MINIMUM WAGE CHAPTER OBJECTIVES CHAPTER OUTLINE CHAPTER OBJECTIVES. When you come to the end of this

Transcription

1 MINIMUM WAGE CHAPTER OBJECTIVES When you come to the end of this chapter you will understand what a labor market is, what a minimum wage is, why it has come about, how it alters the outcome of a labor market, and why the minimum wage must be higher than the equilibrium wage in order to be relevant. In addition, you will understand the consumer and producer surplus argument as a means for seeing why most economists believe the minimum wage increases unemployment. You will be able to use the argument to help CHAPTER OUTLINE CHAPTER OBJECTIVES INTRODUCTION TRADITIONAL ECONOMIC ANALYSIS OF A MINIMUM WAGE Labor Markets and Consumer and Producer Surplus A Relevant vs Irrelevant Minimum Wage What is Wrong With a Minimum Wage Real World Implications of the Minimum Wage Alternatives to the Minimum Wage REBUTTALS TO THE TRADITIONAL ANALYSIS The Macroeconomics Argument The Work Effort Argument The Elasticity Argument WHERE ARE ECONOMISTS NOW? CHAPTER SUMMARY identify real world winners and losers of a minimum wage increase. You will also understand that some economists have taken a new look at the whole issue and disagree with the conclusion that an increase in the minimum wage results in lower employment. You will understand that there is an alternative to a minimum wage that focuses more money on the working poor. Lastly, you should understand that the issue of the minimum wage has been one where there was much consensus among economists and one where that consensus has recently been called into question. 671

2 INTRODUCTION Although there are restrictions set by the government for who must be paid a minimum Minimum Wage: the lowest wage that may legally be paid for an hour s work wage, the minimum wage is the lowest wage that may legally be paid for an hour s work. In 1938 the first minimum wage was set at 25 cents per hour, and the amount has been increased periodically over the years. In January of 2001 it stood at $5.15 per hour. The minimum wage has traditionally been justified as a mechanism to insure a living wage. Living Wage: a wage sufficient to keep a family out of poverty That is, a wage sufficient to keep a family out of poverty. As you can see in Figure 1, the minimum wage was always sufficient to keep an individual above the poverty line. 47 It has been less successful for families. Since 1985 the minimum wage has been insufficient to maintain a one-earner, minimum wage family (constituting more than an individual) above the poverty line. For instance, in order to accomplish the feat of keeping a family of four above the poverty line, the minimum wage for a single full-time earner would have to be more than $8.50 an hour. 47 The poverty line used here is the official poverty line with which there are many problems. Refer to the chapter on Poverty and Welfare to understand this issue. 672

3 F-T Min W/Poverty Line Full-Time Minimum Wage/Poverty Line by family size Year One Two Three Four Figure 4 The Ratio of the Earnings of a Full-Time Minimum Wage Worker to the Poverty Line for Various Family Sizes. Sources: Figure 2 indicates that, although the minimum wage itself has been increased several times over the last sixty years, its real value, that is, the value adjusted for inflation in 1999 dollars, has not fluctuated that much. Since 1950, the lowest it has been in inflation adjusted dollars is $4.47 per hour, the amount in 1989, while the highest level it reached was $7.58 per hour in As stated in Chapter 7 as well as in the Chapter on the Overstatement of the CPI, this measure of inflation over-corrects for inflation. 673

4 8 Nominal and Real Minimum Wage Wage Year Nominal Real Figure 5 The Nominal and Real Minimum wage (1999 dollars) from passage to the present. The minimum wage increased 18 times from 1938 to Its inflation adjusted value peaked in Source: Over time, economists have tended to argue against the minimum wage. We will explain those arguments along with the reasons why, until recently, most economists thought raising the minimum wage to be wrong-headed. We will also look at the arguments that suggest it may have been economists who were wrong-headed. TRADITIONAL ECONOMIC ANALYSIS OF A MINIMUM WAGE Labor Markets and Consumer and Producer Surplus Most economists have had few good things to say about the idea of establishing a minimum wage, and they have based that opinion on a traditional supply and demand analysis of the issue. It is here where we will start. In Figure 3, below, you have a market for low-skill minimum wage labor. The good being sold in this market is labor, and the price at which it is sold is the wage. The supply is made up of workers who will want to work more at higher pay, implying an upward sloping supply curve; demand is made up of bosses seeking to hire that labor. The employers are assumed to want fewer laborers at higher wages, implying a downward sloping demand curve. Without a law that sets its actual 674

