Minimum wage effects

Tony Blair today announced plans to cut the jobs and hours of low-paid workers.

He’s going to raise the minimum wage, from £4.85 an hour to £5.05 in October. This as the Low Pay Commission recommends in its report today; it also recommends a rise to £5.35 in 2006.

The first rule of economics, of course, says that if you raise the price of something, you’ll reduce demand. And this means shorter hours and job losses for some of the low paid.

The Low Pay Commission pretends this won’t happen. Its chairman Adair Turner says: “Our analysis suggests that previous upratings [to the minimum wage] have largely been absorbed without adverse effects.”

Can I give Mr Turner some advice? Try reading your own report matey.

In particular, appendix 3, which starts on page 213 of this pdf. It contains a survey of employers who were affected by the rise in the minimum wage in 2003. It shows that: 37 per cent of them cut staffing levels, whilst only 4 per cent raised them; 31 per cent cut basic hours worked whilst 3 per cent raised them; 28 per cent cut overtime hours; 81 per cent said their profits fell; and 63 per cent said they raised prices.

This, of course, is exactly what basic economics would predict. It corroborates this research, which shows that where the minimum wage bites hard – for example in care homes – it does reduce labour demand.

Which raises the question: how could anyone ever have thought otherwise? For example, TUC general secretary Brendan Barber: "Employers and politicians who said that [the minimum wage] would cause job losses have been proved wrong year in, year out."

One reason is that there is some research (like this pdf) which shows that the introduction of the minimum wage did not reduce employment.

Another reason is that advocates of the minimum wage focus on its macroeconomic effects, where any impact of the minimum wage would be too small to be detected. For example, the Low Pay Commission estimates that 2004’s uprating added just 0.08 per cent to the aggregate wage bill. Assuming a price elasticity of demand for labour of 0.6, and that all the adjustment came in job losses rather than shorter hours, this would have cost just 13,000 jobs. That’s equivalent to less than two days inflows into the unemployment figures.

So, the bottom line is clear and official – the minimum wage costs jobs.

This wouldn’t be so bad if it raised the incomes of the poor. But the impact here is small. For one thing, many minimum wage earners aren’t poor. And for another, those that are poor will (eventually) see their tax credits cut as their wages rise – if, that is, they keep their jobs. The Institute for Fiscal Studies estimates (table 4 of this report) that over 1.7 million working parents face a marginal tax rate of over 50 per cent.

Now, I’m not denying that some people will benefit from the higher minimum wage. Those who keep their jobs and hours will do so, at least marginally. And tax-payers will have a lower tax credit bill. But these gains come at a cost – of lower hours and jobs for some of the low-paid, and lower profits for many small businesses.

There’s no such thing as a free lunch. To pretend otherwise is either dishonest or economic illiteracy.

Comments

[Jarndyce]

I'm not even going to attempt to argue with you on the economics, as that's obviously your bag and my M.Sc. is a few years old now. But you totally miss the moral case for the minimum wage: if an employer can only manage to break even or employ another worker at below the minimum wage, what moral case does he have for being in business? There has to be elements at work here that go beyond simplistic S-D curves, which in any case have been objected to on any number of grounds, if I remember my old training. Without such provisos we'd still be allowing companies to sell asbestos, pollute as they saw fit, employ sweatshot labour, and so on.

[Tom]

Here is another moral case: If one's productivity is such that the value of the output that one produces is below an arbitrary minimum, then why is it better for that individual to remain unemployed rather than to work? The moral case is to let two parties come to a mutually beneficial agreement without government interference.

[Jarndyce]

Well, yes, Tom, but your model totally neglects power. Obviously companies are not paying people a wage at the margin of their productivity, but at the very least they can get away with. In fact, this is their absolute duty to shareholders. If the government withdraws from the market, it isn't a morally neutral decision to allow a 'fair contest': who protects the little guy against the multibillion dollar corp if not the democratically elected government? And a minimum wage isn't 'arbitrary' but the result of a democratic process into which we all have input.

