Monday, November 9, 2015

How a Higher Minimum Wage Actually Hurts Poor People

Recently, we have seen renewed calls for an increase in the minimum wage. For instance, Senator and presidential candidate Bernie Sanders, recently introduced a bill in the Senate to raise the national minimum wage to $15 per hour, to what he called a living wage. And along with Bernie's candidacy more generally, this policy has been gaining traction. On its face, this seems like a good idea. After all, I have had a minimum wage job before, and it's difficult to imagine living independently off such an income, let alone supporting a family. The reasoning follows that increasing the minimum wage would obviously help people in this situation and should thus be supported. But economics and common sense tell us that this assumed positive effect is not the only one. In this article, I aim to show that the overall consequences of the minimum wage will likely exacerbate the very problems it seeks to address.

Before we get started, I should note that most opponents of the minimum wage are viewed as greedy capitalists or disconnected elites that just don't care about the suffering of the poor. And unfortunately, these stereotypes are not entirely unwarranted. For example, many critics like to point out that the American poor just aren't that poor anymore. And in a way, this is true. Poor people in America today have a much higher standard of living than they would have had 30 years ago. That's a good thing, and we should celebrate it. But it doesn't therefore excuse us from acknowledging or caring about the suffering that still does exist--and that's where these commentators go astray. At its most ridiculous pitch, I recently heard Bill O'Reilly challenge a guest to find a single person in New York City that was going hungry for lack of resources. This was not sarcasm. He genuinely believed that it would be impossible to find that level of destitution in the largest city in America. That's absurd, and it gives credence to the idea that opponents of the minimum wage, etc. should just be roundly dismissed as greedy jerks.

I raise this point to stress that I am not approaching this from that perspective. I think most supporters of a higher minimum wage are motivated by a desire to alleviate suffering for those that are less fortunate, and I agree that this is a worthy cause. I just do not believe the minimum wage is a good way to achieve it. This isn't a question of priorities; it's a question of effectiveness.

Having established common cause, let us proceed to consider the effects of a minimum wage increase. Here we'll be looking primarily at the textbook microeconomics framework for understanding this question, and we will assume that our audience does not have much of a background in economics to start with.

We begin by considering a hypothetical fast-food restaurant--Bill's Tofu Shack. Naturally, Bill is the owner of this restaurant, and he makes the personnel decisions. Like most businessmen, Bill decides how many people he was going to hire based on how much work there was, and how much he needed to pay them. Assuming the amount of work stayed the same, Bill would be willing to hire fewer people at higher wages and more people at lower wages. Thus, we could graph a functional relationship between the price of wages and the number of humans Bill wants to hire. We'd call it Bill's demand for labor, or demand curve, in economist speak. (We call straight-lines curves too--don't stress about it.) And it might look something like this.

So we see here that at lower wages, Bill is willing to hire lots of people and it goes down as the hypothetical wage rises. We notice that it goes vertical at 5 employees--this is because Bill has determined this is the bare minimum he can operate with, so he can't cut beyond that. But if the wage goes too much higher than that, Bill's decided he's going to close down his restaurant and open a one-man food cart instead. The reason for this is that he knows he'd have to raise prices too much to accommodate a certain wage, and he thinks his customers wouldn't tolerate it. But at the food cart, he wouldn't have to worry about paying himself a wage, so he'd be in the clear to set prices much lower.

You might also be asking why the discrepancy between the minimum and maximum number of people he'd want to hire is so big. There are two major reasons that could help explain this. First, if labor was really cheap, Bill might experiment with offering more of a full-service set up for his restaurant (bring the meals out, bus tables, refill drinks, etc.). Meanwhile, if the wage is higher, he might prefer a more bare-bones operation. The second and more important reason is that the cost of labor determines the value of efficient technologies. For instance, if labor is really cheap, Bill might be willing to just have 4 people manually doing dishes. If the cost of labor is high though, investing in a time-saving dishwasher might make sense. Perhaps 1 person with a fancy dishwasher, could replace the work of the 4 manual dishwashers. As the wage goes up, investments like this become more economical.

I realize the above (as well as this general exercise) may seem very abstract, but we really do see this technology replacement phenomenon in the real world. For instance, in developing countries, you will still see people manually picking through waste dumps to pick out recycling; it's how some people make a sparse living there. By contrast, that same function in a developed country like the US is carried out on an industrial scale by a massive sorting apparatus, with relatively few humans to help out with the process. Of course, there are a lot of factors at play here, but the point is that when wages are low, companies can generally find ways to use more manual labor to achieve the same thing that could be performed by a more automated process.