5 dollar amount, the wage would be set in this market at the point where the supply and demand curves meet. At this point there would be no shortage and no surplus. The wage would be W* and there would be L* work. Being a market clearing equilibrium, this is a wage at which no one who wants a job at that wage is without one, and no employers who want workers at that wage cannot get them. In this situation workers would be paid a total of OW*CL* dollars. When we addressed the notion of consumer and producer surplus in Chapter 3, we stated that the consumer surplus is the area under the demand curve but above the price line, while the producer surplus is the area under the price line and above the supply curve. Of course, in this case the price is the wage. The key difference here is that businesses are getting the consumer surplus, W*AC, because it is they that are buying the good, or hiring the labor. We interpret consumer surplus here as the money that businesses make from the work of their employees that exceeds the amount they have to pay workers. The producer surplus, BW*C, is also different in that it is what workers get, since it is they that are doing the selling. The interpretation here is that it represents the amount of money that workers get in excess of what they would have worked for. So, just as in any other market, the consumer gets something and the producer gets something. 675

6 Figure 6 Labor Market Without any restrictions on the wage, the market will generate a wage of W*. The consumer surplus, the profit gained from the employment of workers, is W*AC. The producer surplus is BW*C. A Relevant vs An Irrelevant Minimum Wage If a minimum wage is set below W*, would businesses pay the minimum wage rather than the higher W*? Surprisingly, the answer is no they would not. The reason is that, in order to get workers in the numbers that are most profitable to the business, employers have to pay the higher W*. They will rather pay more than the minimum because, even though their labor costs then rise at a higher wage, the output of the extra workers will generate enough additional revenue to pay workers and to produce an increased profit as well. In addition, it is in their best interests to pay W*, because otherwise their competitors will outbid them for labor. Thus, any minimum wage set below W* is irrelevant, because firms make more profit offering W*, rather than a lesser amount. If you have not been convinced by the preceding that setting a minimum wage may be irrelevant, consider what would happen if your professors told you that you would fail if you showed up to class naked. Unless you had planned to do this anyway, an unlikely event since you would be kicked 676

7 out of school, the rule would not affect your behavior in the least. Any rule that tells you that you cannot do something that you had no intention doing anyway is not much of a rule. It does not alter your behavior, and it is therefore irrelevant. In order for the minimum wage to be relevant, it has to be an amount that is set above the equilibrium wage. What is Wrong With a Minimum Wage? As shown in Figure 4 a minimum wage that has been set above the equilibrium wage has several effects. First, it raises the wage from W* to W min. Second, it reduces the amount of labor sold from L* to L min. Third, as long as the money gained from raising the wage to workers, W*W min EG, is greater than the money lost as a result of having fewer people working, L min GCL s, workers in general have more money than they had before. From your earlier study of the concept of elasticity, you will recognize the condition for this is that the demand for labor has to be elastic. Lastly, the imposition of a minimum wage will raise the unemployment rate for workers in this market. This will happen either because more workers will want to work or existing workers will want to work more hours. With a minimum wage set above the equilibrium wage, workers want to provide L s labor, whereas they used to want to work only L*. Further complicating this is that employers now only want to hire labor up to L min rather than the L* they had wanted previously. 677

