Why Minimum Wage Fails and What Will Succeed

The debate over minimum wage is one of the most confused arguments in American public policy. Although on its face minimum wage appears to be a promising and simple idea, it is, in fact, a very bad policy that has surely hurt the very people it aimed to help. Proponents of minimum wage (many of them well intentioned) often advocate for increases as a means to improve the personal welfare of workers earning the minimum. This is often accompanied by the argument that no one working full time should live in poverty.

The debate they’re having is: can we provide a minimum income/standard of living in America for workers? The debate relative to minimum wage law is, as Charles Blahous of 21st Century Economics points out: Whether government should establish a price barrier to employment, and if so how high it should be.

The answer to the first question is: yes, but it should be handled differently. The answer to the latter is simple: no.

The welfare of the poor and the prevailing minimum wage are not inextricably linked. Despite minimum wage’s self-evident virtue among certain ideological factions, there’s actually little reason to think this sledgehammer-style policy would help many people, let alone society as a whole. Before we talk about what would work better, I want to highlight some of the more egregious failings of the minimum wage.

  1. Minimum wage forces people out of work

Because most of us grew up with the idea, it takes effort to even begin considering the minimum wage for what it really is: a price floor. Like other price floors, it has consequences beyond those desired.

One negative effect of a minimum wage is a loss of employment. This isn’t limited to people losing their jobs or having their hours cut, but also includes the destruction of future jobs that are casualties of foregone economic growth.

Artificially changing the price of something doesn’t change how much it’s worth to people; economics is tasked with grimly reminding us that prices emerge as a function of supply and demand. As long as employment remains a voluntary transaction between employer and employee, it’s hard to believe a price floor won’t compromise the ability of some workers to sell their labor.

Tragically, this usually affects workers with the lowest skills—traditionally the young, poor, undereducated etc. By eliminating their ability to charge less for their services, minimum wage laws eliminate their competitive advantage. This forces them onto the public dole and renders them a net drain on society.

2. Loss of societal surplus, deadweight loss

This concept is a bit nebulous, but bear with me.

One of the reasons people like me (handsome, rugged) are fans of free markets (a commonly maligned and misunderstood term) is their ability to maximize surplus—the excess benefits enjoyed by producers and consumers in a transaction. (That is, when we’re talking about privately consumed goods.)

Surplus is the idea that even though someone would be willing to pay more or be paid less to consume or supply a good (in this case, labor), the free-market equilibrium price ensures that both parties enjoy a better price. In the graph below, it’s represented by the triangle formed by the crossing of the supply and demand curves.

price_floor
Left: In equilibrium, surplus is maximized for consumers and producers. Right: A price floor has increased producer surplus at the expense of the rest of society. (Graph from econ101help.com)

Forcing a price above or below the equilibrium diminishes the amount of surplus enjoyed by society as a whole; economists refer this to as “deadweight loss” (the green triangle in the graph on the right). It’s true that implementing a price floor above the equilibrium point can (but won’t necessarily) increase the surplus of suppliers (laborers), but this is a bad idea for two reasons:

  1.     It reduces economic growth and efficiency. The added supplier surplus comes at a direct expense to the rest of the economy. This puts undue pressure on consumers of labor, and thus demand for labor.
  2.     Consumers of labor aren’t exclusively employers; they’re also everyday customers—many of whom are the very laborers we meant to aid with the minimum wage.

In other words, though there is tendency to focus on people as either consumers or suppliers of labor, most are both. While they may benefit from minimum wage increases as an employee, they may lose in many other instances when they find themselves on the other side of the proverbial counter. Which dovetails nicely with my next point…

3. Poor people consume lots of low-wage labor

We all buy food. We all buy clothes. But we don’t all shop at the same places. Poor people are more likely to shop at places with lower prices and–you guessed it–lower costs of labor.

Consider that the average Whole Foods employee earns about $18 per hour while the average WalMart employee makes about $13. The shoppers of the corresponding stores have similar disparities in disposable income that are reflected in the prices they pay.

If the minimum wage were raised to $15 per hour, it might have a negligible effect on prices at Whole Foods. The same is not certain for Walmart. Even if prices were to increase by the same amount in both stores, the impact would be greater on the lower-income shoppers, since it would make up a larger percentage of their income.

The problem is that the money that pays for the higher price of labor doesn’t come from nowhere; too often, it comes from exactly those we’re trying to help.