[Jon Barnard]

Leaving aside the fact that only a minority of jobs are provided by multibillion dollar corps, why should anyone have to protect the little guy from signing a contract to provide a certain amount of labour for a certain price? He's free to leave that contract unsigned if he thinks it will make him worse off - and he's in a better position to judge whether it will than anyone else.

I'm not qualified to argue the economics either, but I thought the whole point was that workers' marginal productivity and what the employer can get awy with will converge in a competitive labour market.

[Blimpish]

Power might apply in a depression or in a labour market monopsony (which is pretty rare), but otherwise it doesn't. The problem with the "power" analysis is that if it's true it proves too much: why wouldn't employers always pay poverty wages, given the choice? The evidence of modern economic history is that they don't - so either we have a lot of benevolent managers betraying shareholders, or it's not simply a matter of power.

Regardless of the justice of the decision-making process, any minimum wage IS arbitrary - in that there's no binding rationale for £5.05 compared to £7, except that the Government think it's going to balance costs and benefits (including political benefits) best at that level. At any rate, it is not the result of the democratic process but the decision of our representative government. Or at least, I wasn't consulted!

To boil moral judgements down to a penny difference in wage rates seem to be very tortured reasoning - £5.06 good, £5.04 evil. The minimum wage CAN be defended on prudential grounds - for example, that people need to believe that work is justly compensated - but the idea that it's the mark of a moral society is stretching a bit far.

[Jarndyce]

B.
But I do think that in many countries, and in all at certain times, conditions of monopsony or effectively oligopsony do apply and in those places large employers are free to set their own very low wages, and do - viz. Haiti right now, sweatshop labour in the Far east, and the very bottom rungs of labour even here in London, some of which I unfortunately have had personal experience of. A minimum wage level is arbitrary I agree, and I wouldn't push the power analogy so far as to say it is the only factor involved in the labour market. But personally I do see having regulation, in this case of a minimum wage, as a significant component of a moral society.

Jon
My argument would be that markets do not 'clear', not ever. Therefore, your anaylsis of convergent productivity and wages in a market just doesn't apply. Well, it does, but in economic theory only. I also think your anaylsis ignores the fact that corporations and business as a whole are social institutions and therefore deserve to be treated as such, but that's a side point.

[Tim Worstallt]

Jarndyce, an M.Sc. in economics? Yet you miss two basic points about pay?
Employers will employ labour to the point where marginal costs equal marginal revenues. So there will always be jobs which a company would fill at lower rates of pay...in essence, every company always has jobs which it would only fill at less than minimum wage. The immorality comes in denying people the chance to do them. To take an absurd and distasteful example, why shouldn’t Sainsbury’s employ a Down’s Syndrome sufferer to collect the trolleys for 3 pounds an hour, the value that person adds to the store’s operations? Better for all concerned than being stuck in the day care centre.

Your views on how average wages are set also seem a little odd. Surely you know that average wages are set by average productivity in that economy...not the marginal productivity of the workers, nor the average productivity of that particular sector? Far East seatshop wages reflect the appalling productivty levels of those general economies, nothing more. As even Paul Krugman points out (no right winger he) what will happen when all Chinese workers are as productive as American ones? They’ll be paid the same as American ones.

[Jarndyce]

Yes, an econ M.Sc. but I haven't used it for many years and unfortunately have forgotten most and lost all my notes, which is why I tried to steer clear of arguing the technical economics too much.

So, you're getting a little advanced for me and my failing memory now. I will assume you are correct in your prescriptions, but more generally I would say that these orthodox/neoliberal models do make predictions about where markets will clear / what average wages will be (though I didn't mention average wage levels, and sweatshop wages paid by individual companies are supposedly determined by marginal productivity levels in those companies operating in a completely unregulated environment, surely?). However, when you build all the various market failures into the equation - asymmetric information, irrational behaviour, transactions costs, etc. - basing economic policy on the point where two curves may or may not meet becomes madness, since no one knows where the real curves are and nobody is behaving rationally or optimally anyway. Too many other factors are intervening to make any reasonable estimate of where the 'equilibrium' lies accurate. The 'theory of the second best' predicts something analogous, I think, even with rational behaviour. So, what IMHO we are left with is the need for politics and therefore the need to make moral decisions, which for me is the category the minimum wage falls into.