8 Figure 7 Minimum Wage With a minimum wage above equilibrium the wage will be W min. The consumer surplus shrinks to W min AE. The producer surplus grows to Bw min EF. The dead weight loss is FEC. In the end, the consumer surplus shrinks to W min AE, producer surplus grows (as long as L min GCL* is less than W*W min EG) to BW min EL min. The sum of the consumer and producer surpluses is less than it was without the minimum wage, by the triangle FEC. What this all leads to is that under this economic analysis of the minimum wage, there are winners and losers. The winners are those workers who get a wage increase and who are still able to continue working as much as they want. The losers are men and women who used to be working and who are now unemployed (L*-L min ). The important part of this analysis is that what is gained by workers (the area W*W min EG minus the area L min GCL*) is less than the area that employers lose (the area W*W min EC). We are thus confronted with what economists label dead weight loss, the net loss to society by the area FEC. Real World Implications of the Minimum Wage Though rather elegant as a mechanism to analyze the impacts of a minimum wage, consumer 678

9 and producer surplus analysis does not put it in terms easy for the average person to see. The winners are the more than four million people who work for the minimum wage and get a pay increase because they keep their jobs. The losers are the people who lose their jobs. Research on the subject has led economists to use the rule-of-thumb that a ten percent increase in the minimum wage results in a one to three percent drop in the number of jobs held by teens. That translates to a loss of 90,000 to 268,000 jobs lost by teens as a result of the increase in the minimum wage from $4.25 to $5.15 an hour. Economists who study those unlucky teens find that they are disproportionately black, Hispanic and uneducated. That is, they are among the very people that an increase is trying to help. This point must not be missed. An increase in the minimum wage may very well hurt the poor more than it helps them. Other losers include small business owners who have to pay the higher wage with perhaps a very small profit margin to do so. Small independent restauranteurs are especially hard hit because the industry is such that many such new entrepreneurs constantly teeter on the edge of bankruptcy and can only afford to pay minimum wage. That means that an increase in the minimum wage may not only destroy the jobs these entrepreneurs are creating, but destroy the entrepreneurs themselves. Lastly, the losers include anyone who buys goods or services produced by minimum wage workers, because part of the increase is passed on to them in the form of higher prices. Alternatives to the Minimum Wage It is for all of these reasons and more that until recently most economists could not endorse increases in the minimum wage. Those who took the position that the minimum wage was an inappropriate cure to the problems of poorly paid workers highlighted the fact that most workers who 679

10 made the minimum wage were under 24. Nearly a third of these were under 19 and therefore very unlikely to be supporting a family. Combine that with the fact that many of those who earn the minimum wage and are over age 24 are spouses who work only to supplement the income of the family s primary income producer and are nowhere near poverty. In the eyes of many economists a better alternative is the Earned Income Tax Credit (EITC). Low-income working families with children are eligible for up to $3,888 that arrives in the form of a tax refund. The benefits of the EITC are concentrated on the people who actually need the money to feed their families. More than seventy percent of the money goes to households who are or who would otherwise be in poverty. This contrasts dramatically with the minimum wage where upwards of seventy percent of the benefits accrue to households not in poverty. The EITC, while born in the 1970's, saw great increases starting during the administration of President Ronald Reagan. It was during this administration that the minimum wage saw a long period of real decline in its value. It was President Reagan s view that the minimum wage was a poor mechanism to help the poor and that the EITC could help working poor families without hurting businesses. While President Clinton s first budget increased taxes for many, it also greatly increased the EITC. Moreover, though he pushed through an increase in the minimum wage as well, the increased level of the EITC has had a greater effect on the working poor. REBUTTALS TO THE TRADITIONAL ANALYSIS In contrast to the preceding, there are a few important points of rebuttal to the traditional analysis that have gained some respectability in recent years among economists. They center on three main lines of argument. Macroeconomic analysis suggests first, that the effect of a decrease in income 680

