The Minimum Wage Fallacy

How Obama’s Proposal Will Have Unintended Consequences

US President Barack Obama

In the recent State of the Union Address, President Obama proposed a new solution to the rising poverty rate: a $9/hr federally-mandated minimum wage.

The declaration garnered a positive response from the crowd, and the public in general. Surely, this will solve the issue of poverty, right?

What President Obama, Congress, Keynesian economists, and many others choose to ignore is what kind of implications a wage floor can have on the economy. To explain these ramifications, we must first delve into the economics of labor supply and demand.

The Supply and Demand for Labor

Labor, as well as everything else in the economy, is subject to the laws of supply and demand – that is, the demand for a good or a service, as well as the supply of such goods and services, will work towards market equilibrium, maximizing efficiency and setting a market price. The market price signals to businesses and consumers alike the actual costs of what is being made available, be it food, shelter, clothing, luxuries, and labor. What many Keynesian/Liberal economists will have you believe is that labor is somehow outside of these laws, and ergo it is not subject to these laws; yet, labor is a service, which a business must purchase for it to operate (just as a business may have to purchase the services of a carpenter or an electrician, the business must also purchase your labor from you, and it is calculated as a cost in the business’ spread sheet.) Just as all services have a market price, so does your labor.

Consequently, when a price floor is established in the labor market through the passage of minimum wage laws, excess supply of labor is created. Businesses are not willing to hire as many workers for a higher price, and thus, cut down on the number of laborers they “purchase” in the labor market. If, say, the market price is $5/hr for unskilled labor, and a minimum wage price-floor of $10/hr is instituted, then firms will only be able to hire half of the number of workers that they would otherwise employ. This example, albeit simple, is exactly the type of an effect any type of price-floor has on the economy. The business then faces a tough decision: Do they hire less workers? Do they fire some workers and keep costs the same, but lose production-capacity? Do they “eat the costs,” so to speak? Do they push off the costs onto the consumers?

How Adjusting For Inflation Won’t Work

There is a common argument made for the minimum wage that entails raising the base wage that workers must be paid in order for them to keep up with the rising costs of living (due to inflation.) At first, this sounds like the right thing to do: if the wage is increased at the same rate of inflation, then true costs will not rise, correct?

Wrong. Inflation is a tricky thing; it distorts the prices in a market, which act as signals to people and firms about the supply and demand for various goods and services. There are three inherent flaws in adjusting wages for rising inflation:

A) The way that the BLS calculates the Cost of Living Adjustment (C.O.L.A.) is flawed. The rise in prices that are monitored in the COLA are based upon a fixed basket of common goods, which composes the Consumer Price Index (CPI.) The issue with monitoring this same basket of fixed goods is that the various inflation rates of these products (apples may rise 33% opposed to bananas only rising 24%, for example) is that consumers typically substitute cheaper goods for goods whose prices rise significantly. Joe Consumer may consume less apples and consume more bananas, so he wouldn’t be spending nearly as much money as the CPI would make it out to be. This misleads government officials and distort Social Security payments and other forms of welfare all the time; one can make the assumption that the wage rate would follow the same path. It may be that the Government would overcompensate or under-compensate workers for their wage, because they would have no true way of knowing what the right wage-floor should be.

B) Different regions experience different prices. California is notorious for its high gas and housing prices, opposite of North Carolina, which has a relatively cheap cost of living compared to the Golden State (no pun intended.) Making a blanket minimum wage for the entire United States disregards these differences, and may pay Californians too little and pay workers in North Carolina too much (and by too much, I imply that workers who would otherwise have been employed in North Carolina would be out of the job while others are overcompensated.) As it was established before, absent of a price-floor for wages, these regions would have their own relative equilibrium wages, accounting for the relative supply and demand for labor in those places. Therefore, adjusting for average inflation across the United States will not account for the differences in prices in the various regions and markets.