In the real world, your Sainsbury's example is a powerful one, I admit. In my experience with some shitty lines of work, most employers I know have found ways to circumvent the MW (e.g. piece rates). Other workers I have met have had their lives improved by the MW. I'm not sure how the anecdotal evidence stacks up, or whether even worthwhile comparisons of utility losses/gains could be made. Partly I think the divide falls on whether you see corporations as social institutions with obligations to us all or as money-making and wealth-creating machines and providers of employment and nothing more. I go for the former personally, while obviously recognising their pivotal role in the latter too.

[Jarndyce]

In fact, I think the Theory of the Second Best (Lipsey + Lancaster 1954? not sure) predicts that adding another market 'failure' like a minimum wage could actually move the economy closer to overall equilibrium, not further away. Is this right? Does anyone know?

[rjw]

A few points ...

1. EVEN if a higher minimum wage means job losses at the margin, those IN work benefit from the higher wage... so the losses to a (relatively) small number at the margin have to be weighed against the gains to the intra-marginal

2. the extent of losses at the margin? - this is empirical - depends on elasticities of substitution in production and other parameters - even in a market clearing model - and labour-capital substitution elasticities are, as far as I'm aware, not very high.

3. And what evidence is there that the UK minimum wage has substantially reduced vacancies ? Isn't UK unemployment pretty much the lowest in europe? Perhaps the minimum wage is not so important after all.. maybe other things matter more....

4. when there is a wage floor this tends to reduce the temptation to employers to compete by driving wages down.. they have to go another route... better management of human resources .... so it helps push management incentives in the right direction

4. there is substantial evidence that labour markets are segmented (people doing the same job being paid different rates for no obvious reason) ... minimum wages - even in theory - can improve efficiency by reducing the degree of segmentation.

5. and then there are the standard monopsony arguments, power issues etc. And the empirical work on this of card and krueger, which found that minimum wages in the states had little employment effect.

[Blimpish]

Jarndyce:

I'd still differ with on thinking of this as a moral intervention. In terms of its distributional effects, a minimum wage tends to raise incomes for a large number of employees who are often from a quite well-to-do background (students, women returners), while employment effects hit at the bottom end of the scale. And I'm still dubious of any moral rule that classifies according to a penny difference either way in wage rates. At any rate, if the minimum wage is a moral wage, then what basis is left for further redistribution, i.e., through tax credits?

As to monopsony, oligopsony effects... I don't doubt that there are abuses in the bottom-end of the labour market, but I think these boil down to two prime problems: (1) hard cases - employees feeling they have to take what's offered; and (2) a socially dislocated workforce. For (1), a tight labour market should ensure that these are only short-term hiccups, and institutionally it might well be better to have a labour market that gets people into work and then worry about getting them to good wages as the next step. For (2), this is a problem tied up with lax immigration rules - the best solution is to ensure that migrant workers become fully integrated with the wider society, including especially knowing the language. It is their exclusion from wider society that often puts them at the mercy of unscrupulous employers. Re the Third World - there are a lot of different issues at work.

Personally, although not greatly convinced on the economics of minimum wage laws, I think they're pretty much standard for an advanced society for political reasons. There's perhaps something here about Chris's truth vs utility post the other day, maybe - that we have to say to ourselves that all work is worth a certain amount in order to buttress our common work ethic.

rjw:

1. Very true - although once we're in the business of calculating net benefits, we're definitely not calling the minimum wage a moral rule. There are also distributional consequences to consider.

2. Agreed, as little as I'm familiar with the evidence.

3. True, but doesn't necessarily prove too much - post hoc ergo propter hoc, etc. The minimum wage was introduced fairly sensibly, and at a low-ish rate, at the time of a very buoyant economy (with low-end labour demand strong enough to pull in migrant labour). The doubt that many of us have is that the principle having been accepted, the minimum wage CAN have deleterious effects if raised too high (which is conceptually true - the question is about finding where it bites hard).