11 by owners of businesses is more than offset by the effect of an increase in income by the lower income people. Low income people spend more and high income people save more. A second line of argument is that the good in question, labor, is not as definable as most other goods and that with better pay, workers can be induced to work harder. If they do so, the increase in the wage becomes less of a burden on employers. The remaining argument is that the elasticity of demand for labor may be so low that the traditional analysis needs to reflect this fact. If it does, the negative aspects of the minimum wage will be small. The Macroeconomics Argument The first argument in rebuttal to the traditional analysis relies on an aspect of macroeconomics that suggests that if you track all of the times a particular amount of money is spent, you can figure up the total impact of new spending. Or, as is appropriate in this case, you can examine the net effect of money s being spent by different people. If, for instance, business owners save most of their profit rather than spend or invest it, then something less than the entire profit of the business works its way through the economy in the form of additional spending. On the other hand, if the business owners have to relinquish more of that profit to workers because of the imposition of a higher minimum wage, then almost all of that money will be spent. Men and women who are paid the minimum wage save very little, and they spend nearly all of their additional income. Because money is spent rather than saved and total consumption in the economy rises. From a macroeconomic standpoint, any negative effects of a minimum wage increase range from being offset, to being nonexistent, to being positive. Suppose, for example, that the result of an increase in the minimum wage is to increase the incomes for workers by $75 while creating a $100 loss in profit to businesses. Remember that it is not 681

12 simply a direct transfer; workers gains are offset by losses to business that are greater. The $25 difference, the dead weight loss, is the amount of damage to an overall measure of economic activity like the Gross Domestic Product. This gap can be made up if the effect of low-skill workers spending it is greater than the effect of bosses spending it. If low-skill workers spend all of their increased income, and bosses spend or invest only 80% of theirs, the net effect of raising the minimum wage is that the GDP shrinks by $5 rather than $25. This is because 80% of $100 is only five dollars more than 100% of $75. This is, of course, predicated on the assumption that a higher minimum wage has the net effect of increasing the income of minimum wage workers. The Work Effort Argument The second argument is probably correct in assuming that people adjust how hard they work depending on how happy they are with their employer. This means that the graphs in Figures 3 and 4 are not as stable as we have previously thought them to be. The good labor is not as fixed in its meaning as are most other goods for which we use this supply and demand model. People can work hard or slack off, and there is not a great deal that an employer can do to force slackers to work harder. If higher pay translates into workers who are happier and who do more work per hour, it may be the case that some if not all of the impact of forcing wages to rise will be mitigated. In this way the minimum wage increase may pay for itself. On the other hand, if it did pay for itself, we would have to assume that employers were either ignorant of this fact or not maximizers of profit. Neither of these assumptions sits well with most economists. It is more plausible that such an increase merely lessens the negative impact. The Elasticity Argument 682

13 The last argument used to rebut traditional analysis simply tweaks the traditional analysis a little to suggest that the negative impact of an increase in the minimum wage is very small. Any increase can thus be interpreted as simply a transfer of money from business owners to workers. If you look at Figure 5 and compare it to Figure 4 you will find that the only real difference is that the demand curve is steeper, that is more inelastic, in Figure 5. The net amount that workers gain (the area W*W min EG- L min GCL s ) is very great, and the resulting unemployment of those that had jobs before, L*-L min, is very low. As we said when we discussed elasticity in Chapter 3, there are two things that will influence elasticity: the number of close substitutes and time to invent them. Figure 8 The minimum wage in the short run With an inelastic demand for labor, both the dead weight loss and the unemployment associated with the minimum wage are small. Given that in the short run there are very few substitutes for having workers on the job, this rebuttal seems, of the three mentioned, the most persuasive to traditional economists. Most economists still believe that the existence of a minimum wage will reduce employment in the long run. They maintain that the only reason the gain to workers is great and the net loss to society is small is that this is an 683