C) Most importantly, adjusting the minimum wage subject to inflation rates does not account for how businesses interpret Revenues and Costs. Again, prices act as signals to firms and consumers about the relative supply and demand of goods and services in the market. Higher labor costs signal to firms that it is costly to hire workers and that it would be in their own self interest to scale back on their demand for labor (just as a consumer would scale back on their consumption of an expensive product, it works the same way.) Costs for a business are much like costs for a consumer in that they both interpret higher costs as a function of supply and demand, and not as a function of inflation of the money supply. Although inflation of the monetary base may be causing a higher asking price for labor, businesses will most likely view this as either a drop in the supply of labor or an increase in the demand for labor by other firms. This is how the business will interpret its costs. Where it gets interesting is in how businesses interpret their revenue. Inflation of the money supply will increase the amount of money chasing the amount of goods in the market-for businesses, it will appear as though demand for their products has actually increased, when in reality, it has actually stayed the same. The lag time it takes for businesses to increase their prices to match what they think is an increase in demand causes firms to interpret the higher revenues as just that-higher revenues-and not inflation of the prices due to an increase in the money supply. This creates the disconnect between wage rates and selling prices: the business will interpret its higher labor costs as an increased demand for labor in the market, while simultaneously interpreting the higher revenues as an increase in demand rather than inflation. Why is this important? Businesses will react to a minimum wage (even if it is adjusted for inflation) as a price floor, and not a shift in prices as a whole. This will cause an excess supply of labor, unless the new wage is precisely what the equilibrium price for labor would be absent of the regulation. Even is the latter is true, it still would not allow anyone to be hired below that level, however menial the task. These jobs would otherwise prove beneficial to the market, but are nixed in the name of fairness.

Who is Affected by Minimum Wage, and Why

Believe it or not, a minimum wage affects everyone. Although one may not experience the affects of a minimum wage directly, they will experience higher prices at the stores they patronize and the services they buy. No matter which path a businesses chooses, it is almost guaranteed that the prices of their product will rise. If the business decides to cut their work force, their production-capacity will fall, and thus the supply of the good or service they make available will be smaller, causing them to charge a higher price. If the business chooses to just “eat” the cost, then their profits will suffer, and they will have a harder time financing their businesses and increasing production in the future (which will most likely cause a rise in prices in order to finance any future business ventures.) Clearly, the imposition of a minimum wage on the labor market affects consumers and businesses alike.

But, what of the workers? How does a price-floor on labor affect them? Well, some workers will be better off, in that the lucky few who are allowed to stay under the payroll will see a definite boost to their income; however, these are the workers who are more efficient and offer their employers more production. Such workers would most likely be in line for pay increases anyways, given that they provide enough of a benefit to the business that they should be compensated for their added efficiency. What is not seen is the teenager or the unskilled worker who would be more willing to accept a lower wage in exchange for the ability to acquire useful skills and increase their own worthiness. These workers are dependent upon the availability of low-skill low-wage jobs that exist outside of a hampered market-these jobs lay the foundation from which their skills and their résumés are built upon.

The Vicious Cycle and the Actual Solution

Now, as one can see, the imposition of a price-floor on the labor market has some dastardly effects on prices and employment. The next step for the state, naturally, is to blame businesses and the market about the increased inefficiency, rather than recognizing the inherent flaws of the Minimum Wage. This brings many politicians to adopt even more radical policies or market alterations that further exacerbate the existing problems in the economy. No matter how it is spun, all workers will not be able to enjoy low prices and high wages. Where true economic improvements are made are in the increases in production capacities of firms that drive costs down and makes more available. Increasing labor costs for businesses by raising the minimum wage hampers their ability to increase their reinvestment. Many are unable to recognize this, and only think of the economy as a single pie that must be divvied up and spread around. If this was true, then the production capacity of cavemen in the early days of human history would be the same as today, since their would only be X amount of work and production that could take place. The truth is that work and production capacity is nearly limitless, and has to be improved upon with reinvestment and innovation. Where the focus should be placed is in the Federal Reserve and how the inflation of the monetary base is leading to many of the problems we are experiencing in the economy today.

5 thoughts on “The Minimum Wage Fallacy

  1. This is delightful. As a Macroeconomics student, I was able to relate to it completely and am fascinated by this. Nice going.

    However, I did not understand this line – these are the workers who are more efficient and offer their employers more production.
    Why are these workers the most efficient and productive? Aren’t they ideally the lest productive workers; isn’t that why they would seek the minimum wage?

  2. Siddharth:

    When I mentioned the more productive workers, I was saying that those workers would most likely earn higher wages absent of any Minimum Wage laws, and that is why those laws would not affect them directly.

    Workers who are the most inefficient would have more difficulty finding employment with the institution of a wage-floor.

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