The Economics Supports the Minimum Wage Movement

By Devika Dutt

Minimum Wage

Walmart has done it again. Despite paying its employees a wage only marginally above the Federal minimum wage of $ 7.25, Walmart continually seeks newer and craftier ways of reducing worker compensation. After requiring employees to purchase clothes that would meet the newly instituted dress code at their own expense, it has now decided to terminate health insurance coverage for about 30,000 part time workers. This gives a renewed legitimacy to the demand of workers, especially in the fast food industry, around the country and the world for a just compensation. One of the major successes of these movements (like Low pay is not okay and Fight for 15) is raising the minimum wage in Seattle to $15 an hour by 2015. In my estimation, in a time when inequality has been emerging as a major policy challenge all over the world, these movements are very welcome. Predictably, the naysayers have emerged out of their mansions, slamming down the drink they were nursing with a sense of urgency. And the usual suspects in terms of the arguments against a hike in minimum wage have been out in full strength. So, I think it would be worth my while to spell out the opposition, and argue why the arguments thus presented are fallacious.

The main reason given against raising the minimum wage is that, while the minimum wage would make the people who have jobs better off, it would discourage businesses from hiring more workers, and would in fact encourage them to fire some workers, thereby reducing the total employment in the economy. The economic rationale behind this is as follows:

When making a decision about how many workers to hire, an entrepreneur tries to ascertain whether it will be worth her while to hire the additional worker. Hiring one more worker would do two things: the new worker would contribute to the production process. However, the additional worker would also have to be paid a certain wage. In general, if the value of the additional workers contribution to output is greater than the amount that the worker will be paid, it makes sense to higher the additional worker. I would stop hiring additional workers at the point where the contribution to output equals the wage that is paid to them. Now, in general, it is argued, as a business hires more and more worker, the contribution of the individual worker to the value of the total output falls. This is called the Law of Diminishing Marginal Product (the jargon for the contribution to production of output made by an additional worker is ‘Marginal Product’). So what we then get is a relationship between wages that are paid to the workers, and the number of people businesses would want to hire: given all other things, as the wages that are paid to the workers rises, I hire fewer workers, since the additional contribution of a worker is higher at a lower number of total workers. Okay, I know that sounds a little loopy, so I’m going to draw a diagram to make that easier.

The Marginal Product of workers fall as more workers are hired. Therefore, as an employer, I would only hire more workers if I could pay them less. On the other hand, as a worker, I would work more as a higher real wage is paid to me. The classical argument says that the imposition of a Minimum Wage would lead to a lower number of workers, N’, being employed, as compared to the number of workers, N, in the absence of a minimum wage.

The story, I’m afraid, isn’t complete yet. Bear with me. Now, as far as people making a decision about participating in the labor market are concerned, if wages are higher, more labor is supplied, and if less wages are being paid, less labor is supplied. So basically, as you can see from the little diagram,  demand and supply for labor interacts in the labor market, so that in equilibrium, the number of people that are employed are N, at a real wage of w/p. Note that the people employed are paid a wage that is equal to their contribution to output.

I’m going to go on a teeny tiny digression to explain what a real wage is. When workers bargain for a wage, they primarily care about how much they can buy with their wages. How much they can buy depends on the amount of wages they get in terms of money, and the prices of the things they are buying. In order to capture this, we complicate matters by defining a real wage: the value of the goods that can be bought with the money wage. We get this by dividing the money wage by the price level. Both workers and entrepreneurs care about the real wage and make their decisions based on it.

We now have all the tools to explain the argument against the minimum wage. Without a minimum wage, the real wage rate and the level of employment is determined by the demand and supply for labor, as was shown in the diagram. If the government now mandates that all employers must pay a minimum wage to their workers, a lower amount of labor would be demanded, while a higher amount will be supplied. Employment would fall from the level that was determined by the market, and while the people employed receive a higher minimum wage, fewer people will be hired.

That being said, this is not the way employment is determined (I borrow from Keynes’ General Theory in explaining this).  A small indication of this fact is that we cannot really speak of a supply curve of labor with supply related to real wage in the same way we can speak of labor demand. The supply curve as drawn would mean that as the real wage moves higher, more labor is supplied, and if the real wage falls, less labor is supplied. However, while I may be able to say that with certainty as far as the money wage is concerned, I cannot say the same for the real wage. This is because if it were the case, every fall in the real wage should bring about a contraction of the labor supply, even if the fall of the real wage is coming from a rise in the price level. We do not typically find a contraction in the supply of labor with movements in price level (unless it proceeds to an extreme degree). So then, how else is employment determined?

Yes, that is the real question. Now, the thing that a business owner is concerned with, first and foremost, is her profit. Given the technique of production, and the wage rate, the amount of employment that a business decides to create depends on the amount of proceeds that the entrepreneur can expect to receive from the corresponding output. These proceeds depend crucially on whether what they produce will be demanded. And the demand of this commodity, and analogously, demand in the economy as a whole, will depend on the level of consumption and investment in the economy. The demand determines how much the entrepreneurs should produce, which in turn determines how many workers should be employed in the economy as a whole.

While raising the minimum wage certainly affects the costs that an entrepreneur has to incur, there isn’t a unique relationship between the minimum wage and the level of employment. Therefore, it does not lead to a significant loss of jobs as Classical Theory predicts. If the level of demand were higher, more output would be produced and more people would be employed despite the higher minimum wage. Conversely, if the level of demand were lower, employment cannot be increased by lowering the minimum wage. Moreover, raising the minimum wage will increase demand, especially for things such as fast food. Keep in mind that I’m making this argument while continuing to assume that workers are paid their marginal product. If this is not the case, that is another reason to ensure that workers are at least paid a basic minimum wage.

To conclude, I think raising the minimum wage would be a splendid idea. It is important to empower workers in the economy to earn at least as much as is necessary to live at a reasonable basic minimum standard of living. Not only will this empower more people to not be dependent on various kinds of state support, it can go a long way in reducing poverty and inequality. As far as the minimum wage hike in Seattle is concerned, here’s an article to put things in better perspective. And anyone interested in this question should most certainly watch this video. Bob Pollin makes a great case for a higher minimum wage. More convincing yet is the data which shows that hiking the minimum wage does not adversely affect employment. A list of studies that shows this can be found here.

One comment

  • “… the minimum wage would make the people who have jobs better off …” This is a wrong assumption. All other things being equal, a few would be sacked that were not paid at the new, higher, rate, because their productivity was not worth as much. Even with incumbents, a minimum wage tends to reduce the workforce. Why, if you were renting out cars and car prices would rise, but renting prices or demand would not, you woul eventually have to reduce your fleet. As for “higher wages will increase the supply of workers” this is erroneous too. Do you think some people just sit on their hands waiting for wages to rise? And only if they rose would they apply? Not in this universe.