Gangsters and Guns: The Root Causes of Violence in Drug Trafficking (Well, It’s Complicated #5)

A common argument, especially among the more libertarian-minded, is that because a lot of gun violence in American comes from drug dealers, ending the “War on Drugs” would immediately lead to plunging gun violence, especially in poor inner city neighborhoods where the drug trade is rampant and controlled by violent gangs.  But the truth is that’s too simple.

While I do tend to agree that a significant percentage of gun violence is directly tied to the economics of the illegal drug supply chain, the problem is that “calling off the drug war” does not in itself mean “take steps to make it an aboveground legal market.” To see what I mean, let’s look at what motivates violence in the drug market.

Gangsters, by and large, don’t go around shooting each other for no reason (though sometimes they do–the profession attracts a lot of violent sociopaths). Generally, violence is used for two main purposes in black markets (of any kind, from drugs to human trafficking to gun running to illegal food sales in Venezuela): to maintain property rights (e.g., protect one’s stash, one’s territory, one’s supply chain, etc, against competition), and to enforce contract rights (e.g., to ensure people play by the rules and don’t try to rip you off, by ensuring they fear your reprisal).  Both can take the form of what is sometimes called “instrumental violence,” that is, violence directly related to economic activities.  But the latter–enforcing contract rights–can also account for a significant amount of what is called “expressive violence,” in that such violence serves to reinforce the gang’s power, control, and reputation in its territory, thus decreasing the likelihood competitors and customers will attempt to cross them.

To remove both of these sources of violence requires giving drug dealers alternate means to maintain their property rights and to enforce their contracts. This requires not merely ending prosecution and incarceration for nonviolent drug offenses, but actually giving the drug market access to legal structures: they need to be able to set up shop legally in exchange for rent, so they aren’t fighting over corners; they need to be able to enter legally binding contracts with suppliers; they need to be able to enforce their rights through the legal system–call the police when someone steals from them, sue a supplier for breach of contract when shipments go missing, etc.

Further, the individuals currently in the underground drug trade either need to be able to transition peacefully to the aboveground drug trade, or be removed from the market entirely–if the barriers to entry into the legal market are too high, the illegal market will continue to operate until it is either economically untenable (through competition with legal alternatives) or shut down by law enforcement. And we’ve seen how well the latter works in practice through the past half century of the Drug War, so it may not be the best option except for the most egregiously violent criminals. By giving current illegal drug dealers the ability to transition to a legal, profitable, and regulated drug market and shifting the burden for enforcing property and contract rights onto the government, they no longer need to risk felony charges for doing so themselves (and for that matter they no longer need to risk getting shot themselves in disputes with other illegal drug traffickers). Only those individuals enamored of a “gangster lifestyle” would have an incentive to continue criminal activities instead of shifting to the safer and profitable legal drug trade, thus greatly decreasing the overall rate of violence currently fueled by drugs being a highly profitable black market.

This will not solve gang activity, nor will it solve all gang related violent crime.  There are certainly other criminal enterprises that many gangs involve themselves in–prostitution, gun running, illegal gambling, extortion, racketeering, etc.  Legalizing and regulating the drug trade, even with low barriers to entry to allow current drug traffickers to transition to legal markets, will have no effect on these other sources of revenue and their associated criminal violence.  But it will absolutely decrease overall violence as gangs get out of the drug trade and its associated high levels of street violence fades away, in favor of the relatively low violence in other criminal markets that rely less on direct territorial control of prized retail locations.

Ending the Drug War alone won’t affect the primary motivations for drug related violent crime, because the crime isn’t generally caused by criminals trying to avoid prosecution and incarceration.  Violence in the drug trade isn’t caused directly by the drug war; it’s caused more broadly by the fact the drug trade is a black market controlled by organized crime. Because it’s a black market, those in the business of selling drugs have no alternatives to ensure they stay in business but to make sure everyone plays by the rules or gets shot.  That’s the problem that needs to be addressed in order to solve the associated outcome of high levels of violence.

Heroes or Villains? The Economics of Price Gouging (Well, It’s Complicated #4)

The technical definition of price gouging is the practice of producers and/or retailers raising prices well above normal equilibrium levels during periods of short supply, generally during exogenous shocks that both decrease supply and increase demand.  In plain English, that means that when something happens to limit available supplies of high-demand items, such as an environmental disaster, some sellers increase their prices for those products to levels so far above normal that they’re seen as exorbitant.  For example, we often see the price of water and other basic staple supplies skyrocket in the days following major hurricanes and other disasters that disrupt supply chains.  The general public tends to condemn such behavior as taking unfair advantage of customers in their time of need, and many states have laws against it in the name of consumer protection.

