The minimum wage is an issue people can get very passionate about, and rightfully so! It plays an important role in the quality of life of low income earners, the profitability of many enterprises, and the overall economic performance of a whole country. Issues surrounding the minimum wage arise sporadically anywhere around the globe with economists, politicians, unions, employers and other people and associations calling for it to be raised, lowered, transformed into a living wage, or even abolished.
Contents
- Preamble
- Supply and demand; price floors and price ceilings
- Market imperfections
- The Macroeconomic perspective
- Dynamic and complex outcomes
- Conclusion and recommendations
Those arguing for its restraint or elimination will warn about the danger of loss of jobs, rising unemployment, higher inflation, and erosion of competitiveness of the national economy. Those proposing a minimum wage hike highlight the economic stimulus that would result from the surge in the spending power of low-income families, contend that it encourages people to enter the labour market (possibly getting off social services), and that it fosters equity and social justice. The truth is that both sides pose valid arguments that deserve our consideration.
For a doctor to prescribe the right cure, he must carry out the correct diagnosis! In order for us to to make the right call we first need to have a clear picture depicting all the major factors affecting the minimum wage, the effects that would result from it undergoing a change, and how they intertwine with each other. So we venture into building a holistic framework that allows us to examine the minimum wage issue by incorporating all the pertinent underlying economic theory, and also considering the major points of view surrounding the matter at hand.
Supply and Demand; Price Floors and Price Ceilings
First we will start by investigating the minimum wage issue from a “demand and supply” (technically “Price Mechanism”) point of view which provides one of the most common and powerful basis for those opposing minimum wage hikes or even proposing to abolish it.
Introduction to the Price System
The price system (a.k.a. price mechanism) is a fundamental building block of economic theory. Microeconomics, the oldest of the three main branches of economics, is mostly concerned with its workings. Central to this system is the notion of markets. A market is defined as “a group of firms and individuals who are [loosely] in touch with one another for the purpose of selling or buying some good”(Mansfield and Yohe 2000). The market for any commodity (whether a physical good or a service) has a demand side and a supply side.
The Demand side
A commodity might be desirable in principle; but what would people be willing to give up in order to acquire it? I might love to have 20 nice pairs of quality shoes in my closet – but what would I be willing to give up to obtain them? some of my free time to work some extra hours? how many? would I be willing to give up a kidney or my right hand for the 20th pair if I already owned 19?
The demand side quantifies what potential buyers would be willing to give up (i.e. what price they would be willing to pay) in order to acquire a specific commodity. The demand curve is a graphical representation of the quantity of the concerned commodity that potential consumers would buy at each and every price. The demand curve is shaped by:
- Consumers’ taste;
- Consumers’ incomes;
- Price of substitute goods;
- Price of complementary goods;
- Time period – describes the situation as it stands at one particular point in time and might take a very different shape in the long run.
The price-sensibility of the demand for labour depends on various factors:
The importance of the Geo-location of production relative to that of the market being served. An export oriented manufacturing facility would be more susceptible to react to a wage hike by relocating than a retail outlet or a restaurant. A work to intrinsic need to be performed on location street sweepers and garbage collectors.
Profitability of the economic activity. If the firm employing workers at minimum wage is already operating at low margins, or struggling to break-even; it might not be able to sustain a wage hike and just carry on, but need to enact a drastic change. On the other hand if a firm is currently enjoying high profit margins it might deem the profits after absorbing the added cost still acceptable and preferable to cutting jobs and scaling back operations.
Note that in a perfectly competitive market high and low profit margins should not exist in the long-run in the first place, hence their existence could be a symptom of the market already not working correctly.
Substitution effect: The ease and cost at which the job can be automated, or performed through alternative means.
The price of complementary inputs: The relative importance of minimum wage labour within the economic venture it operates in. A factory or a fast food chain employing most of its workers on minimum wage is going to react very differently than a Financial firm or Tech company employing one cleaner to keep the offices of tens of highly paid investment bankers and engineers clean.
A couple of clarifications:
I would like to point out that the demand for labour is somewhat special as its usefulness derives from its ability to produce; hence it is intrinsically tied with the production side and factors that would normally influence the supply side.
In this article labour refers to services rendered voluntarily by workers in exchange for remuneration and not the workers themselves. Labour-hours are treated as a commodity themselves and we are consciously bypassing the philosophical argument of whether work is a necessary evil to finance living, or an instrument through which human beings further their development, find purpose, and achieve fulfilment.
