The Minimum Wage from first principles
Jul 27, 2014

The Minimum Wage from first principles

The minimum wage, like most government policies, is first and foremost a form of wealth distribution. There are winners and losers from the distribution. The biggest group of winners is the obvious one: low wage workers who now get paid more. Raising the wage floor also raises wages somewhat for workers above the bottom as employers needs to differentiate on wages to attract higher valued workers.

The losers depend on how companies react to a minimum wage.  If they fire low wage employees to compensate, then those fired or not hired suffer and the unemployment rate will rise. If they raise prices of their goods and services to customers, the public quite broadly will suffer. In particular, you would have a lot of middle class customer subsidizing low wage workers in retail and other service industries through paying higher prices. And if companies take a reduced profit then the relatively wealthy will be the main losers.

The exact breakdown of these three main reactions is an empirical problem that requires data, but for now let us just dispense with one oft quoted claim: that companies will never take lower profits, but will always adjust to hurt either employees or customers. This may happen occasionally, but economy wide it would be incredibly unlikely.

Consider, if a company could get by with less employees, or remain competitive with higher prices, they could just do that now and increase their profit. Instead, reducing employees is likely to lower the companies ability to earn money, this is why they hired the employees in the first place. The marginal benefit of firing an employee and or raising a price needs to be recalculated given any change in market conditions and after the distortion that the minimum wage applies, it would only be occasionally true that everything balances such that one can raise prices and fire employees exactly in proportion to the lost profit due to wage increases. In general, it won't be 0% the reduced profit factor and thus there will be a net wealth transfer from the ownership class to the low wage worker class.

Let us accept some form of normative goal where we aim to help out the disadvantaged in society and reduce the level of inequality that persists. Seeing the problem just at this level of wealth distribution, the reason to support it is due to the increased wages of low wage workers and the reason to oppose it is due to potential for increased unemployment among people competing for low wage jobs. Both are good or bad relative to this goal. There is certainly a likely undercurrent, particularly among the political right, that opposes minimum wage for that other group of losers - business owners - in effect rejecting the normative goal, although since it is hard to feel sorry for the Waltons, their arguments usually are about the potential for increased unemployment.

The Macroeconomic view:
Thus far we have been doing microeconomics; that is, we have looked at the options a specific company could take and who that helps or hurts. However, if we look at this from a macroeconomic level we know that different market distortions have different, often difficult to predict, macroeconomic consequence. For instance, wealth distribution in a vacuum gives dollars to certain people and takes it away from other people. However, the macroeconomic effect is typically to grow or contract the economy based on different wealth redistributions. So opposed to just listing winners and losers, ought we expect this distortion to result in favorable macroeconomic consequences?

It is well known that when the government spends money, there is a multiplicative effect in net economic growth. As in, most of the time that the government spends a dollar, the economy grows by some amount that is either more or less than a dollar, and only coincidentally would work out to precisely a dollar in growth, at least in the shorter term. Things like unemployment benefits and infrastructure spending have a multiplicative factor greater than 1, and things like tax cuts for the rich and military spending have a multiplicative factor less than 1. The basic reason this exists for policies like unemployment benefits is that this money immediately goes back into the local economy because unemployed people really need to spend it on the basics, thus increasing aggregate demand and growing the economy. Contrast this with money to the rich which often has a low velocity, staying in bank accounts, or finding its way offshore, which has a lower increase in domestic demand. . 

Low wage earners are in this category where their extra money quickly finds its way back into the local economy, thus driving up demand. Money taken from high wage earners also is taken out of the economy and reduces demand, but the multiplicative effect of this is lower, which is the key. Net aggregate demand creation percolates through and helps everyone (although unequally) by creating more jobs and more profits.

This is the basic reason why we get the following statistical quirk: studies don't tend to show a big jump in unemployment following minimum wage increases. One of the three ways companies can adjust is by firing people, and they surely do some of thus, but it seems to be more or less made up for by increased demand in the economy resulting in increased jobs. What is left is largely the redistribution from the wealthier owner class to the low wage earning class, with associated GDP boosts.

Why does this have to be done by the government?
The nature of the boosted demand by a minimum wage law is that is broadens the economy generally, but isn't focused specifically on the companies likely to use minimum wage employees. Companies like McDonalds might suffer a lower bottom line if they can't fire employees or raise prices without losing business, but Apple might benefit as more low wage employees can purchase their fancy devices and have a lower dependence on low wage workers. Because the benefits are delocalized no individual company reaps the benefits of increased demand if they act unilaterally. Most of the result of giving extra money to your employees is that they spend it somewhere else. But if lots of companies do this, the benefits spread out widely. It is a classic tragedy of the commons scenario where the benefit is only realized if the government mandates it - at the largest jurisdiction possible - otherwise companies are always incentivized not to engage unilaterally.

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