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The economics of the minimum wage

Minimum wages are a popular topic. Barack Obama proposes a nearly 40% increase from $7.25 per hour to $10.10 and David Cameron has faced calls from some of his own backbenchers to raise Britain’s minimum wage of £6.31 per hour for over 21s. What are the economics?

A wage is the price of labour. At a given price/wage (W1) a certain amount of labour will be purchased (L1). We can show that with the following chart

 w1

 

Many argue that we can make people better off by either setting minimum wages or raising those that there already are. But what are the effects of this? Put another way, what is the effect of raising the price of labour? We can show that with the following chart

 

w2

 

As with anything, if you raise its price the quantity of it demanded falls (caveats discussed below); there is less employment, in other words. As economists Paul Krugman and Robin Wells put it, “when the minimum wage is above the equilibrium wage rate, some people who are willing to work  that is, sell labor  cannot find buyers – that is, employers willing to give them jobs.” (Krugman and Wells 2008) Indeed, most supporters of higher minimum wages tacitly accept this. When you ask them “If raising minimum wages makes people better off, why not raise them to £/$50 per hour?” they generally reply “Don’t be so silly”. Well, indeed. A minimum wage that high would be unaffordable for many employers and unemployment would increase.

But by acknowledging that at a higher price a lower quantity of labour will be demanded they are acknowledging that the demand curve for labour slopes downwards as shown in the following chart

w3

 

But if the labour demand curve slopes downwards between £/$50 per hour and the current minimum wage why would anyone assume that it doesn’t continue to slope downwards below the minimum wage? In other words, might we not see an increase in employment if we reduced the minimum wage (in real or nominal terms) or eliminated it? At that point the conversation often moves to whether people should be able to hire/work at those lower wages, a question outside the scope of economics.

Now for those caveats. I recently asked some friends whether they would continue to buy the same amount of something if its price went up 25%. One answered “Well, cigarettes pretty much have (over a comparatively short time), and I pretty much have continued to buy them. But I admit that my sickness at having to pay that much for my brand has now driven me to tobacco during the week and the odd cigar at the weekend now (rather than the fiver per day for a pack of Embassy)”

What my friend Miguel has identified here is the notion of elasticity, the change in the quantity of something demanded resulting from a change in its price. If the quantity of something demanded varies greatly with changes in price then demand is ‘elastic’, if the quantity demanded changes very little (or not at all) with changes in price it is, like Miguel’s cigarettes, ‘inelastic’. We can show an inelastic demand for labour with the following chart

 w4

Here, with the steep curve given by the inelastic demand for labour, a large rise in the wage from W1 to W2 gives a comparatively small drop in employment, from L1 to L2.

But is labour demand inelastic? One of the factors determining elasticity is the availability of substitutes. If nothing else can fulfil the role of the good which is rising in price you will have to pay more (up to a point) but if something else will do well enough you will switch to buying that instead. And there is a substitute for labour; capital, the price of which is falling thanks to technological innovations just as people campaign to raise the price of labour. In a supermarket lately you might have used a machine to scan your own shopping. Those machines are direct substitutes for the labour of checkout staff. Or, as a meme humorously put it recently,

 w5

 

Another friend replied “Depends on the price to start with, the income of the person and their lifestyle. If Nigella Lawson was on a fixed rate water bill and it went up 25% then I think we can be pretty certain she would buy and consume the same amount.”

Indeed, as Tom says, rises in prices are felt differently by different people – and companies. Raising the price of labour by 40% might not have much of an effect on a big business operating on wide profit margins but it would be crippling for a smaller business with its much thinner margins. It’s curious that many supporters of ‘Buy Local’ also support minimum wage policies which give big businesses a crushing competitive advantage over smaller businesses.

So much for the theory, what about the practice? An extensive review of studies into the effects of minimum wages carried out in 2006 by economists David Neumark and William Wascher (Neumark and Wascher 2006) found that

the oft-stated assertion that recent research fails to support the traditional view that the minimum wage reduces the employment of low-wage workers is clearly incorrect. A sizable majority of the studies surveyed in this monograph give a relatively consistent (although not always statistically significant) indication of negative employment effects of minimum wages. In addition, among the papers we view as providing the most credible evidence, almost all point to negative employment effects, both for the United States as well as for many other countries. Two other important conclusions emerge from our review. First, we see very few – if any – studies that provide convincing evidence of positive employment effects of minimum wages, especially from those studies that focus on the broader groups (rather than a narrow industry) for which the competitive model predicts disemployment effects. Second, the studies that focus on the least-skilled groups provide relatively overwhelming evidence of stronger disemployment effects for these groups.

Neumark and Wascher updated and expanded this study in their 2009 book Minimum Wages (Neumark and Wascher 2009), concluding that

minimum wages do not achieve the main goals set forth by their supporters. They reduce employment opportunities for less-skilled workers and tend to reduce their earnings; they are not an effective means of reducing poverty; and they appear to have adverse longer-term effects on wages and earnings, in part by reducing the acquisition of human capital.

A fitting conclusion here also.