Alright, back to Bill's restaurant. For the sake of our example, let's assume there's no minimum wage that applies to Bill restaurant. What would the going wage rate in the market be in that case? To answer this, we have to determine the supply of labor.

In the neighborhood near Bill's restaurant, certain people would be willing to work at virtually any wage (say, high school students just wanting some spending money) while others would only be willing to work at a higher wage. Others might be already employed at a higher rate than anything Bill could offer and thus be unwilling to work there altogether. When we accumulate the preferences of everyone possibly interested in fast-food job at the Tofu Shack, we could graph the supply of labor (or supply curve) to look something like this--again, more people interested in the job at a higher wage.

Where the two curves meet, economists say that's where the market would be in equilibrium. In our example, market forces will set the wage at $9 per hour and 10 employees. Because at $9, 10 people are willing to work and Bill wants to hire 10 people. (Obviously, I don't know what the "market" wage would be in the real world since there really are minimum wages in effect. But that's how we're making the numbers work out for this example.)

We're about ready to introduce a minimum wage here. But before we do, note that there are really just two key principles that are driving our understanding. Namely,

  • Businesses want to hire fewer people as the required wage rate goes up, and vice versa.
  • More people are willing to work as wages go up, and vice versa.
As long as you're on board with those two ideas, the next part should be intuitive.

Results of a Minimum Wage Increase

Next, Bernie wins the Presidency and implements a $15 minimum wage. Since we're assuming nothing else has happened to Bill or the people in his neighborhood (aside from Feeling the Bern, of course), we'll just add this minimum wage to the chart and leave everything else alone.

Now, we see that at this new higher rate, a lot more people are interested in working (16 on the orange line on the chart), but unfortunately, Bill only wants 7 employees now. Assuming he's able to cut the workforce back to 7, the new unemployment figure (in terms of heads) would be 16 - 7 = 9 (the yellow bit). This is part of what economists mean when they say that the minimum wage increases unemployment--it does so both because it would increase the number of people looking for work and reduce the likely number of jobs available. That said, we might not care too much about those 6 extra people who decided just now that they wanted to work at the $15 wage, when they were too good for the $9 wage. But based on how the statistics work, those 6 people would be included in what we typically call unemployment.

The nuances of unemployment statistics aren't that important though. What we really care about is what happened to the people that were already working. Does the minimum wage improve their lives? In our example, the answer is... it depends. Again, let's assume Bill is able to lay off 3 people to get down to 7. (We'll come back to justify this later.) Now, 7 people would be working at $15 an hour for a total of $105 an hour in aggregate, whereas before 10 people were getting paid $9 an hour for an aggregate of $90 an hour. In this way, the total money being paid to the workers has increased. Of course, that's only how it worked out in our example because we designed it that way--whether the aggregate impact would be positive or negative in real life depends on how sensitive the business owners are to wage increases and the amount of the wage increase. When you hear economists suggest that the impact of a minimum wage increase depends on the "elasticity of demand", this is what they're talking about--how sensitive the employers are to wage increases. The result we saw above of a net increase in wages paid out is what some economists mean when they say that increasing the minimum wage would be beneficial.

Having said that, I would like to suggest that this kind of standard analysis totally misses the point. So what if the aggregate amount paid out by the employer went up? If you're one of the 3 people that lost their jobs, I think you would say that the minimum wage was decidedly unhelpful. Indeed, it essentially becomes a kind of income redistribution program from one set of poor people (those who lose their jobs) to another set of poor people (those who kept their jobs). And so, what this means in practical terms is that you would take people who are probably hanging on to the lowest rungs of the economic ladder and step on their fingers till they get let go. Already desperate people will get more desperate. If you care about alleviating suffering and reducing poverty, it's hard to see how this is a good outcome. Indeed, it seems to me that this actually makes things worse--regardless of whether the net wages of "the workers" went up.

Would businesses really lay people off?

Now, let's return to the question of whether the business would really lay people off in response to the minimum wage. Obviously, there's no way to know this for sure. They've probably adapted to running their business at a certain staffing level, so it's unlikely that people would be fired immediately. In the very short-term, businesses would probably try to adapt by raising prices on their customers as much as possible. Then in the long-run, they might develop a plan to run their business with fewer people / more advanced technology, etc. We can't know exactly what this would look like. But our basic understanding of economics tells us that companies hire fewer people when wages are higher. It thus follows that if wages are suddenly increased, companies will find a way to cut staffing, either in the short-run or in the future.