4. Minimum Wage Has Sloppy Aim

A central challenge to minimum wage’s credibility as a form of poverty relief is that it only affects people with wages. It’s easy to make the assumption that poor people are the ones working low-wage jobs, but the two groups aren’t as synonymous as one might think.

First of all, in order to be considered poor, you must be from a poor household, 57% of which have no income earners (Federal Reserve of San Francisco, pg 2). The idea that we would help them by making things cost more is ludicrous.

In reality, about 22% of minimum wage earners live below the poverty line. Their median age is 25; 3/5 of them are enrolled in school; 47% of them are in the south (where costs of labor and living are lower); and 64% of them work part-time.

Fully ¾ of minimum wage-earning adults live above the poverty line.

It’s clear that we’re largely talking about two different groups of people when we discuss minimum wage earners and the poor. Given that the majority of minimum wage workers aren’t poor and that the majority of the poor are unemployed, we should consider another strategy for fighting poverty: one that doesn’t reduce employment opportunities for the unskilled.

Okay, okay…so if minimum wage isn’t a good solution, what is?

Phenomenal question! The many problems with minimum wage policies share a common root: minimum wage effects transactions before they occur. This passes the cost on to employers or customers and impacts demand. The evident solution then, is a policy that goes into effect post-market. My answer to this is a wage subsidy.

We lose more than we gain by interfering with labor markets. Instead, we should eliminate the minimum wage and—very carefully—create targeted wage subsidies for people that aren’t making enough money from their jobs to survive.

This has to be done precisely to avoid creating disincentives to work. Welfare programs can perversely discourage people from earning more money by stripping away benefits faster than wages rise (and this really is more like a welfare program than minimum wage). To give a simple example: if everyone earning under $10,000 were given an extra $5,000, it would discourage people from earning between $10,000 and $14,999, thus encouraging economic stagnation.

We want to encourage people to be as productive as possible. When we design a welfare system, we have to make sure the total benefit enjoyed by the recipient is greater for every dollar earned than the one before it. In order to accomplish this, we need to design our wage subsidy as a function of market wages (the price that employers pay) that increases at a decreasing rate until it hits a wage that we as a society find acceptable.

Wage Subsidy
The subsidy is equal to the height difference between the two curves at any given value of x.

I chose to have the subsidized curve cross with the market wage (y=x) at $13/hour, beyond which point it will cease to be applied. Of course, we could write any equation and phase it out at any point. This subsidy curve is a concept, not a strict recommendation.

There are some profound advantages to this “after-market” approach:

  1.    The cost is borne by society instead of individual employers

I’ve spoken before about how the cost of consumption should be borne by the consumer, so you can be forgiven for feeling confused about why I feel a subsidy funded by taxes is appropriate here. However, the true price of a dishwasher (for example) is not $15 per hour. We know this because there are currently an abundance of dishwashers willing to work for far less than that. If we as a society want them to take home more money for their work, we should pay the difference.

Because of the way this subsidy curve is designed, employees will still have incentive to search for the highest paying jobs available to them. By tying subsidy receivership to work, we encourage workers to maximize their productivity. As long as these conditions are met, our subsidy won’t unnecessarily burden society with the cost of inefficient labor allocation.

  1.     No one is locked out of the labor market

Young people’s employment opportunities are eroded by high minimum wages. Keeping them out of the labor market has negative repercussions for their futures. From the Center for American Progress:

Not only is unemployment bad for young people now, but the negative effects of being unemployed have also been shown to follow a person throughout his or her career. A young person who has been unemployed for six months can expect to earn about $22,000 less over the next 10 years than they could have expected to earn had they not experienced a lengthy period of unemployment. In April 2010 the number of people ages 20–24 who were unemployed for more than six months had reached an all-time high of 967,000 people. We estimate that these young Americans will lose a total of $21.4 billion in earnings over the next 10 years.

Everyone, even the White House, recognizes that the larger implications of a “first job” for our young labor force extend far beyond the pay they receive. Absurdly, they have crafted a program that calls for $5.5 billion in grant funds to help young people get the jobs they have been priced out of by their own government.

  1.     Markets will function better

Advocates of raising the minimum wage are effectively claiming that making a market inefficient will improve outcomes. Here this fallacy is presented as: if the cost of labor is higher, workers will have more money to spend and demand will increase.