But of course, the advocates of free market economics see it as nothing more than natural market forces, and often after such events they come out to proclaim store owners who engage in price gouging as heroes of the free market.  Recently, after Hurricane Harvey devastated the Houston region and Hurricane Irma did the same for the Caribbean and swaths of Florida, multiple articles appeared praising price gouging shopkeepers as heroic, or at the very least helpful rather than harmful.  The argument in both cases had basically four parts.  First, increased prices moderate demand by reducing hoarding tendencies and making customers only buy what they genuinely need, freeing up resources for other customers in need.  Second, higher prices encourage suppliers to bring in more of the goods in question to take advantage of the demand opportunity.  Third, there is no “right” price, only that dictated by the market—if the market dictates prices ten times what they were yesterday, that’s not immoral, it’s just economics.  To quote one such article, “facts should trump feelings,” so the feeling of unfairness is an illegitimate argument against economically rational behavior.  And fourth, private property rights mean individuals should be allowed to set whatever prices they want, because no one has a right to their property except through voluntary free exchange.  And since it’s just good business sense to sell your property for as much as possible, no one should tell you otherwise.  But I personally believe this, like many other pure free market views, presents an oversimplified picture of a much more complicated reality.  So let’s look at each in turn, and see what modern economic theory tells us is really going on.


 

Point the First: Price Increases Moderate Demand, Increasing Efficient Allocation of Resources

Well, yes and no.  Basic supply and demand theory tells us this is what SHOULD happen: prices increase, so people buy less (e.g., only what they really need), thus preventing hoarding.  The problem is that this moderation of demand is bounded by the fact that the goods in question generally are staple goods, necessary to survival in emergency conditions.  Thus, there’s a limit to elasticity.  Elasticity is how much demand changes as prices increase or decrease, and the more “inelastic” something is, the less sensitive demand levels are to price changes: few people drink more water when the price is low, nor are they physically able to drink much less even when the price is extremely high.  People need a minimum amount of water intake to survive.  Similarly, they need food.  They need heat.  Depending on the emergency situation in question, they may need other basic staple supplies like wood to reinforce their shelters and protect themselves from the elements, etc.

The reason societies find price gouging so egregious is because it’s seen as taking advantage of inelastic demand in a time when customers have no other option but to pay whatever the seller asks.  Yes, it might moderate hoarding behavior, but that purpose could be achieved by limiting purchase quantities per customer, without hurting those who can’t afford the elevated prices on goods they literally need to stave off death.  Plus there’s the flip side of the coin: it may also increase hoarding, as customers are afraid prices will continue to rise or supply will run out entirely, so it’s better to pay exorbitant prices now than risk going without later.  Limiting hoarding, even if effective, is a relatively minor positive when the potential externality is extreme hardship and potential death for those who literally cannot afford the high cost of these basic necessities.


 

Point the Second: Higher Profit Margins Encourage Suppliers to Increase Supply to Meet Demand

In an ideal hypothetical economic landscape, this would absolutely be true.  Unfortunately, we don’t live in the hypothetical world of free market models.  Our real world has what is sometimes called transfer friction, or in layman’s terms, logistics concerns: increasing supply means either producing more or bringing in supplies from outside sources.  In the emergency situations that often lead to price gouging, like natural disasters, often neither of these are physically possible for days or even weeks following the initial event.  Producers within the disaster zone are unlikely to be able to increase production capacity when all the infrastructure, including their own supply chains, has just been destroyed.  Nor can outside suppliers transport goods into the zone effectively when the logistics infrastructure has been devastated.  The logistics infrastructure that DOES exist is often commandeered for general disaster relief efforts, so there’s not much capability to flood the market with goods for a profit motive, even if outside suppliers desperately want to do so.

Take, for example, Hurricane Harvey: the public water system was contaminated with floodwaters, making it unsuitable for human consumption in many areas.  Thus drinking water had to come in the form of bottles or purifiers.  But no one IN the disaster zone could readily produce a significant supply of potable water, and no one OUTSIDE the zone could readily transport such a supply into the zone for sale, as the roads and railroads and ports were under water or heavily damaged.  The market could not easily respond to the increased demand level by increasing supply (and thus bringing prices back down) at least until the infrastructure could be repaired.  Thus increased prices do NOT effectively incentivize increased supply during an emergency when the supply chains cannot support it.


 

Point the Third: There Is No Right Price, Just the Market Price.  Facts, Not Feelings.

Maybe.  In terms of morals, sure.  But human markets aren’t made up of perfectly rational and emotionless decision makers.  They’re made of humans.  And both neuroeconomics and behavioral economics provide very strong evidence that feelings matter as much as reason in economic decision making.

