Price floors and ceilings are among the most contentious issues in a free-market society, and the minimum wage price floor is perhaps the most hotly debated issue of all. It hits all of the emotional buttons, as some see it as a “free lunch” for low-skilled workers and an anchor around the neck of business, while others see it as a means to alleviate poverty and improve society as a whole. Even in the rarified realms of academia, Nobel Laureates argue various economic models which demonstrate either great harm or great benefit from a minimum wage.
As we see in Figure 1, from a standard model perspective one can argue strongly that a minimum wage set above the equilibrium level will decrease demand for low-skilled employees, thus creating a surplus in the market (unemployment). With this surplus then comes a drain on the rest of the economy as the unemployed require government assistance (provided through taxes) or simply drop off the employment roles entirely, resulting in a higher incidence of poverty and general economic malaise.
While this simple, common-sense explanation of the effects of the minimum wage act as a powerful tool in the arsenal of those opposed to the minimum wage, it is somewhat more complicated than this simple model will allow. (Note: For this argument, we ignore externalities such as international competition, which obviously have an impact. They should be taken into account, but are beyond the scope of this paper.)
Probably the weakest assumption is that demand is highly elastic, resulting in massive unemployment for every unit of wages increased. This assumption, that employers will immediately respond to an increase in wages with layoffs (and the resultant decrease in productivity this would entail), is itself based on another assumptions: (a) that employers will be unable to recoup the added expense, and thus will lose revenue unless they cut payroll; (b) that the markets are perfectly competitive; (c) that ceteris paribus is in effect, and no other factors change except wages; and (d) (as implied by (c)) that the increase in income for low-skilled employees will have no net effect on the economy (or, that because of massive layoffs, will have a negative net effect), and no other determinants of demand or supply apply.
Let us examine each of these sub-assumptions carefully. Beginning with (a), that employers are tied to a fixed revenue stream and thus are bound to eliminate employees if the minimum wage increases or else they will have to increase prices and thus lose customers, we find that we have a kind of reverse of the “fallacy of composition”. Instead of taking a single example and expanding it to all cases, we see that this assumption is based on the effects on individual companies. If a single company were forced to adopt a minimum wage, it would certainly lose market share if it increased its prices compared to its competitors. However, the assumption loses validity when one looks at the aggregate economy, and all employers who are affected by the minimum wage increase. The individual company is no longer the only one having to recoup the added expense through increased prices; in fact, all companies will have to do this. Therefore, the price consumers see on the shelves for all competing products will rise by approximately similar amounts (taking into account the various companies’ individual production efficiencies). Therefore, consumers will not have a viable substitute, and will continue to purchase the same products they had before at slightly elevated prices. The individual companies will see perhaps a slight bump in their demand curve while prices stabilize at the new, higher rates, but in the long run analysis little would change.
Looking at assumption (b), that markets are perfectly competitive, hardly needs a detailed explanation. It is something that is simply ignored in most descriptions of the effects of the minimum wage. However, it is extremely important to understand; without perfect competition (a homogenous amalgam of numerous small businesses, all producing pretty much the same thing for their particular market), we are left with a heterogeneous business landscape: the big companies and the little companies. Obviously, bigger companies employ more people but also have huge revenue streams, so can absorb the operating cost of a minimum wage hike more easily. Similarly, smaller companies have smaller payrolls but they tend to make up a larger proportion of operating cost, so a minimum wage hike has a bigger impact on them. What this means in aggregate is that bigger companies will tend to shake off the increased wage costs, while smaller companies will have to either raise prices, lay off workers, or go out of business. On the surface, this seems to bolster the argument that the minimum wage is bad for small business, and to some extent, this is true. A company operating at the margins of profitability, maximizing their productivity with their existing workforce and budget, suddenly forced to spend more money on a workforce that they cannot reduce in size without reducing productivity, and hence eliminating their profit or even achieving negative profitability, will soon find itself in financial hot water. However, this demonstrates only that the small company was in a weak position already (probably already experiencing shortfalls in growth planning or other expenditures), and should revise its business model, innovate, or die. Though this would definitely result in layoffs on a local level, it would actually result in more jobs nationwide as competitors increased production to take the place of the failed company.