The Supply side
The supply side interprets how much of a commodity will be supplied to the market at each and every price, and is graphically represented by the supply curve. Firms’ willingness to produce and sell a commodity is mainly determined by how much it would cost them to produce it. The supply curve is shaped by:
- Input prices/economic cost: the economic cost of the factors of production required to produce the product or service;
- Technological change: the efficiency at which those factors can be used to achieve the aforementioned result.
In general firms will be willing to supply a product as long as the price covers the marginal cost of the last unit they produce. Normally the market supply curve is upward sloping; meaning that the higher the price offered by the market, the larger the quantity they would be willing to supply.
In the labour market the supply can be affected by:
- Idle potential workforce (inactive population which could still be available to join the labour market);
- Immigration policies;
- Alternative to working (e.g. structure of social benefits);
- Support services for working people (like childcare services and extended school hours);
- Level of education, skills, and expertise.
Market Equilibrium
In his groundbreaking publication “The Wealth of Nations” Adam Smith introduces the concept of the “invisible hand” whereby the market will drive the price of a particular commodity to go up or down until it reaches the level at which supply and demand match each other and market equilibrium is established. At this equilibrium point all units will have cost less than or equal to the market price to produce them. On the other hand each unit will yield its purchaser as much value as the market price or higher.
Demand and supply: Market equilibrium
Since this framework takes into account opportunity cost the resources employed to produce the product could not have been used to generate a better return; while consumers could not have spent their money on any good or service that yielded them a higher utility. Classical and Neo-classical economics maintains that, if unhindered, the market will clear itself towards the outcome which will lead to the most efficient allocation of resources. Hence concluding that a free market system is the most efficient way to run an economy and maximise utility.
Arbitrary Price Mandates
Of course the market’s “invisible hand” is not the only way in which the price of a commodity can be determined, and one such example is the government authority decreeing what the price should be (perhaps by law). While such arbitrary price mandates can be very effective at dictating the price of a particular commodity; they do not override the natural laws of economics, but rather work within their frameworks.
Price Floors
A price floor is when a minimum price is imposed. While the price mandate can dictate the price, it will not be able to simultaneously control the quantity of a commodity the suppliers will want to sell and buyers will be willing to buy at that price. If the arbitrarily mandated price is higher than the one at which the market would reach equilibrium it naturally transpires that this will result in a mismatch with regards to quantity. At a mandated price higher than equilibrium supply will be greater than demand. If the price is set at the equilibrium point or lower, it would have no effect whatsoever.
Price Ceilings
A price ceiling is when a maximum price is arbitrarily set, and just like a price floor will also potentially result in an unbalanced market. If the imposed price is lower than equilibrium, demand will exceed supply causing a shortage in the market. On the other hand a price ceiling set at the level of the equilibrium price or higher will just be redundant.
The Minimum wage is a type of price floor
The Labour Market is also a market, and hence is subject to follow the fundamental law of demand and supply. If the price of labour is set by law at a price higher than the market equilibrium the result would be an excess of supply. There would be more workers wishing to work than firms willing to hire them, hence leading to unemployment.
Effect of a price floor on quantities supplied and demanded.
So is the case closed?
That’s it?
If the minimum wage is set at a higher rate than that determined by the market it will only result in unemployment, hurting the most the people it is supposed to help. If it is set at the natural market equilibrium or lower it is just useless! Right?!
Well if you stop reading your introductory economic textbook at chapter 2 sure, but it’s not really true. This conclusion assumes that the market always operates under perfect competition, which is not the case. It also ignores how a change in the minimum wage might affect the economy on a macroeconomic level, or trigger more complex dynamics.
Market Imperfections
The notion that an unhinged market will result in the most efficient allocation of resources assumes the market is operating under perfect competition. However, perfect competition is not the only market structure that exists.
Monopsony
Most people are somewhat familiar with the term “monopoly”; but the term “monopsony” is much more unusual. Monopsony is essentially the inverse , not the opposite, of a monopoly. While a monopoly describes a market where one particular seller possesses such a dominant position to be able to single-handedly manipulate, or even dictate the equilibrium price; monopsony describes a market where such power is wielded by one particular buyer.
The founding assumptions of the price theory is that businesses are driven by the motif to maximise profits, while consumers want to maximise utility. A monopsonist would employ additional quantities of the input as long as they generate at least as much extra revenues as the extra cost involved in their employment. While at first this might not sound that different from what a firm would do in a perfectly competitive market, there is actually one very important difference.
