Minimum Wage Economics

Don Boudreaux, at Cafe Hayek, discusses the various reasons why economists don’t find it persuasive to argue against the minimum wage by sarcastically asking why the minimum wage isn’t set even higher. Here is a shorter route to illustrating why the argument can be a bad one (although not always),

Minimum Wage (Inelastic Demand)

The downward sloping curve is the firm’s demand curve for labor and the upward sloping curve is the supply of labor. Notice the steep slope of the demand curve. It suggests that the firm’s demand for labor is inelastic. Elasticity refers to how much a change in price will affect the quantity demanded (or supplied, if we’re talking about the elasticity of the supply curve), and the more inelastic demand is the less effect changes in price will have.

Why not $90 instead of $9? $90 could have a huge impact on the quantity demanded for labor, while the elasticity of the curve between $7.25 and $9 could be steep enough such that the change in quantity demanded would be miniscule. Does this reflect reality? This isn’t a theoretical question, but an empirical one — the seminal study by Card and Krueger suggests that the negative effects of minimum wage are often overstated (but, their work is not without controversy).

But, to look only at labor might lead one to underestimate the costs to minimum wage hikes. Suppose the firm’s quantity demanded for labor remains the same, despite a minimum wage increase that ends up costing it, say, $100,000 per year. An advocate of minimum wage might correctly assume that this money will come out of profits. But, I suspect that those who think this isn’t important are those who equate profits with management incomes. This isn’t necessarily true. Retained earnings are also invested. It’s possible that the costs of minimum wage are seen in places other than the labor market, including foregone investment into increasing productivity (which also may suggest foregone wage increases — meaning the minimum wage can be superfluous as well as damaging). Just because the same amount of people are employed after an enforced wage hike doesn’t mean that the theoretical costs have been averted.

Boudreaux brings up another good point closer to the end of his post. The minimum wage isn’t the only piece of legislation the hurts employers. There are various ways that the government can increase the costs of hiring and therefore reduce the quantity demanded of labor. By itself, an increase in minimum wage can have a minimal effect, but in concert it can be particularly damaging. If other Obama programs will raise the costs of hiring, is it smart to also raise the minimum wage? I think it’s a good question and deserves attention.

10 thoughts on “Minimum Wage Economics

  1. Roman P.

    Every time you use a partial equilibrium diagram, God kills a kitten.

    On the more serious note, though, it is true that higher wages mean lower profit share, but on the other hand, on the macro-scale this very same profit comes from the wages too! I guess a better model of the economy (Kaleckian?) is needed to answer the question of minimum wage hikes.

    1. JCatalan

      Wages are paid out of profit, not vice versa. When you manufacture a
      commodity and sell it on the market you’re making a profit, not earning a
      wage in the sense of contracting out your labor. But, I don’t expect this to be an uncontroversial point (nor one that most might agree with me at first — I’m influenced here by George Reisman).

      But, even if this weren’t the case, I don’t see how this would impact our analysis of the minimum wage. This isn’t about the chicken or the egg. It’s about a firm that hires labor, and so for our purposes wages are paid out of savings. Retained earnings can add to these savings, and whatever portion of revenue the new net wage bill eats can impact capital accumulation by the firm.

      1. Roman P.

        All you’ve said is true… on the microeconomics level. My point was that money spent on wages doesn’t disappear, it keeps circulating in the economy. If you own a small store selling paint, then your decision to pay workers more will only mean that there will be less money for you and your store. If you owned Walmart, then paying all of your workers more will mean that some part of this money will come back to you (workers will buy things from your stores!). If minimal wage was risen across the country, then… Well, I don’t know, actually. My intuition is that it will boost GDP in the short run as there’d be more purchasing power amongst the consumers, but in the long run it will be eradicated by inflation and rising inequality. But you can’t talk about macro-level changes by thinking on the level of micro-firm.

        1. JCatalan

          Right, it’s just a redistribution of income, but income redistributions aren’t harmless. In a world where there is a conceivable optimal allocation of the means of production (towards the highest valued ends), the redistribution of income essentially makes it more likely that resources will be allocated towards less valued ends. This was the thesis behind my Mises Daily on the effects of wealth redistribution, or the consequences of going around the market process. No less, if the low wage workers have a higher propensity to consume, this will lessen the volume of capital accumulation (and therefore the volume of future consumer output — making consumers worse off).