Prospect theory, for which Daniel Kahneman won the Nobel Prize in Economics in 2002, tells us that we as humans don’t judge value in terms of absolutes, but in terms of gains and losses from the previous baseline.  Comparisons are relative—we might say that our subconscious minds think in terms of percentages rather than absolute values.  When my bank account is empty, a $100 windfall is a huge gain; when I’m a millionaire I barely even notice it.  Similarly, if a product is $1000 one day and $1100 the next, it’s a small jump, but when it instead goes from $10 to $110, we say the price “skyrocketed,” even though both increases are exactly the same amount of money in absolute terms.  What this means is that modern economic theory tells us there in fact IS a “right” price in economic decision-making, at least when the decision-maker is Homo sapiens rather than Homo economicus: the prior baseline from which the decision-maker is judging relative gains and losses.  If the price goes down, we are happy.  If it goes up, we are unhappy.  And if it skyrockets, we are angry.

This becomes important, because emotions have a major impact on our decision-making.  Which ties into the final point.


 

Point the Fourth: It’s Good Business to Maximize Profit, and Property Rights Mean No One Should Tell Us No

First, let’s be clear here.  I am staunchly in favor of property rights and the freedom to do what you want with your property so long as it isn’t actively infringing on the rights to others.  That said, human beings are social animals.  We’ve evolved in a social context, and many of our evolved behaviors are directly optimized for social, rather than individual, survival.  Two of the most interesting (and relevant) of these evolved social behaviors are what behavioral economists call “inequity aversion” and “altruistic punishment.”

Inequity aversion is the well-demonstrated tendency for people to dislike being treated unfairly and seeing others being treated unfairly.  The Golden Rule isn’t just something your elementary school teacher taught you to ease classroom interactions with the other kids—it’s a fundamental feature of human nature.  Yes, we’re by and large self-centered, but almost all of us have an innate sense of fair play, and we disapprove of behaviors that violate such unspoken norms.

Altruistic punishment is the (also well-demonstrated) willingness of human beings to go out of their way, often to the point of actively hurting their own self-interest, to punish those they see as behaving unfairly.  So not only do we dislike unfair behavior, but we want to punish it when we see it, even if it costs us to do so.  (This is a fascinating social trend, and some researchers believe our unique version of altruistic punishing behavior is one of the keys to human success versus other social animals.)

Why does this matter?  Well, while individuals should have the right to sell their property for any price they want, a basic understanding of modern economics tells us why price gouging is a terrible business decision in the long run.  From behavioral economics, we know people dislike being treated unfairly and seeing others treated unfairly.  We also know that they are willing to go out of their way to punish those they see as treating themselves or others unfairly.  And from Prospect Theory, we know that such judgements of unfairness are influenced not by absolute value of the price increase, but rather its relative value compared to the prior baseline.

Game theory helps us mathematically model optimal decision making in interactive situations, like when a seller is deciding whether to raise the price of an inelastic good to take advantage of temporary increased demand.  But there’s a different answer when the game is played once (such as a transaction between individuals who will likely never see each other again) and when it’s repeated (such as transactions between a shopkeeper and his or her regular customers).  With an individual interaction game, there is no long term loss from treating someone unfairly, because they have to take it or leave it—and for inelastic goods, they’re probably going to take it.  But with a repeated game, treating people unfairly may lead to a temporary spike in profit margins, but is likely to be repaid with long-term punishment, such as formerly regular customers shopping elsewhere because they no longer want to deal with someone who they feel took advantage of them in their time of need.  There is a strong business incentive for local stores to avoid being seen as acting unfairly, because long term profits are heavily impacted by short term perceptions.

Maximizing profits when your customers are desperate may well lead to having no customers when they have competing options.  Altruistic punishment means they’ll likely be willing to go to the competition, even if it’s a bit out of their way, rather than reward you with their custom.  And they may even be able to get their friends and neighbors to do the same—we’re social animals.  Do what you want with your property, but be aware that actions that are seen as unfair may very well have longer term repercussions.


 

Price gouging is not merely increasing prices in response to demand.  It is a huge price increase relative to previous baseline prices, at a time of high inelastic demand, when supply physically cannot increase to match said demand.  Thus, it’s sellers taking advantage of a situation in which buyers must buy their product at the price they set, because there are no other options like going without or shopping elsewhere.  Human social nature means we see this as unfair and are willing to punish such behavior even at cost to ourselves, which makes it a risky business decision, trading short term certain profit for long term potential losses.  It may or may not limit hoarding, but it most certainly hurts those who can’t afford the new prices for goods they desperately need.  Price gougers may not be evil villains, but they certainly aren’t noble heroes.  They’re just people trying to make a quick buck.