In a competitive market no supplier or buyer has enough sway to affect the price, all sellers and buyers are price takers. On the other hand in a monopsony the price demanded by the market will completely depend on the quantity the monopsonist decides to buy. As the monopsonist purchases more of an input it will drive the price up. The monopsonist will not only have to pay a higher price for the last unit purchased, but also for all the others it is buying at the same time.
Static partial equilibrium in a monopsony
Generally, the monopsonist firm will buy less of the input factor than it would have in a competitive market. which will enable it to acquire the input at a lower price, and allow the monopsonist to make abnormal profits. These abnormal profits will come at the cost of both lower remuneration for its suppliers, but also less overall output. The income lost by the suppliers will outweigh that seized by the monopsonist, the difference is called dead weight loss.
A labour market dominated by a monopsonist will result in less jobs and lower wages than an efficient economic output would warrant. If a labour market is dominated by a monopsonistic employer, mandating a higher wage should result in the creation of more jobs not losses. Trade unions can be a counter balance to a monopsonistic employer, but sometimes they can turn into a monopolistic market power themselves.
Asymmetric Information
For a free market to function properly all buyers and sellers must have perfect knowledge of the relevant economic and technological data. Asymmetric information is when the participants in a market do not all have access to the same information. If one party to a trade has better information than its counterpart they will have the upperhand in determining the value they could reap off the exchange.
Asymmetric Information can lead to market failure, moral hazard, adverse selection, and principal-agent problems. Generally a firm hiring an employee would be in a better position to determine the value it would be able to extract from his labour. On the other hand workers would be more informed about their relative productivity compared to their peers.
Efficiency Wage Theory
Efficiency Wage Theory explores the possibility that worker’s productivity depends on the level of the wage rate, rather than being an exogenous factor. If firms paid the wage where quantity of labour demanded equalled the quantity of labour supplied workers could have an incentive to shirk. There would be little incentive for workers to work hard as they could readily find employment elsewhere at the same wage. By paying an above equilibrium wage rate a company could discourage shirking by creating a cost for employees to losing their job. The wage rate where no shirking takes place is called the efficiency wage.
Companies can reduce the worker’s motivation to leave their occupation and look for a job elsewhere by paying above-market wages; thus minimising turnover costs such as searching, recruiting, and training replacement workers.
Physically and mentally healthy workers will be more productive than unhealthy ones. Higher wages can raise productivity by mitigating stress related to not being able to cope with basic financial needs, encouraging high morale. A wage rate higher than “equilibrium” might be more efficient by allowing workers to afford their basic shelter, nutritional and healthcare needs, especially in developing countries.
The price mechanism assumes labour to be a homogeneous input factor. However, different workers might have a different level of ability – yielding varying levels of productivity. By offering wages that exceed the market clearing level, firms might manage to attract more able job-seekers.
The Macroeconomic Perspective
While Microeconomics deals with the behaviour of individual firms and consumers Macroeconomics is concerned with the aggregate behaviour of an economy as a whole.
Introduction to the General Theory of Employment, Interest and Money
In pursuit of better understanding the Great Depression, John Maynard Keynes published the General Theory of Employment, Interest and Money in 1936.
Aggregate Output and Aggregate Income
Within the context of the economy as a whole every dollar spent by a person or company is received as income by someone else, which implies that aggregate output (production) has to be identical to aggregate income. The higher a household’s income is, the higher its nominal consumption is likely to be; but this relationship, unlike the previous, is not perfectly identical. Hence aggregate expenditure can be classified into two broad categories: expenditure that is directly correlated to the level of income; and autonomous expenditure (which is independent of income).
Autonomous expenditure consist of autonomous consumption, planned investment, net government expenditure, and net exports. An economy will reach equilibrium at the point where aggregate output is equal to aggregate income. So stability would be achieved at the level of income at which the portion of income that is not spent is equal to the autonomous expenditures.
Marginal propensity to consume and the multiplier effect
The marginal propensity to consume describes how much more would a household (or country) spend given an increase in their income – it is the fraction of a change in income that is consumed. Its stretch depends on households’ propensity to save, level of taxation, openness to trade, economic outlook (i.e. expected inflation and economic growth), and the sensitivity of the money market. Additionally the marginal propensity to consume is not linear but varies according to level of income.
