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.

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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.

Of Course Minimum Wage Reduces Employment

In his opus, Economics in One Lesson, Henry Hazlitt devotes an entire chapter to minimum wage laws. He’s quick to identify a semantic problem that lies at the heart of the debate on minimum wage.

“…for a wage is, in fact, a price. It is unfortunate for the clarity of economic thinking that the price of labor’s services should have received an entirely different name from other prices. This has prevented most people from realizing that the same principles govern both.

Thinking has become so emotional and so politically biased on the subject of wages that in most discussions of them the plainest principles are ignored”

Today Hazlitt’s gripe still rings true.

Presidential candidates Clinton and Sanders are calling for huge increases in the federal minimum wage (Clinton recently echoed Sanders’ call for a $15 federal wage floor). California and New York scheduled incremental increases in the state minimum wages to $15/hour by 2022 and 2021 (with New York’s timing of increase stratified by county). All this is sold to the public as a means to help poor workers, with rarely a mention of the costs of such policy, or who would bear those costs.

Despite a wealth of study on the subject and large consensus about the effects of price floors, economists aren’t speaking out against such an aggressive price-fixing scheme as loudly as one might think.

Twenty-four percent of economists surveyed by the University of Chicago disagreed that advancing the federal minimum wage to $15/hour by 2020 would reduce employment. That is, a quarter of economists disagreed that forcing employers to pay twice as much for labor would reduce their ability or desire to employ people. Fully 38% of economists surveyed responded that they were “uncertain.”

It’s hard to imagine economists making such a statement about anything else. For example: that doubling the price of  laptops would have no effect on the amount of laptops purchased. Since labor is purchased just like anything else, we can expect that making it more expensive will cause people to consume less of it.

Consider that when governments want to cut down on behaviors they deem harmful, one of their go-to tools is taxation aimed at increasing the price paid by consumers. Sanders understands that making people pay more for producing carbon means we will produce less carbon. Other politicians have proposed or implemented taxes on soda, tobacco, alcohol, and more activities in order to suppress demand for them. Yet apparently even economists fail to see the parallels between this and minimum wage.

As Hazlitt states, labor is best thought of as another good. Raising its price by mandate will yield the same effects as any other minimum price: some will be purchased for a rate higher than the free-market equilibrium, but a portion of the previously available supply will not. In other words, while some workers will get a raise, others will work less, be fired, or not hired to begin with and employers will enjoy less productivity from their workers.

No one—least of all economists—should be surprised to hear that setting the price of labor higher than people are willing to pay and accept will lead to less efficiency and productivity, nor that this would lead to slower job growth and less employment. We can even observe this happening during past increases of the minimum wage.

Minimum wage is rationalized as an intervention to alleviate poverty and give a leg up to the most vulnerable workers. However raising the minimum price of labor not only prevents consumers (employers) from buying labor beneath such a floor, but also prevents producers (employees) from selling labor below that cost. Since some people don’t have skills that are worth at least $15/hour to employers, they are going to have a much harder time finding employment under such a policy.

When we consider the people that most likely fit this description, the cynicism of minimum wage laws becomes clear. Those most unable to command premiums for labor–the young, poor, under-educated, and inexperienced—are the very people we purport to be helping! It’s no coincidence that minimum wage laws all over the world have roots in racism and ethnic nationalism. In many cases, their goal was to create unemployment among marginalized groups by eliminating their comparative advantage to native workers.

As for employers, it actually gives an advantage to bigger businesses and puts undue pressure on marginal producers (think mom and pop stores, rural and inner-city employers, etc.) who have smaller profit margins and must operate more efficiently. Quite bizarre for an election cycle marked by consternation of income inequality and skepticism of big business.

The ability to sell your labor competitively is important when you don’t have a lot to offer. We seem to understand the value of this for the affluent. No one thinks twice when a college kid takes an unpaid internship or starts volunteering to gain experience. If it’s fine to work for $0/hour, why not $1, $5, or $7?

The scale of federal minimum wage is what truly makes it a bad idea. It’s one thing to try to fix the price of a specific item in a given location (though it’s still a bad idea). But to impose a national price floor on all incarnations of labor should be unthinkable. To suggest that this won’t lead to any reduction in employment (especially in poorer places) is ridiculous.

Some proponents of minimum wage hikes seem to understand this, yet proceed regardless. Upon signing California’s minimum wage increase into effect, Governor Jerry Brown stated:

Economically, minimum wages may not make sense. But morally, socially, and politically they make every sense because it binds the community together to make sure parents can take care of their kids.

To be honest, I don’t understand the morality of pricing people out of work or making consumers spend more than they have to. Given that “57% of poor families with heads of households 18-64 have no workers”, I don’t think making them harder to employ is going to be beneficial to anyone.

It’s good to care about the poor and try to implement policies that help them, and to be clear, I’m not advocating that nothing be done. But economic policies should make economic sense, rather than being rooted in feel-good or politically expedient gestures. Minimum wages help some (often the wrong people) at the expense of others, who, now unemployable, are unable to gain experience that might lead them to prosperity or at least self-sufficiency. At the same time, the rest of society is robbed of the potential productivity of those victims of the wage floor.

After-market transactions (which I’ll get into next essay) are a much better method of helping the poor, precisely because they don’t distort labor markets or reduce demand for labor. Hopefully, our economists will soon get back to the dismal science and stop playing politics.