This is tempting logic, but it doesn’t hold up to scrutiny. To see how, we can substitute workers for something more specific, like carpenters. Yes, if we passed a law saying that carpenters had to be paid more it would be great for some carpenters. But any additional money spent on carpenters can’t be spent on something else. Society loses any additional benefits it might have gained from having more surplus.

If the reverse were true, it would make sense to ban power tools and all sorts of technology, thereby increasing demand for and price of human labor.

An efficient market creates more surplus, and is less burdened by the cost of those who must rely on public welfare. Additionally, the cost of supporting those people will be defrayed by their renewed ability to provide (in some part, at least) for themselves.

  1. It’s way more targeted than a minimum wage, and could absorb other welfare programs

We could write different equations for different people who might require larger or smaller subsidies to meet their basic needs. For example, a single mom of four kids in Long Beach could receive a steeper subsidy than a childless teen living in rural Alabama, who might not need one at all.

This could theoretically absorb other welfare programs. Instead of receiving a SNAP card, a section 8 voucher, and WIC benefits, the cash needed to cover one’s expenses can be calculated in the subsidy. This has the benefit of cutting down on expensive bureaucratic systems and increases the utility of the money given through welfare while incentivizing work.

*

The United States is a rich country. If we spend our money wisely, there’s no reason we can’t afford some minimum standard of living for workers. Helping our poor citizens is one of the best uses for taxes and far better than a lot of the things we spend public money on.

But rather than mess with markets, we should simply give more money to the people we want to help by redistributing income after markets are allowed to produce as much wealth as they’re able. Additionally, if we’re going to combat poverty with public money, we should do it in a way that stands a chance of eventually readying people to support themselves and without sacrificing economic efficiency. Minimum wage fails both of these tasks.

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12 thoughts on “Why Minimum Wage Fails and What Will Succeed

  1. This is a thorough analysis of the minimum wage, and I agree with your position. One suggestion is to divide it into 2 or 3 smaller posts. I think more people would read it and be impacted.

    I too support the idea of wage subsidies. When you subsidize something, you get more of it. If you subsidize work, you get more people working. Currently, governments often subsidize “not working”, encouraging people not to work.

    The problem is, if a wage subsidy isn’t designed properly, it could be an economic disaster. I think the subsidy should be paid directly to the employee based on the number of hours they work a week. If they work more, they get more of a top-up wage. If they work less, they get less of a subsidy.

    I wrote a short post (450 words) called “Why a Higher Minimum Wage Can Result in a Lower Unemployment Rate.” If you would like to read it, I am open to any feedback: https://christopherjohnlindsay.wordpress.com/2016/05/11/minimum-wage-unemployment/

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    1. Hi Chris, thank you so much for reading! I read your piece as well and totally agree. I thought about basing a subsidy on hours worked, but that might encourage people to merely work long hours as opposed to being productive (a variable which I’m assuming is more wholly captured by compensation). In any case, either approach would likely be preferable to our current attempt!

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  2. re: Artificially changing the price of something doesn’t change how much it’s worth to people; economics is tasked with grimly reminding us that prices emerge as a function of supply and demand. As long as employment remains a voluntary transaction between employer and employee, it’s hard to believe a price floor won’t compromise the ability of some workers to sell their labor.

    Rent and cost of living is ‘artificially’ changed all the time. Landlords jack up rent when they can (though I am against rent control as well, too long to go into it now – they mess up the supply and encourage slumlords) – though they claim it’s because of market, it’s BS, it’s what they can charge, there are always more people who can’t afford housing than those that could and they can raise the rent to weed out the ‘type’ of tenants they don’t like to attract the kinds they do. Prices of food and basic necessities are changed all the time and usually in 1 direction, up.