Since every dollar of expenditure is received by someone as income, a portion of it would be spent a second time, resulting in a second person’s income who would then spend yet another portion of it and so on. Therefore the equilibrium output changes by a multiple of the change in planned investment or any other autonomous variable; this is called the multiplier effect. The steeper the marginal propensity to consume the stronger the multiplier effect will be, as a larger fraction of the initial change in income will be carried forward to each subsequent transaction.
Equilibrium Aggregate Output (Income)
Aggregate demand and aggregate supply
Aggregate demand and aggregate supply are not the sum of all the individual market demand and supply curves in the economy. The aggregate supply curve depicts the relationship between the aggregate quantity of output supplied by all firms in an economy and the overall price level.
The aggregate demand is the total demand for goods and services in the economy; and it is negatively related to the price level. At every point along the aggregate demand curve both the goods and money markets are in equilibrium, and the aggregate quantity demanded is equal to planned aggregate expenditure. An increase in the money supply, government spending, or a decrease in net taxation will boost aggregate demand; while a stringent money supply, spending cuts, or higher taxation will contract it.
The Minimum Wage and Aggregate Demand
Low-wage earners are those most likely to put a larger proportion of any additional income back into the economy through consumption. Therefore a change in their income is expected to produce the largest shift in aggregate demand.
A minimum wage raise-induced increase in their income is likely to boost consumer spending and stimulate the economy by raising demand for goods and services. This could kick-start a virtuous cycle of greater demand for goods and services, job growth, and increased productivity; which would result in a significant increase in GDP and employment. However, if a hike in the minimum wage rate translated predominantly into loss of jobs and reduced working hours the opposite would hold true.
Making work pay and encouraging people to work, increasing the supply of labour
The demand and supply price mechanism is used to determine the outcome of a market in a vacuum. This is fine when dealing with a commodity that has a limited effect on the overall economy. However labour is by no means your run of the mill commodity, but one of the main factors of production which has a widespread effect on the economy.
The downside of price floors is that they lead to an excess of supply, as a result of both buyers wanting to buy less but also of sellers trying to supply more. Let’s investigate the latter part of the equation: normally producers willing to supply more than the market demand could lead to a misallocation of resource by wasting them to produce unwanted goods rather than devoting them to products there is demand for. However, labour is not just any product or service; it is itself a factor of production. Making work pay and encouraging more people to work could push (outwards) the production possibility frontier of an economy, encouraging future economic growth.
Inflation
The powerful impact labour remuneration has on aggregate demand also has its downside. A boost in the aggregate demand can lead to economic growth, if sellers can produce and sell more. On the flip side, if the economy is already at maximum output, higher purchasing power will likely lead to Inflation.
The prices affected the most will be the ones that are intrinsically tied to the income level of the lowest earners, both through their production process and their demand. Commodities for which labour represents a significant share of the total cost of production would be the most prime for a hike in their prices. However goods consumed widely by low income earners might experience a boost in demand due to the income effect, unless they are an inferior good (i.e. a product people will ditch as soon as they can afford a better alternative).
These shifts in prices might disproportionately affect low income households, including those not directly affected by a reform in the minimum wage itself like pensioners and the unemployed. Hence it is important that such reforms take a holistic approach when investigating the possible fallout, so that adequate policies to mitigate any potential downside can be put forth.
Dynamic and Complex Outcomes
Previous models examine the issue mostly in a static context, but raising the minimum wage can trigger some long-term adjustments. While a portion of the economic activity might just cease (or relocate abroad), other firms might decide to substitute labour with capital by automating jobs.
Automation
The most immediate and noticeable role of automation would be to substitute labour, resulting in loss of existing jobs. On the other hand, it would also spur the creation of new complementary jobs to engineer, manufacture, develop the supporting software, and maintain automation. Automation would also become a complementary input factor boosting the productivity of workers in existing jobs.
These new kind of jobs would be less repetitive, more creative, and better remunerated than the ones they replaced. However automation would still be expected to lead to a net loss of jobs in the short-term and possibly greatly increase economic inequality. The low-income earners displaced by automation (especially if the process is triggered by a minimum wage hike) are unlikely to be able to fill the new kind of jobs it would create.