          And, I disagree that you can’t talk about macro. w/o considering micro. I’m a firm believer in “microfoundations,” even if it’s not the microfoundations of DSGE models. You can only make sense of the macroeconomic through micro. considerations, because the macro is ultimately a coordination process that allows wants to be fulfilled on the micro. level.

          1. Roman P.

            1) I do not consider your Mises Daily article your highest point, sorry. You seem to imply that income redistributions are always harmful, but that could only be the case if we all live in the general equilibrium paradise. (And we don’t). In the real world income has already been redistributed a thousand times over, by force or fraud, and nobody gets their share according to their marginal productivity. So the ‘market process’, as it exists, needs not be a holy cow.

            Also, I just have to note that your assertion that income redistribution towards labour will decrease investment is shaky at best. You seem to imply that investments are made out of funds provided by the savings of people. Not all will agree with you on that point, to put it mildly.

            2) Fallacy of composition all the way. You try to talk about the effects of the economy-wide legislation by considering what happens to a single firm but hold EVERYTHING else in the economy unchanged. I don’t really know how to prove my point of the need for macroanalysis; it should be kind of obvious to a person of your intellect and education, which I think are superior to mine.

          2. JCatalan

            If we lived in general equilibrium then resources wouldn’t have to be distributed at all — they’d already be optimally redistributed. The market process is best understood within the context of disequlibrium, because it provides a framework for understanding how order can be established despite disequilibrium caused by kaleidic valuation and contradictory expectations. The market process is an all-encompassing term for the processes of coordination. Re-distribution of income outside of the market process represents a rupturing, or at best a circumnavigation, of these coordination processes.

            The market process isn’t perfect. But, you can’t say that the market process is perfect and then assume, uncritically, that government must be better in these cases. It could be, as it is, that the government preforms much worse. It can make the situation worse than it already is.

            You write,

            You seem to imply that investments are made out of funds provided by the savings of people.

            You can only invest resources that have been set aside. Investment doesn’t arise ex nihilo, and this includes consumption goods set aside to fund the productive processes which are temporarily deferring production of consumption goods.

            You follow,

            You try to talk about the effects of the economy-wide legislation by considering what happens to a single firm but hold EVERYTHING else in the economy unchanged.

            It’s likely that I’m being dense, but I don’t see the significance of your argument here. Yea, I’m looking at one firm, but it only makes sense then to take this analysis and apply it to all the firms affected (each of which have their own elasticities of demand for labor). I don’t see how any macro. phenomena overrules these micro. concerns.

          3. Roman P.

            1) Ah, so the conversation has once again taken a familiar turn. Every time you are presented with a rebuttal towards your ‘optimal allocation’ argument – implying a competitive general equilibrium a la Arrow-Debreu – you immediately shift to the not so strictly defined idea of the disequilibrium market process.
            But you can’t have both. Either the current resource allocation is suboptimal, and can be improved, or it is optimal and we live in the general equilibrium world.
            Concerning the actions of government, so? If my government has policies that implicitly redistribute wealth to the owners of resource rents, does that mean that we should not change them in order to improve the welfare of people in fear of disturbing some ‘market process’? Even by the procedure of plebiscite? I do not care for an argument of such sort. By your logic, doctors should not conduct surgeries since our bodies are such delicate systems.
            There is another way I could reject your argument. The history is a succession of income distributions. In the course of the last ~150 years most countries have adopted legislations that redistributed income in the novel and important ways. We’ve got 40-hour work week, social security, welfare state – the pinnacles of the modern democracy – and the ‘market process’ is still alive and kicking.

            2) We have to divide a discussion of the investment process into the matter of how real goods move (‘production of commodities by the means of commodities’, if you want) and the discussion of how money and financial instruments move.
            On the first part, I will argue that there is little substitution between the consumption goods and the means of production. For it to be otherwise, we’d have to live on the production possibility frontier, and we do not. A fine specialization of production and skills, as well as the general availability of resources, mean that somebody’s decision to build a plant does not mean that you’d have to eat less for the duration of the construction. You could, of course, mention corn, that you could either consume or invest, but now is not the fifteenth century when this question was truly important.
            On the financial side, well, it depends. I might as well subscribe to the Kaleckian theory that investment finances itself, because I don’t think that contradicts the fact that banks create the loans that finance such investments ex nihilio. The loanable funds theory you seem to imply has big holes in it, starting from the actual institutional structure of the FRB.