As for (c) and (d), let us combine these two assumptions into one largely overlooked (or actively ignored) category: we’re assuming that the only thing happening in society is an increase in costs to the employer. Obviously, ceteris paribus is an economist’s ideal, not reality. Everything in an economy, whether social, political, monetary, fiscal, environmental, or what have you is changing constantly. Nothing is static, and nothing can be treated as such for any reason other than to produce models for analysis (it’s hard to analyze a flock of birds, but easy to examine one bird at a time). Therefore, viewing a minimum wage increase as simply an added cost to employers, who must either reduce their employment numbers to save costs or pass those costs onto their customers (which may result in reduced demand and therefore loss of employees anyway), is far too simplistic.
To get a better idea of how a minimum wage increase would affect society as a whole, let us examine things from the employee’s side of the coin. As a low-skilled, minimum-wage employee, you have $X disposable income per month, which translates to dollars spent on various consumer goods above and beyond bare necessities. This may be something as simple as buying a single DVD for your children, or going to a McDonalds for lunch once a week rather than carrying a sandwich from home. When you receive an increase $Y on your paycheck due to a minimum wage increase, you now have $X +$Y = $Z disposable income. This may translate as
your ability to purchase two DVDs per month, or go to McDonalds twice a week, or even perhaps upgrade your spending to non-inferior goods; instead of buying the cheapest toilet paper, you buy a better brand, or you use the extra money to save up and buy a newer car that had previously been out of your reach, or you decide to take the family out to Applebee’s for Grandpa George’s birthday, instead of a barbeque in the rain on your leaky back porch. This new expenditure is what makes the minimum wage sustainable; producers do not lose revenue, they gain it through added consumer spending aggregated across the entire economy. This added spending shifts the demand curve to the right, resulting in higher producer output and more employment. Figure 2 demonstrates this relationship:
Therefore, a minimum wage can have the effect of hurting small businesses that were marginal to begin with, but taken as an aggregate across the economy, the net effect is beneficial and expands the production possibilities curve for the entire society (when the lowest-paid workers in our society benefit, everyone benefits). The idea that raising the minimum wage is harmful is on the same level as believing there’s a monster in the closet. On closer examination, we find there really is no boogeyman.
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Chinn, Menzie. (December 10, 2006). The Economic Debate over Minimum Wage Effects. (Blog Post). Econbrowser. Retrieved June 11, 2009 from http://www.econbrowser.com/archives/2006/12/the_economic_de.html
Gwartney, Stroup, Sobel, and Macpherson. (2009). Microeconomics: Public and Private Choice. 12th Edition. Mason, OH: South-Western Cengage Learning. Figure 1 is based on Exhibit 4, p. 90.
Kennan, John. (1998). Minimum Wage Regulation. The New Palgrave Dictionary of Economics and The Law. Retrieved June 11, 2009 from http://www.ssc.wisc.edu/~jkennan/palgrave.htm
Sawhill, Isabel and Adam Thomas (May 2001). A Hand Up for the Bottom Third: Toward a New Agenda for Low-Income Working Families. The Brookings Institution. pp. 16-20. Retrieved June 10, 2009 from http://www.brookings.edu/~/media/Files/rc/papers/2001/05useconomics_sawhill/20010522.pdf
Sawhill, Isabel and Adam Thomas (May 2001). Chart 13: Distribution of Earnings Gains Under a Simulated $1.00 Increase in the Minimum Wage. Accompanying charts to A Hand Up for the Bottom Third: Toward a New Agenda for Low-Income Working Families. The Brookings Institution. Retrieved June 10, 2009 from http://www.brookings.edu/views/papers/sawhill/20010522_charts.pdf