14 analysis that only works in the short run. They argue that in the long run business owners will search until they find substitutes for labor such as easier to use machines and self-serve devices. If you look at the fast-food industry and the equipment that it uses, you will find that the companies involved are always looking for new ways to reduce the need for employees, and they have had great success in their endeavors. Putting the drink machines in the lobby and using chain ovens or broilers that cook the food for exactly the correct amount of time without needing employee monitoring are just a couple of examples of how employers of minimum wage workers have substituted capital for labor. Where are Economists Now? If the more recent, non-traditional analysis is correct, it is probably because in the short-run there is not much dead weight loss to be made up. The combined impact of the macroeconomic effect and the harder worker effect is therefore enough to completely eliminate the problem. The data on whether recent minimum wage increases have had a net negative impact on unemployment for the 1990 and 1996 increases is mixed. Two influential economists, David Card and Andrew Krueger, published a study of the minimum wage utilizing data on fast-food employment. They surveyed establishments in two neighboring states in a period where one increased its minimum wage and another did not. They found that the increase did not negatively impact, and perhaps positively impacted employment in the state that raised its minimum wage. Since this study ran against the conventional wisdom of labor economists, many were quick to try to duplicate their results. The attempts to replicate the work of Card and Krueger turned up serious data and methodology problems with their work. As a result of the newer work casting doubt on the 684

15 Card and Krueger conclusion, most labor economists have not moved much from their earlier assessment. In particular, many still use the teen employment rule-of-thumb mentioned above but concede that a ten percent increase in the minimum wage translates to a one-or-two percent decrease in teen employment. In any event, economists have expended considerable time rethinking an issue that they thought they had put to bed a long time ago. CHAPTER SUMMARY In this chapter we have explored the minimum wage. We began by discussing why it exists in the first place and what its implications are for our supply and demand model for labor. We used our consumer and producer surplus techniques to identify the winners and losers of any minimum wage increase and then put real world observations with our abstract model. We explored the diversity of opinion among economists on the subject and explored the Earned Income Tax Credit as an alternative to it. Minimum Wage Living Wage KEY TERMS 685

16 Quiz Yourself The majority of minimum wage workers are a) trying to support a family b) young people who are not supporting families c) older workers who are retired. d) none of the above The longest period of time where the minimum wage remained constant in nominal terms was during a) the Reagan Administration. b) the Bush (George Herbert Walker) Administration. c) the Clinton Administration. d) the Eisenhower Administration. If the minimum wage is set below the equilibrium, the effect of the law will be a) a higher wage. b) more money going to workers. c) less profit to businesses. d) a dead weight loss. e) a) through d) f) nothing If the minimum wage is set above the equilibrium, the effect of the law will be a) a higher wage. b) more money going to workers. c) less profit to businesses. d) a dead weight loss. e) a) through d) f) nothing The more elastic the demand for labor is, a) the more unemployment will result from a minimum wage. b) the more dead weight loss will be. c) the more the minimum wage will increase worker s pay. d) a) and b) e) a), b) and c) If you view a dollar s worth of consumer surplus (going to bosses) equal to a dollar s worth of producer surplus (going to workers) then the minimum wage a) usually increases consumer surplus and decreases producer surplus and the net is positive. b) usually increases consumer surplus and decreases producer surplus and the net is negative. c) usually decreases consumer surplus and increases producer surplus and the net is positive. 686

17 d) usually decreases consumer surplus and increases producer surplus and the net is negative. Draw a supply and demand diagram with inelastic supply and elastic demand for labor. What is the effect if a minimum wage is set in that circumstance? Label the consumer and producer surplus and the dead weight loss of the minimum wage. Think About This Should there be a minimum wage that is different in different parts of the country since it costs more to live in New York City than it does to live in Medford, Wisconsin? What would the effect of that be? Talk About This Should the minimum wage be indexed to the CPI so that it increases every year for inflation? For More Insight See Brown, Charles, Curtis Gilroy and Andrew Kohen The Effect of the Minimum Wage on Employment and Unemployment Journal of Economic Literature June 1982 Brown, Charles Minimum Wages Laws: Are they Overrated? Journal of Economic Perspectives Summer 1988 Card, David and Alan Krueger Myth and Measurement: The New Economics of the Minimum Wage Princeton NJ Princeton University Press