            3) The problem is that you have to provide macrofoundations for your theories. Macrofound your micro – because microeconomical relationships don’t happen in the vacuum, don’t they?
            What you are doing is an equivalent of doing such a thought experiment: giving every citizen a 100 thousand dollars in cash. One could conclude that the first citizen will spend them according to his MPC, the second will too, and so the result will be the same for everyone: they’d spend some of the money on consumption goods, cetaris paribus.
            This example is obviously absurd and bad since we will immediately note that there are other subjects in the economy other than citizens who all interact with each other. There will be inflation, a rush for this money, financial panics and other macro-phenomena. Yet you do not treat a question of how economy will behave after some economy-wide change (minimal wage law) any better than me in that thought experiment.

          4. JCatalan


            1. I never wrote about an “optimal allocation problem” if what you mean by optimal is an optimal distribution of resources. I only claim that the market process is a better process of resource allocation than alternative forms of coordination, and in fact attempts at alternative forms of (planned) redistribution can disrupt the market process and make the outcome worse than it would have been. You don’t need to think in terms of general equilibrium or optimal allocation to find truth in this description of the market.

            Even if the current allocation can be conceivably improved, this doesn’t imply that any form of attempted improvement will actually improve the allocation.

            By your logic, doctors should not conduct surgeries since our bodies are such delicate systems.

            Or engineers design complex systems? It’s an issue of complexity. The market economy is much more complex than anything humans can design on their own (Hayek, in The Sensory Order, argued that we can only understand things that are just as complex or less complex than our own minds). The argument has always been the same, so there’s never been a “retreat.”

            And, yes, that income redistribution exists doesn’t mean capitalism can’t co-exist. Nobody ever claimed that the this last statement is untrue, so I’m not sure how it’s a rejection of my worldview.

            2.You write,

            We have to divide a discussion of the investment process into the matter of how real goods move…

            No, we really don’t. We’re trying to figure out the impact of the minimum wage on the worker, which is ultimately a microeconomic question. It’s a relationship between the firms and its employees.

            You write,

            A fine specialization of production and skills, as well as the general availability of resources, mean that somebody’s decision to build a plant does not mean that you’d have to eat less for the duration of the construction.

            Yes you do, otherwise you wouldn’t have the resources to complete your project. Production of means of production means sacrificing production of consumers’ goods, which is why an economy needs savings to support investment. Even if a consumers’ goods and a producers’ good are not substitutable, the production of the latter precludes the production of the former — it’s just an application of the concept of scarcity.

            That banks can create net money substitute doesn’t mean that “investment funds itself.” Investment is funded by resources, which are purchased with money substitute. Net creation of money substitute simply draws resources away from other sectors of the economy, which is the foundation of Austrian Business Cycle Theory. But, money creation isn’t the same thing as creating producers’ goods.

            3.You write,

            because microeconomical relationships don’t happen in the vacuum, don’t they?

            There might be a degree of reflexivity, but macro. relationships are puzzles and ultimately the pieces are microeconomic. And no, I’m not assuming that all the pieces are homogenous.

    2. Stadius

      We in Britain had a minimum wage introduced in 1999, and there was the predictable opposition from conservatives and industry arguing that it would deter employment. However, there really wasn’t any noticeable impact in the event, perhaps partly because of inelastic demand for labour, but probably mostly because the rate was set so low that virtually nobody was paid less than the new MW anyway …

      P.S. I’d point out to Roman P that though higher wages are likely to increase wage share, under some common assumptions about underlying technologies and/or the elasticity of demand, the firm could just substitute other factors and/or add a markup, increasing capital share. Just being pedantic there though; I like that I’m not the only Kalecki enthusiast around here!

  2. Silvano

    Up to a certain extent we may try to assess the effect of a decrease of positional & luxury goods vs an increase of the sums spent on normal goods.


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