Assessing the Minimum Wage

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Issues surrounding poverty and inequality tend to be the most polemic of any social or economic issues. However, the almost universal relevance of these issues for economic actors requires that they receive as much calm and rational discussion as possible. To this end, I embark upon an examination of one of the more obvious attempts to solve the problem of poverty: the minimum wage. I will argue in this paper that the minimum wage not only cannot do what it is intended to do, i.e., alleviate poverty, but that it actually exacerbates poverty in various ways.

There are effectively two aspects of any economic policy decision: the practical and the ethical. Before any ethical discussion may be undertaken however, it must be shown that the practical arguments regarding implementation are sound, that is, it must be first shown that the policy can actually achieve its intended results. Second, it must be demonstrated that any unintended results are negligible when compared to the intended ones. Without sufficient demonstration that the above two conditions are satisfactorily met by any policy, ethical argumentation is not particularly meaningful, and with this in mind, this paper will focus primarily upon practical considerations. The minimum wage is designed to help those most likely to be affected by poverty, namely, young workers (especially minorities), the unskilled, and the uneducated. It is therefore sensible to evaluate the effects of the minimum wage upon these groups.

We must begin with some general observations regarding the nature of wages in a market economy. The first principle to note is the tendency for wages to equal Marginal Revenue of Product (MRP), or in other words, the individual workers' wage tends to equal his or her productivity. We can deduce this logically if we consider the other two possibilities: either that wages paid are greater than MRP, or also that wages paid are less than MRP. To take the first possibility: if a worker earns more than he or she produces, the employer loses money and thus cannot continue to employ the worker. The second possibility, that the worker makes less than his or her productivity, is also prevented by the market process. In this case, the market bids up the wage rate until W=MRP. It can do this in two ways which are really two different sides of the same economic coin. First, the employee can search for other employment at a higher wage rate, but second, employers can also search for labor in an attempt to both maximize its own productivity and keep highly productive labor away from the competition. With this is mind it becomes clear that even geographic immobility on the part of the prospective employee is not necessarily a hindrance when evaluating employment opportunities.

It should be noted that the above tendency only holds with any certainty in the long run, because the above process cannot take place instantaneously, but only over time. There is a necessary period wherein productivity and wage rates must be measured and then evaluated by employer and employee both. However, we must also note that although the tendency only emerges with any certainty in the long-run, this does not necessarily mean that it cannot exist in the short run as well. Short-run emergence of the principle is certainly possible, especially in industries in which the amount and quality of labor is relatively uniform, and it is worth observing that many unskilled jobs fall into this category. Outside of this limited observation however, we cannot make any meaningful predictions about whether or not the above principle will hold true in the short run.

In order to be effective, a minimum wage must necessarily artificially hold wages higher than they would otherwise be on the free market (that is, hold wages higher than MRP). If a minimum wage is introduced then, employment must fall, because otherwise employers incur (essentially hourly) losses. Professor Walter Block sums up this problem by stating:

If the law requires that a low-skilled person be paid, say, $4 per hour, and his productivity is only $3 per hour, all the firm need do is take on several highly skilled employees (and some sophisticated machinery) instead, and avoid like the plague the unskilled workers it would have otherwise hired.

So by requiring minimum wage rates which are over the level of productivity of the employees, minimum wage legislation causes unemployment. The above quote hints at another aspect of the minimum wage problem, discrimination, which will be discussed further below. First, however, we must recognize that an employers' profitability – and thus, his ability to employ – depends upon his ability to pay workers wages equal to their productivity. Without this ability, the employer does not merely reap lower profits, he necessarily incurs losses.

Regardless of our sympathies for young, unskilled, and uneducated workers, it almost absurd to argue that unemployment is better than employment at a low wage rate. This is especially true when employees wish to work at a certain wage rate and find themselves unemployable due to the minimum wage.

