There was a fascinating review of new research into minimum wages in The Age last week, written by the Sydney Morning Herald’s business editor:
When the Fair Work Commission announced a 3 per cent increase in the national minimum wage to more than $640 a week – or almost $16.90 an hour – from last week, employers hinted it would lead to fewer people getting jobs and maybe some people losing theirs.
And to many who’ve studied economics – even many professional economists – that seems likely. If the government is pushing the minimum wage above the level that would be set by the market – the “market-clearing wage” – then employers will be less willing to employ people at that rate.
That’s because market forces set the market rate at an unskilled worker’s “marginal product” – the value to the employer of the worker’s labour.
Almost common sense, really. Except that such a conclusion is based on a host of assumptions, many of which rarely hold in the real world. And over the past 20 years, academic economists have done many empirical studies showing that’s not how minimum wages work in practice. They’ve also developed more sophisticated theories that better fit the empirical facts.
The reason the “higher minimum wages cause more unemployment” argument is so influential is that it is based on Econ101 models. Because so many of us took Econ101, they are intuitive.
The basic Econ101 (perfect competition) idea is that with heaps of available workers and heaps of firms hiring and price being the only bargaining chip and perfect information everywhere, firms will end up paying workers exactly what they are worth. If a worker demands more than that, they get fired and can’t find another job anywhere. If a firm pays less than that, all their workers quit for better jobs across town, and they cannot hire anyone else.
That, obviously, is a cartoonish fantasy world.
In the real world, it’s a bit more complicated. In most low wage sectors of the economy, firms are better equipped than workers to handle employment interruptions.1 And this has big implications for the impact of wage laws such as the minimum wage.
For example workers, who often face tight household budgets, cannot afford to go without getting paid for more than a couple of weeks. Beyond that, there are real consequences for their ability to house and feed their families. Firms, on the other hand, can often carry a temporary labour shortage without it crippling the enterprise.
This means firms are more powerful than individual workers in pay negotiations, with the result that the eventual pay rate ends up below the perfect competition equilibrium. (There are plenty of other, similar, fictions in the low-wage labour market, most of which point in the same direction – more power for the firms, less for the worker.)
This is where things get interesting:
If firms are paying workers less than their marginal value to the company, then a government demand for higher wages should not lead them to lay anybody off, so long as the new minimum wage demand is not higher than the worker’s marginal product.
The key calculation for the firm is not “do I have to pay this person more than I did last week?” It is “do I have to pay this person more than they contribute?” If a firm pays $14 an hour to people who produce $20 an hour of productivity, then raising the wage rate to $15 an hour won’t cause anyone to get the sack.
That is what the Australian research quoted in The Age / SMH has found.
Earlier this year, more than 600 US economists – including seven Nobel laureates – signed an open letter to Congress advocating a $US10.10 minimum wage. They said that, because of important developments in the academic literature, “the weight of evidence now [shows] that increases in the minimum wage have had little or no negative effect on the employment of minimum-wage workers”.
The first such study, published by David Card and Alan Krueger in 1994, compared fast food employment in New Jersey and Pennsylvania after one state raise its minimum wage and the other didn’t. They did not find a significant effect on employment.
Since then, many similar US “natural experiments” have been studied and have reached similar findings. In Britain, the Low Pay Commission has commissioned more than 130 pieces of research, with the great majority finding that minimum wages boost workers’ pay but don’t harm employment.
This may appear alien to many of us, who have had “if the price goes up, the quantity demanded will fall” beaten into us since high school.
But the world is not nearly as tidy as that, allowing the community to protect the dignity of low-wage workers without costing them their livelihoods.