How Is the Money Supply Like Gastric Acid? (Well, It’s Complicated #2)

Discussions of banking and financial regulation, at least on social media with non-experts, tend to take one of two fairly absolutist views: either bankers are inherently malevolent extortionists who do nothing more than taking advantage of honest workers’ effort and thus need to be reined in by the watchful eye of government regulators, or the free market is a glorious paradise in which regulation is nothing more than an inefficient and unnecessary evil that hurts everyone by making the market less effective that it could be in producing wealth.  I hate to be the one to tell you, but neither view is correct.  Sorry.  But to see why, let’s take each in turn, and look at some examples.

First, there is little to no evidence that bankers are evil.  In fact, such views have been perpetuated throughout human history, and even underlie many anti-Semitic conspiracy theories (as until the modern era, Christian usury laws meant Jews were the primary financiers of medieval and renaissance Europe).  But the truth is the banking sector is a fundamental base of trade: it provides liquidity and investment capital that allows businesses to operate and expand.  Without investors, only the rich could afford to start businesses.  Thus the financial sector is not only not evil, it is intimately intertwined with every transaction in the modern world.  It allows for the existence of everything from start-up capital to pension funds to widespread home ownership.  Bankers want to make money, sure.  But by and large there’s no evidence they’re any more evil than their fellow non-financial industry citizens.  The existence of occasional bad actors like Bernie Madoff does not refute the vast amount of good that modern financial systems have done to develop economies and build general wealth and fuel trade and growth around the world.

But even with that firmly established, it does not mean regulation is unnecessary.  Even with the absolute best intentions, individual agents in the finance industry operate in a complex system.  Markets are highly interconnected and interdependent networks, and even if we grant the classical assumption that each agent is perfectly rational, the system in which they work means that the market does not act like a classical model would predict.  Rather, because of the high level of interconnectivity and interdependence, thousands of individually rational actors making perfectly rational decisions to optimize their own utility in their local environment interact in complex and often unpredictable ways, and feed off of each other.  What Agent A does in New York affects an investment decision of Agent B in London, which in turn influences the choices of Agent C in Tokyo, and so on for millions of decisions, rippling across the globe.  And all of these decisions are based on outside information as well, like weather patterns (for agricultural commodities futures) or political stability estimates or individual corporate strategies.  This network effect leads to emergent properties like speculative bubbles and market crashes and credit crunches and supply bottlenecks.  We see such inefficient trends even in 100% mechanically deterministic, perfectly rational simulations in agent-based computational models.  It’s even more inefficient when we introduce irrationality and the quirks of human individual and social behavior, like tendencies toward collusion and coercive practices and gaming the system through asymmetrical information and other “unfair” advantages. (For further information, please see the references I’ve listed at the end of this article.  I’ll also be elaborating more on the topic in my continuing Complex Systems series.)

All of these features of markets, especially with the actual human elements, can and do lead to widespread harm, from massive financial losses in crashes even to widespread starvation and death in the case of depressions and economic collapse.  So what, then, can we do to try to control such inefficient emergent properties like irrational bubbles and crashes as supply and demand get out of sync?

To answer this question, let’s briefly turn from economics, and turn instead to the human digestive system, using a metaphor first suggested to me by my dad.  Now, to be clear up front, I am neither a biologist nor a physiologist, so this will be a simplified metaphor to illustrate a point, rather than an examination of the mechanics of digestion.  But the human digestive system has evolved in such a way that it can control the amount of gastric acid in the stomach at any given time.  It does this because, when we were hunters and gatherers, we did not have a reliable source of food, so often our nutrient intake came in brief feasts—after a successful hunt or a profitable foraging effort—punctuated by long periods without food.  Thus the stomach needed to be able to adjust the level of acid, to digest food when it showed up, but avoid hurting itself when there was no food present.  Too much acid without food, and we get ulcers.  Too little acid when there IS food, and we can’t digest efficiently and have to sit around waiting for the food to dissolve slowly.  But the digestive system evolved a way to regulate the level of acid and adjust it as conditions change: keep it low during periods without food, ramp it up as necessary when food shows up, and then lower again to protect itself when the job is done.  This remarkable regulatory system gave us the flexibility to succeed as a species when we didn’t have a reliable food intake, and without it we’d likely have died off long before we figured out agriculture.  It’s not a perfect system: we still sometimes get ulcers, and we still sometimes have digestive problems if we gorge ourselves too fast and the system has to catch up after the fact.  But it works, pretty well, most of the time.