References

15 comments to The economics of the minimum wage

  • nick peters

    I’d be intrigued to hear the author’s thoughts on the impact of tax credits on the minimum/living wage argument. It can be argued that the credits subsidize wages by bringing them up to a notional minimum standard. Is that so? And if so, are they also a form of subsidy for inefficient businesses that can only survive by paying low wages that would not otherwise be acceptable to the employees? If such market distortion is indeed happening, then the tax credits policy is in effect propping up zombie companies.

  • Paul Marks

    Prices (and wages are prices) should be set by supply and demand – not by government edicts.

  • chuck martel

    “, might we not see an increase in employment if we reduced the minimum wage (in real or nominal terms) or eliminated it? At that point the conversation often moves to whether people should be able to hire/work at those lower wages, a question outside the scope of economics.”

    Maybe it is outside the scope of economics. Maybe morality doesn’t mean anything. Nonetheless, it is immoral for the state to become involved in voluntary contracts between two individuals, regardless of the rationalization.

  • John Phelan asks a good question in relation to his downward sloping demand curve for labour, but he doesn’t answer the question. He asks, “But if the labour demand curve slopes downwards between £/$50 per hour and the current minimum wage why would anyone assume that it doesn’t continue to slope downwards below the minimum wage? In other words, might we not see an increase in employment if we reduced the minimum wage (in real or nominal terms) or eliminated it?”

    Well the obvious answer is: “yes: employment would rise”. But there’s a dilemma there, which is that we pay generous in-work benefits. I.e. if employers could pay 50p/hr in the knowledge that taxpayers make up employees wage to a socially acceptable take home pay, then many employers will be tempted. So how do we get the benefit of that extra potential employment without the excessive burden on the taxpayer? Well here’s how.

    Many of the potential very low paid employees are not hopelessly unskilled or untalented: they are “the unemployed”: a group of people who TEMPORARILY cannot find a job that suits them. Thus I suggest it would be beneficial to let employers take people on for 50p/hr, or indeed hire people for free, but on a TEMPORARY basis: perhaps one month maximum.

    An additional benefit is that some of the unemployed are people whose skills are not going to be in demand for quite some time, and who would thus benefit from trying out types of work they haven’t tried before so as to see what suits them.

    Put another way, the above argument is one that supports the Work Programme, thought WP jobs can last 6 months which is too long I think.

    • John Phelan

      An earlier draft did answer the question but I chopped it for simplicity.

      The answer, of course, is that the labour demand curve will continue to slope down and to the right until it reaches either a) the level of income which can be had from welfare benefits or b) the level needed for subsistence. At whichever of those levels is higher the labour demand curve will go flat.

    • Many of the potential very low paid employees are not hopelessly unskilled or untalented: they are “the unemployed”:
      Q: How can they be ‘very low paid employees..’ and ‘unemployed?

      • George Thompson

        Um, that’s “potential” very low paid employees …

        • waramess

          Um no, thats supply and demand. Very different

          • George Thompson

            abolishincometax asked “How can they be ‘very low paid employees..’ and ‘unemployed?”. He overlooked the adjective “potential”, even though he copied it from Ralph Musgrave’s earlier post to the paragraph preceding his query. ‘Supply and demand’ was not mentioned in his post, and has no place in my response which simply pointed out his oversight. I answered the question asked. Nothing more. Nothing less.

  • waramess

    I have some difficulty with the concept of the minimum wage per se.

    What is the point of the government implementing the minimum wage and then taxing those who receive it? Am I mad or are they?

    This is a nonsense concept that has been spoon fed to the population by politicians who want to curry favour with the electorate at no apparent cost to themselves.

    Let’s have no debate about whether or not to reduce it below or even above the curve: if the governent are minded to ensure a sector of the population receive a minimum or even a living wage then achieve it by first raising the tax band and then through the tax credit system.

    The government should either reduce it’s spending in order to achieve this or openly and transparently raise other taxes.

    • By taxing Minimum Wages, means effectively that the government is breaking it own minimum wage law and should throw itself immediately in jail.

      Two points on the Minimum Wage:
      Ron Paul wrote about the racist, white Unions in South Africa who managed to impose a minimum wage which effectively kept blacks from competing with their workers.

      Peter Schiff recently said:- ‘The only reason people are unemployed is because they are getting a better deal from Government..’
      It starts and ends there.

    • George Thompson

      Mr. waramess, In the USA many who earn minimum wage receive earned income tax credits, which is nothing more than a wealth redistribution scheme. In order to receive these benefits, at least as originally planned, they had to have earned income and file a form 1040 by tax day (usually April 15) of the following year. If their earned income fell below the government’s minimum level based on things such as family size, they would receive a tax refund in excess of what they overpaid. That’s why they are taxed. It’s but a vehicle for giving them more money.
      http://www.irs.gov/Individuals/EITC,-Earned-Income-Tax-Credit,-Questions-and-Answers

      • waramess

        If as a result your (USA)minimum wage employers can pay whatever rate they wish then it would not be a disincentive to hire and it would not add to unemployment although, it would of course add to the tax burden already carried by the rest of the population, and all that entails.

        In the UK the burden is full square on the employee wjth the governments involvment being only to set the rate. That is of course a direct disincentive to hire and a direct cause of (some) unemployment

  • Paul Marks

    On wage subsidies (now called “tax credits” – even for people who do not actually pay income tax) the idea is an old one.

    It goes back to the village of Speenhamland in the 1790s.

    It is an idea that never turns out well.