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August 26, 2003

How Minimum Wage Increases Employment

Here's the problem with the simplistic argument that minimum wage laws automatically cut jobs. It's based on Economics 101 for commodity markets that says if prices rise, demand falls. But labor markets are not like commodity markets for a number of reasons:

1) When demand falls for one item, the demand shifts to other items, which in commodity markets inevitably hurts the item where demand falls. Not necessarily so for labor markets. If apples get too expensive, you can't convert them into more appealing oranges. Workers can shift into different jobs, so a fall in demand for one kind of work can still lead to the workers getting jobs in a new venue.

2) More importantly, labor is not a static commodity-- it's human beings whose skills on the job improve over time, so substituting new workers for old has far more serious costs. There is a real tension betweeen looking for the cheapest labor and paying a premium price to reduce turnover and maintain skills.

3) Since the minimum wage applies across the labor market, there is by definition no alternative low-wage labor to substitute for the now more expensive labor. To assume lost employment, you have to assume an overall drop in consumption across the whole population or the substitution of capital for labor costs in that particular industry -- which in turn drives new employment in other sectors to produce the needed capital goods.

4) Crucially in thinking about the minimum wage, work is not done in a single system of production, even when producing the same goods, so raising the price of labor may cut production in a low-wage version of production but increase it in a higher skill, higher-wage version of production for that same commodity.

5) Labor is the one commodity that in turn consumes itself-- ie. workers go home and buy other goods which in turns drives demand for more labor. So raising the minimum wage puts money in the pockets of consumers living in low-wage communities, thereby driving employment through worker consumption, a kind of localized Keynesian expansion of jobs in the low-wage sector.

The Debate: The empirical case for the minimum wage is best argued in David Card and Alan Krueger's Myth and Measurement: The New Economics of the Minimum Wage. The classic response is by Neumark and Wascher who argue for the more classic effects of decreased employment. Folks should wade through the literature to be convinced one way or the other on the empirical results, but the key is to understand why the Econ 101 simplistic model does not necessarily hold or why other factors partly or fully counterbalance the effects of classical models.

The key here is to understand that the minimum wage very well may at times decrease employment IN PARTICULAR FIRMS using PARTICULAR SKILL MODELS-- but don't mistake the loss of jobs in particular firms for loss across the economy. Further, because of incomplete information, search costs and other imperfections in the labor market, even individual firms won't always follow classic responses to rise in costs of labor.

Card & Krueger model: Card & Krueger illustrate a more complex understanding of labor markets that I can only roughly describe here (read the last chapter of their book), but the key is based on the heterogenity of labor in the market indicated above. Rather than decreasing employment, a rise in the minimum wage encourages the substitution of higher-skilled labor for lower-skilled labor.

Further, even many particular firms have large "sunk costs" of capital that will be wasted if employment is reduced. For such firms, it is irrational to cut employment since they would lose more profits by cutting production than they lose from increasing the wages.

Card & Krueger also discuss the problem of turnover in low-wage labor markets, which prevents employers from being assured of being able to buy labor in the marketplace on demand in the same way as other commodities. The implication of this, counterintuitively, is that a modest increase in the minimum wage will INCREASE overall employment because employers will be able to fill vacancies that had been left open due to the churn of turnover.

Other models: Other models look at workers' willingness to take jobs from a bargaining viewpoint which implied that most workers are more productive than their initial wage, so an increase in the minimum wage will not lead to cuts in employment but in fact will often lead to some increase in employment because of better matching of employee productivity to wage, thereby reducing turnover.

All of these alternative models imply a better job situation for moderate minimum wage increases, although the employment losses do start to occur with large increases in the minimum wage.

So the point is not that some debate on the proper level of the minimum wage is not warranted. However, the simple equation that raising the minimum wage inevitably leads to some loss in employment is disputed both empirically and theoretically.

Increases in demand: It's also worth noting that these models look at particular industries, so the overall effects of the minimum wage on the larger economy may be even more positive. While particular low-wage industries might lose out from a rise in the minimum wage, the boost in worker income may drive expansion of other low-wage sectors. If wages increase more than any wages lost to unemployment, then this will often feed expansion of jobs that service those low-wage workers, often themselves staffed by low-wage employees. So again, the effects of the minimum wage need to account for more than the classic microeconomic models but recognize that employees are not typical commodities but integral parts of a more complex set of economic relationships.

And my bottom-line is this-- as long as the evidence is ambiguous, I go with raising the minimum wage, since the obvious empirical benefits for the workers effected are clear while the supposed downside is unproven and disputed theoretically.

More on the Minimum Wage:

  • Economic Policy Institute Minimum Wage page
  • International Labor Organization on Minimum Wage
  • Finance Project Living Wage/Minimum Wage page
  • John Buell on Minimum Wages and the Human Commodity

    Posted by Nathan at August 26, 2003 10:07 AM