Now take that concept and apply it to the economy.  In this metaphor, food is market demand, and the acid is the money supply: it allows the market to process the demand as necessary.  But much like the stomach acid, a single constant level doesn’t work well.  Too much money supply, and we get massive inflation, and no one can afford anything regardless of demand.  Too little, and no one has money to buy things and trade grinds to a halt, and we might even get deflation (where people know their money will be in more demand in the future, so they’d prefer to hold on to it rather than spend it now).  The money supply, like our metaphorical gastric acid, has to be appropriate to the market’s requirements at the present time.  Therefore, the ability to adjust the money supply is essential to a smoothly functioning economy.  Money supply regulation helps the economy, by and large, by letting the market efficiently process demand through trade, without excessive inflation or deflation.

Now, much like the gastric acid regulatory system, money supply regulation isn’t perfect.  Generally it’s done by central banks like the Federal Reserve, which is a favorite target of free market advocates who are convinced the Fed has made the market worse and attributes many market problems, such as bubbles and crashes, to its interference.  However, there’s some decent evidence showing that’s not the case at all.  About a year and a half ago, I ran some numbers to see if the Fed has really made things worse.  What I found was that in the United States, prior to the founding of the Federal Reserve, depressions and recessions occurred on average every 4.33 years, lasting an average of 2.16 years each, with an average 22.8% peak-to-trough loss of business activity.  Since the founding of the Federal Reserve in 1913, they have occurred every 5.76 years, lasting an average 1.08 years, with an average peak-to-trough loss of only 10.1%.  If we look only at the period since the end of the Great Depression—an event which led to the creation of macroeconomic theory and its application by central banks—they drop to an average of 11 months every 6.33 years, with a peak-to-trough loss of a remarkably low 4.2%.  Now, I freely admit this was not a scientific, econometric analysis.  I did not control for confounding variables, so I’m not going to argue the Fed has itself caused the lower volatility of the markets since 1913.  But I’m not alone in noticing this trend: in financial economics, the period of approximately 1950-2007 is known as the “Great Moderation,” and prior to the 2007-08 crash, some financial and macroeconomic theorists firmly believed we’d “solved” the problem of major recessions, largely through high-level monetary and fiscal policy regulation.  Clearly, we have not (there’s a reason the Great Moderation ended in 2007).  But it’s virtually impossible to look at the empirical data and proclaim that the Fed somehow made things worse.  And there’s a very strong indication that policies such as regulating the money supply HAS dramatically reduced market volatility by matching the metaphorical acid level to the metaphorical food level.

Much like the digestive systems, however, it’s not a perfect system.  The experts and the regulators don’t always get it right.  Everyone makes mistakes and every system fails sometimes—especially when trying to control complex systems like economic markets.  Bubbles and crashes have not gone away even with a guiding hand on the wheel of the money supply.  There’s even some strong evidence that several Federal Reserve policies, combined with the independent actions of other regulators, inadvertently fueled the housing market bubble and risky financial practices that led to the the 2007-08 Wall Street collapse.  I’m certainly not arguing against regulatory reform.  I’m just saying that the idea regulation always makes things worse does not stand up to even the most cursory examination.  Sure, it certainly can make things worse—micromanaging policies add an unnecessary and often harmful regulatory burden that makes companies less effective and the market worse overall—but, if applied carefully and gently in the areas it CAN help, then it can also reduce volatility and decrease the negative effects when market agents get it wrong and everything goes bad.  Bankers aren’t inherently evil actors who exploit those less fortunate than themselves, but complex systems like financial markets mean even when everyone is acting with the best intentions, things can go very wrong in a hurry, and effective regulatory systems can help prevent them doing so or mitigate the harm when they do.

The money supply is just one example of a regulatory system that can help the market as a whole, if used carefully.  It’s certainly not the only one—others include limiting collusion and coercive behavior, reducing the impact of asymmetrical information in decision-making so “insiders” can’t take unfair advantage of the rest of the market, and other regulations that act as referees to keep the market as fair as possible.  But there are clearly harmful and wasteful regulations, too, like burdensome tax requirements and unnecessary micromanaging rules.  “Regulation” is such a broad term that no pithy one line explanation can possible capture the whole picture, and each needs to be examined individually in the context of how markets actually work to understand whether or not its valuable.  Like the title says, it’s complicated.

 


Further reading:

Eric Beinhocker, The Origin of Wealth: Evolution, Complexity, and the Radical Remaking of Economics, Harvard Business School Press, 2006

W. Brian Arthur, Complexity and the Economy, Oxford University Press, 2014

 

 

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.

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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.