4. True, although I'm a little cautious of the idea of using the law to impose tidiness on market phenomena. What looks like chaos from the outside can be the best working of the market within.

5. The empirical work here is not without critics or doubts. Card and Krueger has been subject to heavy methodological criticism, mainly associated with their comparison of two areas with very different labour markets and on a very particular industry. Our host here did a whole article on the subject in 2000.

[Mark]

What a lot of wordy twaddle from some contributors.
What some academic minded types seem to ignore is that for some tasks, when the cost of labour reaches a certain level the economic case for being in Blighty evapourates. i.e. companies relocate abroad where there is no such thing as minimum wage.
For my company that day is getting much closer. Quite simply it is becoming impossible to compete with imports.
What use is a £5.35 p.h. to my staff when they lose their jobs when I am forced to move to eastern Europe to stay in business?

[David Wildgoose]

It's not Minimum Wage that's the problem, it's its interaction with Social Security.

The Minimum Wage should be set at the amount at which social security payments are lost. I see no reason why my tax monies should be used to subsidise another business, but a minimum wage that results in social security spending is just that - a hidden subsidy to that business.

[Tom]

You can't make an omelet without breaking a few eggs. If some poor slob is so unproductive as to not be able to even earn a minimum wage, well, then that is the price I am willing to pay to have a minimum wage. I mean, if you are so stupid and unproductive that you don't have the ability to produce very minimum that society has deemed necessary of you, then you could have the decency to not try and get up in the morning and have the gall to look for a job. It is just so unsightly to have such unproductive people among us. Better if you would just stay home in bed, wake up around noon and trudge down to the welfare office to pick up a government check.

There are much more important issues to worry about than unproductive slobs such as yourself. Macroeconomic aggregates, elasticity curves, theories of second best, monopony buyers, distributional consequences, the evils of capitalism and business, ect... are much more important and exciting issues to talk about than your inability to find a minimum wage job. Not to mention the importance of my moral posturing as a friend of the little guy and down trodden (just as long as your not too little and not too down trodden to find a minimum wage job). Anyway, look at the bright side, although you're out of work, someone got a raise.

[Daniel]

Your analysis is somewhat simplistic. Quote: 'This, of course, is exactly what basic economics would predict. It corroborates [Machin et al 2002], which shows that where the minimum wage bites hard – for example in care homes – it does reduce labour demand.'

First, even the abstract states that 'There is some evidence of employment and hours reductions after the minimum wage introduction, but there appears to be no effect on home closure.'

Notice the word 'some'. Further research by Machin and Wilson* shows the employment effects of the NMW on the care-home sector to be at worst 'moderate' and statistically insignificant. It is important to recognise that this case study was chosen exactly because it employs a massively large number of low-paid workers relative to most industries, and the aggregate workforce.

Second, you state: 'the Low Pay Commission estimates that 2004’s uprating added just 0.08 per cent to the aggregate wage bill. Assuming a price elasticity of demand for labour of 0.6, and that all the adjustment came in job losses rather than shorter hours, this would have cost just 13,000 jobs'.

You make the mistake that a number of economists make on this issue, in rejecting any possibility of monopsonistic effects before you have even started considering possible employment effects, so there is little surprise that you 'calculate' a negative employment effect. Specifically, you need to consider the labour elasticity of supply which is the whole point of the monopsony argument. If LES is relatively inelastic, then the monopsony effect is greater - firms have a greater ability to pay workers less than their marginal-revenue-product. Of course, there is a level of wage increase which will cause the wage to be greater than workers' marginal-revenue-product, but this is not true for all wage increases. With relatively moderate wage increases, employment will increase, even though firms' profitability decreases. This isn't necessarily a bad thing if firms are otherwise exploiting workers by paying them less than their MRP, especially when one considers that women with children who are often less flexible than men with regards to employment are the ones that will be exploited.

Read Manning (2003) - Monopsony in Motion for more on this.

* Machin, S. and Wilson, J. (2004). 'Minimum wages in a low-wage labour market: care homes in the UK', Economic Journal Vol. 114 (March) 102-109.