In the long run the advantages of automation will massively outweigh the negatives. Lower costs of production can lead to higher profitability for firms and lower prices for consumers. Automation will allow to reallocate the workforce to more productive endeavours and deliver a wider choice of goods and services to the market
A minimum wage reform could trigger a process which was bound to happen anyways. However a proactive approach could ensue into a better process management, allow to reap the rewards while mitigating the negatives, and gain a comparative advantage over countries that do not automate. A price floor for labour could serve as a catalyst to raise the minimum economic value added per worker, hence act as an incentive to innovate and make jobs more efficient. By accelerating this process a country might get ahead of the curve and gain first mover advantage in the automation industry itself.
Equality
Historically Economics has been primarily concerned with the level of output. GDP per capita is indeed a very good approximation of the standard of living enjoyed in a country, but is nowhere near a perfect fully comprehensive measure. There is a lot of economic theory and empirical evidence suggesting equality could have economic merits in itself.
Due to the law of diminishing marginal utility, at any given level of output a higher degree of equality could yield society increased total welfare. An additional dollar is worth much more to someone who is struggling to pay the rent than to a billionaire. Less consumption-inequality could allow society to enjoy a higher utility level.
Empirical evidence suggests that equality yields better results in respect to life expectancy, infant mortality, literacy, homicide rates, obesity, imprisonment rates, social mobility and mental illness. The Data indicates that once a country becomes an advanced economy, income-inequality is a much better predictor of outcomes in such fields than average income. While the difference in income between countries seems to bear no correlation, the difference in income within a country translates into significantly different results.
A more equal distribution of wealth can reap economic benefits with regards to investment in innovation and entrepreneurship by facilitating a more widespread access to capital. Social mobility inspires entrepreneurship while high income inequality and low social mobility encourage rent seeking. Zweimüller (2000) maintains that “inequality affects growth because it affects the time path of demand faced by an innovator.”
According to Aghion et al (2016) top income inequality is positively correlated with innovation, but broad measures of inequality are not; and that this is, at least partly, a reflection of causality. Innovativeness, mainly due to entrant innovators rather than incumbents, seems to lead to upward social mobility. However, higher lobbying intensity dampens the relationship between innovation and income-inequality, and negates the upward social mobility effect.
Next it is important to determine the impact the minimum wage has on income inequality, or if it has any at all. Rinz and Voorheis (2018) examined the distributional effects of minimum wages using evidence from administrative earnings data from the Social Security Administration linked to the Current Population Survey. They found that “raising the minimum wage increases earnings growth at the bottom of the distribution, and those effects persist and indeed grow in magnitude over several years.”
Conclusion and Recommendations
Any minimum wage reform should be done with the acknowledgement that it cannot magically override the natural laws of economics. Therefore it should be carried out within the context of economic theory and empirical findings. Deep knowledge of how it works will allow decision makers to determine if and when a minimum wage reform is needed, apply correctly. Broad awareness of how it relates with other economic will enable them to draw up policies and strategies to mitigate the possible negative consequences while taking advantage of potential opportunities.
The minimum wage is a type of price floor, therefore it carries the risks associated with this instrument. If applied correctly the minimum wage can serve not just as a means to decrease inequality and fight poverty, but can also increase market efficiency and the productive potential of the country. On the other hand if misused it can result in the loss of jobs, decline of competitiveness, a depression of the aggregate demand curve, or inflationary pressures.
The minimum wage itself is an economic tool designed to achieve economic results, hence it should be used based on economic criteria not dogmatic beliefs. While it has social and economic merits in its own right, the minimum wage should be viewed as a tool whose function is to increase people’s well being, not as an end in itself. Those striving for social justice should also look into alternative means of increasing the purchasing power of low income workers.
Bibliography
Aghion, P., Akcigit, U., Bergeaud, A., Blundell, R. and Hémous, D (2016) “Innovation and Top Income Inequality”
Case, K., Fair, R., (2004) Principles of Macroeconomics, Seventh Edition, Pearson Education, Inc., Upper Saddle River, New Jersey, USA.
Mansfield, Edwin and Yohe, Gary (2000) Microeconomics, Tenth Edition, W.W. Norton & Company, Inc, New York, USA.
Rinz, K. and Voorheis, J. (2018) “The Distributional Effects of Minimum Wages: Evidence from Linked Survey and Administrative Data”, Center for Administrative Records Research and Applications U.S. Census Bureau Washington, D.C., USA.
Varian, Hal R. (2003) Intermediate Microeconomics, Sixth Edition, W.W. Norton & Company, Inc, New York, USA.
Zweimüller, J. Journal of Economic Growth (2000) 5: 185. https://doi.org/10.1023/A:1009889321237
https://www.economicshelp.org/
Wikipedia
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