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August 27, 2003

Who Pays for the Minimum Wage?

Whether the increased costs of the minimum wage are passed onto consumers or decrease business profits is as much disputed as whether it effects employment levels. And the questions are related.

Different Models: The classical model assume that employees are paid exactly the value of their marginal production, so an increase in costs will lead to some level of higher prices depending on the elasticity of demand for the product in question. Rarely will all costs be passed onto the consumer under such models, so some of the costs will invariably come out of profits.

But if the employer is not paying the employee the full value of their production, which many models of the low-wage labor market assume, then it is likely that little of the increased wage costs will be passed onto the consumer. Essentially, in such situations where bargaining or information inequality led to artificially low wage rates, the employer has been pocketing the difference between the market price of the good and wage costs that were below their productive value. Any increase in wage costs less than the productive value of the labor will just come out of the employer's "pocketed" profits.

Another alternative is the scenario where a higher minimum wage leads to employers adopting more productive models of production (i.e. higher-skill and lower turnover) either at the original firms or by higher productivity firms replacing them in the markeplace. In those situations, there is no reason to expect either a loss in profits or a price increase-- this outcome is sometimes called the "high road" alternative since it allows a win-win for employees, employers and the public.

Who Consumes Minimum Wage Labor? Even if some of the increased wages comes out of consumer pockets, rather than employer profits, this will still redistribute income to low-wage workers. The blunt reality is that while low-wage workers buy some goods effected by the minimum wage, they have such a miniscule percentage of family income (the bottom 20% have only 4.2% of income) that they will collectively benefit far more from increased wages than lose in any potential increased consumption costs. The fact that low-income people spend such a high percentage of income on rent rather than disposable goods sadly just sharpens their likely insulation from increased cost of living.

And don't delude yourself- high-income people are some of the largest consumers/employers of low-wage workers in America, from using them as nannies for their kids to low-wage renovation in their homes to mowing their lawns to cooking or bussing tables at their restaurants to making sweatshop garments for them.

How about Big Macs?: The increase in prices even for goods most likely to be consumed by the working poor are within reason. Since labor costs are about a third of prices in the restaurant industry, even if the whole increase to an $8 per hour minimum wage were passed onto consumers, that's still only 37 cents of increase on a $2 Big Mac, an 18% increase. Given that minimum wage workers will have over a 50% increase in income, they still come out ahead. And if fast food restaurants don't fully raise prices and take some or all of the increase out of profits or increased productivity (the result indicated by the Card-Krueger studies which showed no increase in prices), the consumption loss for the working poor will be even less.

How About Inflation? One question raised is whether an increase in the minimum wage will cause inflation. It's important to separate two issues-- immediate increase in prices in particular sectors versus spurring broader inflation in the economy. As noted above, various models assume only part of the increase in the minimum wage will even show up as increased prices. And it will be confined to products made with low-wage labor (note again only 4.2% of overall income for the bottom 20% of the population). This would probably lead to at most about a 1% increase in prices, since the median worker in the bottom 20% of the population effected by the increase to an $8 per hour minimum wage would see a 25% increase in wages.

And that's a one-time jump in prices overall -- at most. The more of the minimum wage increase absorbed out of profits or through higher productivity, the less of a one-time increase you will see in overall prices in the economy. In the larger scheme of prices, such an increase is a blip.

If the minimum wage is indexed to inflation -- as it is in some states such as Washington-- the yearly increase in overall prices will be miniscule. On 3% overall inflation, the contribution by minimum wage workers would be less that 0.1%-- again assuming a complete pass-through to consumers of the increase.

The direct effect on prices is tiny and the effect on overall inflation seems too tenuous to take seriously. In the 70s when many high-wage union contracts had wage increases directly tied to inflation, there were concerns that this was reinforcing inflation, but that involved a far broader segment of the workforce and of overall income. Minimum wage workers have so much less income and are a smaller part of the population, so inflation fears are just not warranted.

But see Bruce Barlett on the role of the minimum wage and inflation. Given rising unemployment with extremely low inflation, it's sort of hard to take his arguments seriously.

The bottom-line is that there is good evidence that much of the costs of a minimum wage will not be passed onto consumers and, in any case, the costs will be pretty minor in the scheme of the broader economy. So it will pump a lot of wage income into the hands of the working poor while increasing prices a miniscule amount.

That's a damn good progressive result.

Posted by Nathan at August 27, 2003 09:00 AM