Some people are inclined to vilify companies for this behavior. The argument goes that if these companies weren't so bloody greedy, they would already pay their employees a living wage and none of this would be necessary. Thus, I think the idea is that the minimum wage could force them to share some of their massive profits with the employees. The trouble is that there's a big internal contradiction here. If you believe that companies are run by greedy jerks, then you should also acknowledge that they are accustomed to earning a certain level of profits. And since they are so greedy, you should believe that they would like to continue earning this much or more in the future. Thus, if the government raises the minimum wage, they aren't just going to sit back and deal with life with lower profits. They're greedy, remember? No, they're going to try to get back to the same level of profits as before, and if that means laying a few people off, don't you think they'd do it? You can't have it both ways. Either they're greedy and underpaying their employees right now--in which case they'd probably try to lay people off after a wage increase--or they're reasonable people who are already trying to do what they think is fair. In either case, it's not clear how the minimum wage is supposed to be helpful.

Couldn't they just raise prices?

For the sake of being thorough, let's assume that our businesspeople are deeply loyal to their employees and want to do everything they can to avoid laying people off. Most likely, this will involve raising prices as much as is needed to cover the new costs. But this has problems of its own. Are the customers going to be completely unaffected by those increases? No. More likely, since the general population isn't getting a salary increase, they will adjust their preferences in response to price increases. Maybe that means eating at different restaurants that managed to keep prices down, or maybe it means eating out just a little bit less. But if the price increases are at all noticeable, it will change their behavior in some way--almost certainly leading to less business for Bill in total. What then? Well, presumably some of the businesses that tried to raise prices will ultimately fail in response to reduced customer demand. Maybe Bill's would survive, maybe not. But in aggregate, we would still expect a reduction of jobs in the minimum wage-affected sector as a result.

To counter this analysis, some people will say that consumers will just adjust to the higher prices in food-service and other minimum wage-affected industries. If so, the additional cost of the wages would be borne by the general consumer. The end result would be a wealth redistribution effect from everybody to the poor people in these jobs. That could be a desirable result, but it rests on the very questionable assumption that an overwhelming majority of consumers would be unaffected by a price increase. And given that there's really no reason to think this is true, it would be irresponsible to implement a policy based on it.

Weren't there some studies that proved everything you just said wrong?

There have been a series of econometric studies in recent years purporting to show that the conventional economic wisdom laid out above is wrong. This research actually led to a group of economists penning an open letter endorsing a minimum wage increase (to around $10 in that case). Unfortunately, there are two issues with this research:

  • First, they appear to rely on a pretty sketchy statistics trick to get the result. The details are here if you're interested, but the short version is they manipulated variables in such a way as to almost guarantee the result they got.
  • Second, the economic theory presented above tells us that the minimum wage will make unemployment higher than it otherwise would be. Since we can't really know what it otherwise would be, you can't test this conclusion directly. The studies just found that the adverse effect of the minimum wage was far smaller than might have been predicted, but they do not deny the linkage in principle. Further, the data they used reflect far smaller wage fluctuations than the jump from $7.25 to $15 that is currently being promoted.
I should also note that more conventional analyses of the minimum wage still expect it to cause job losses. For instance, a 2014 analysis by the Congressional Budget Office (CBO) considered the impact of raising the minimum wage to just $10.10 from the current rate of $7.25. It found that many people would benefit and a projected 1,000,000 would be lifted out of poverty. But it also projected that 500,000 people would still lose their jobs. This article from the progressive website Think Progress summarizes the results of this analysis and similar studies. And even though Think Progress concedes that most of the evidence points to people losing their jobs, they still focus on the silver lining of a projected "net gain" to the economy. This is a real world example of the standard economic approach mentioned previously. And again, it assumes that a lot of people losing their jobs--and presumably falling into deeper poverty--is an acceptable outcome as long as enough other people benefited. This is a very aggressive and alarming degree of utilitarian thinking, and, as before, I submit that it would do very little to console the people that do lose their jobs.

What about internships?

Another topic worth considering in the context of the minimum wage debate is the question of unpaid internships. I haven't heard of anyone calling for the prohibition of such internships. But why not? Surely, if getting paid $7.25 an hour is a starvation wage, getting $0.00 an hour is even more abominable. But of course it isn't. People are willing to take unpaid internships because they need to get their foot in the door and get experience. They see it as the best option available to them, and no one objects to it because it's obviously voluntary. They're taking the internship because they see it as the best option available to them. The trouble is that the same logic should apply to a job in the $0.01 to the $7.25 range.

Summing Up

Ultimately, the case for a higher minimum wage does not stand up to close analysis. There are winners and losers in this policy, and the people who are likely to lose the most are the very people the policy is trying to help--the people who can least afford it. Poverty remains a real problem in the US, and it's a good thing that so many people want to address it. But good intentions cannot be used as an excuse for bad policy. And if you really care about helping people in poverty, you should oppose raising the minimum wage.

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