It is simple to demonstrate the validity of this principle if we look at an exaggerated example: suppose that the minimum wage was 25 or even 100 dollars per hour, how then would employment be effected? The answer is obvious: employment would cease as we know it, because very few employers would be able to afford such wages. It is vital to understand that the same principle applies to low-wage earners as well, and that the above argument is not merely empty or abstract reasoning. Empirically, we see the principle illustrated in numerous cases. Especially, we may observe a close correlation between rises in the minimum wage rate and higher unemployment among younger workers, minorities, and the unskilled labor force.

Another major problem with the minimum wage, from the standpoint of the economically disadvantaged, is that it creates disincentives for employers to hire unskilled or inexperienced workers. If an employer must hire a worker at a wage which is higher than the potential productivity of the job in question, he has an incentive to hire the most-qualified worker he can find, as opposed to a worker who could merely have been productive at a lower wage rate.

For instance, let us imagine an employer who must hire an additional employee at the minimum wage level of $7/hour, as opposed to the $5/hour the employer would otherwise pay. The employer faces two negative incentives. The first involves hiring practices. In any such scenario, the incentive is to always discriminate against those who are less qualified to hold the job – that is, those who are uneducated or have limited work experience who, absent the minimum wage, could perform the required job adequately at a lower wage rate. If, for example, an employer has a choice between a college undergraduate seeking student employment and an uneducated manual laborer, his incentive – when the minimum wage is in effect – is always to hire the undergraduate, because he will tend to have more potential for overly-productive work than the laborer.

However, this incentive does not exist in an economy where wages rates are adjusted through the interaction of the supply and demand for labor. In such a case, the employer only requires an employee who can do the required amount of work at the desired wage, because he has no wage-productivity gap to fill. The minimum wage, like all attempts to alleviate poverty, is aimed, not at the educated or those who compete for middle- or upper-class jobs, but at the relatively uneducated and those who cannot compete for better-paying jobs. And yet, we see in the above an incentive to discriminate against the uneducated and less-qualified in favor of the less-needy and more qualified, an incentive which clearly runs counter to the intended goals of the minimum wage.

Another negative incentive which employers face is to work all employees harder than normally required, in order to raise productivity as much as possible to offset the loss taken from wages. In other words, any business has a minimum amount of work which must be done, and thus cannot lose staff beyond the number required to perform this minimum (although, as noted above, an employer can merely higher fewer, yet more productive, workers). If he wishes to stay in business, an employer will have to keep a certain amount of staff, although at wage rates which he knows are too high. An employer must then search for other methods of deferring the additional cost of paying workers wages higher than their productivity. One obvious way to do this is to demand an increase in productivity from all employees, beyond what is expected of them under conditions of free wages. This could take the form of demanding more labor per hour, or perhaps requiring a higher degree of quality in the labor performed from the employee.

Since it is often claimed that there are ethical reasons for desiring a minimum wage, it is relevant to mention one argument advanced against this view. Murray Rothbard pointed out that absent minimum wage laws, employer and employee may choose to contract with each other at an agreed-upon price. However, with the minimum wage in effect, both parties are coerced into abstaining from a mutually agreeable arrangement which would otherwise have taken place. The law requires that no contract be made below the required minimum. Thus, even if a worker wishes – or desperately needs – to work, he or she is prohibited from doing so.

Through the previous arguments, we have seen that all parties incur costs when confronted by the minimum wage. Those who the minimum wage is designed to help are priced out of the labor market, and thus slide further into poverty. The economically disadvantaged also face the problem of discrimination when compared to relatively more-skilled workers, thus further decreasing their likelihood of finding employment. Next, the employee who does secure a job must work harder than otherwise necessary in order to keep it, and also to keep his employer's business profitable. Finally, employers are put at a disadvantage through having to pay higher wages and thus reap lower profits, which in turn makes business success more difficult, and thus endangers the jobs of the employees.

There is not a single discernable group that benefits from minimum wage legislation. It is quite simply the case that the minimum wage law cannot achieve its intended goal, because it prevents those who need extra income from working at all. It should be clear for anyone who wishes to arrest the growth of poverty that the first sensible course of action which must be taken is the immediate repeal of the minimum wage laws.

April 29, 2008