labor Markets.” 2015

Congressional Budget Office. “The Effects of a Minimum-Wage Increase on Employment and Family Income.” 2014

Litwin, Benjamin. “Determining the Effect of the Minimum Wage on Income Inequality.” 2015.

5 thoughts on “Well, It’s Complicated (#1): The Dose Makes the Poison”

  1. I assume this means you favor different rates in different places. How do you propose to judge what’s right? And how can you tell if it’s not working? (Besides waiting for disaster, obviously.)

    Like

    1. There are many potential ways to figure out the appropriate level. Ideally, I’d suggest independent agencies control local minimum wages using evidence-based methods such as agent-based computational modeling using local data inputs. But it could be automatically pegged to various indicators such as minimum wage demographic unemployment levels, how long entry level workers go between pay raises, or any of several other potential indicators about where the current minimum wage is relative to natural market forces. But the rule of thumb should be that the minimum wage, if implemented at all, needs to be low relative to prevailing wage rates, flexible, and adjust only in small increments.

      Like

  2. My question is always why is it the poorest people’s income potential that is sacrificed but never the overly inflated salaries of CEO’s and other super wealthy executives? I’ll give a little when it comes to needing to have large profits for shareholders, but the pay gap between the average worker and the highest levels of management are disgusting and should be revolting to anyone with a conscience. Why aren’t companies closing that gap to maintain the “market equilibrium” you were talking about instead of firing or not hiring low wage earners when the minimum wage creeps up enough to throw off that equilibrium? I appreciated your explanation of the situation in terms of pure economics but as usual it’s the wealth inequality that bothers me. The personal effects on REAL people, not the equations on a paper are what should matter to society. That is also not to say there shouldn’t be ANY pay gap, of course there should be. As people are more educated, trained, or possess specialized skills, of course their earning potential goes up and should. Somebody with no special skills or education who is simply flipping burgers shouldn’t have the same earning potential as somebody who is college educated, has been working in the field for years, and whose responsibilities are greater and require more skill. It’s the enormity in the pay gap that I find repulsive, not that there is a pay gap. People who work full time, or in some cases two or more jobs, should not still be barely surviving, while the CEO at their company has literally more money than any one person could ever need in their entire lives many times over. It’s just my personal opinion, but it just seems a backward system that we live in when profits are used as an excuse for underpaying many workers while still grossly overpaying others.

    Do you have any thoughts on this?

    Like

    1. Economically, yes. I’ve actually got a planned future article on the realities and mechanics of executive compensation and income gaps, so I won’t dive too in depth here, but bottom line, it comes down to a question not of individual value as a human being, but rather of individual importance to a company’s success or failure. A single CEO has much greater impact on that question than any single assembly line worker, no matter how important said workers are in the aggregate. Though, to be fair, those CEOs still have individually much LESS impact than they tend to believe.

      But morally, no. My intent with this blog is not to take moral positions except in the truly egregious cases. The moral answer to this question, like most economic questions, depends entirely on what cultural values one sees as more important. It’s very difficult to claim an absolute monopoly on virtue, so I won’t try. I want to present people with the way the world actually works as best I can, then let people think and draw their own conclusions based on their own values. So I will not be taking a side as to whether an income gap is revolting.

      Liked by 1 person

  3. […] There are two parts of my response to this.  First, that body of previous research is MUCH more divided than Ms. Smith seems to believe, but that’s to be expected from someone who so demonstrably cherry-picks statements to support her point.  While one school of thought, led by researchers like Card and Krueger (the so-called New Minimum Wage Theorists), believes their research supports Ms. Smith’s argument, their claims have consistently been rebutted on methodological grounds by other researchers like Wascher and Neumark.  Over 70% of economists looking at the conflicting evidence have come down in support of the hypothesis that minimum wage increases lead to job loss among minimum wage workers, as cited by Mankiw in Principles of Economics.  I discuss both points of view more extensively in “Well, It’s Complicated #1.” […]

    Like

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s