    Walmart – a corrupt multinational organization who abuses its workers that needs to be put down. The Chinese Walmart workers are complaining about the low pay and erratic hours and we thought Chinese workers are willing to take all sorts of abuse from their employers. The low price model may serve walmart customers and shareholders, but they harm their workers and even suppliers. Their profit margin is so slim but to not do business with Walmart would put them under entirely. And Walmart has a habit of going to their suppliers and demanding that they offer the product at 1 to 2 cents less than previous year when inflation only goes up, which means the vendor has to 1) cut wages or lay off people 2) refuse to do business with Walmart and go out of business. Also, over 1/3 of Walmart’s workforce is on some sort of public assistance – your wage subsidy idea would come in well here but why? Walmart can afford to pay more to workers they just won’t. There’s a difference when a mom/pop local hardware store can’t pay more than minimum wage because they are mom & pop but Walmart isn’t. They’ve made a practice of abusing their workers, up to and including pregnant women. I really hope you stop using Walmart as an example of good business practice.
    http://thinkprogress.org/economy/2016/05/25/3781706/walmart-pregnancy-discrimination-continue/

    And the idea that people on welfare don’t pursue work so they can stay on welfare, pardon me, but you are perpetuating an ugly stereotype about the poor in America. The majority of welfare recipients do not want to be on welfare, it’s not a dignified life. They want to work, and not just work, but work enough to sustain their basic lifestyle. The idea that you only ‘deserve’ the life that you are able to go out and earn is disgusting and is neoliberalism at its core. Meaning for whatever reason, you cannot earn a middle-income lifestyle, because you didn’t have access to higher education, your education was cut short because of death of parent, your parents lost their income or whatever, and so that person has to scrape the barrel because ‘hey, tough shit’ – then you go and tell them minimum wage is bad because you are making the cost of peanut butter go up…

    The ‘market’ isn’t some all knowing deity. It doesn’t know everything, it’s not right about everything. Markets can be manipulated by people, by governments but forces unforeseen.

    Also, even those that work full time, after they pay their bills, rent, utilities, gas for car, they are left with almost no money for food – also known as food poverty and resort to eating poorly or not at all. Is this meant to be market driven too?

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    1. I don’t recall saying that people on welfare don’t pursue work so they can stay on welfare and I don’t think that we should say ‘tough shit’ to people…
      I was only saying that a welfare system that takes away as fast as one gains provides disincentive to work and suggesting that we slow the rate at which we strip aid.

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      1. The “disincentive to work” is the excuse/reason used over and over again on why aid needs to be cut, quickly and swiftly, in some quarters of the GOP, it shouldn’t be offered at all and let ‘local charities’ and ‘neighbors’ step in.
        “Disincentive to work” is also a coded term to describe people who don’t want to work because it’s easier to sit on your ass and collect a check. You may not mean this, but the word “disincentive” has been bandied about to mean not nice things about those on welfare. In some areas in the country, there is simply no work. Thanks for replying and engaging in debate.

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      2. Sure thing. And I think I have a thought experiment for you that can at least help explain what I mean when I say it.
        Imagine you sell fish, but things aren’t going very well, so you get $10 in aid to support yourself. BUT for every fish you sell (let’s pretend they’re $1/each) you receive $1 less in aid. In this case, until you sell more than 10 fish, you may as well have sold none. When you sell the eleventh, you’ve effectively sold 11 fish for $1, not $11, because you could have been paid $10 to sell none. IMO a better way to adjust the aid given in this case is to reduce by an amount less than $1 for every dollar you earn. That keeps you wanting to earn more until you get to a point of self sufficiency, which should be the real goal of welfare systems.

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      3. The problem with a lot of your analogies look perfectly well on graphs, plot charts, pie charts, bar graphs, all the numbers work out, but reality is not so clear cut where 1+1 =2. We should really strive for a society where such inequalities are minimized. Where job loss doesn’t equal disaster, or illness or accident doesn’t equal financial ruin. If everyone’s basic needs are taken care of or within access of most people – including the very rich, there will no such resentments as ‘my taxes are paying for *those* people over there who just on their ass all day’.
        I agree with wage subsidy as its tailored the need of every individual.

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      4. Yeah, you know that’s true. I always throw in a caveat about that when I put a graph in an essay. The world isn’t linear or rational like we pretend it is on paper. But graphs and thought experiments are useful in conveying general ideas, and that’s what I rely on them for.

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  3. And I forgot to add – I agree with your wage subsidy idea. But it won’t have any GOP support because of their total hatred and contempt of the poor and needy. But to institute a wage subsidy, don’t you need a ‘floor’ to start – just to determine who needs it? So if mom/pop hardwares store can only pay $6.50/hour – how would the government subsidize that wage? Up to what? The cost of living of the employee in the town they live?

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    1. That would be my guess, if you wanted to target it to location. I think that would be appropriate but I can’t say for certain it’s the right move. I don’t know what the right amount is, just that this would be a way to do it without skewing labor markets.

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