Friday, August 16, 2013

Minimum Wage: Part 1

This is one of a two part post on the minimum wage. The second half will put a more human face on the discussion of the minimum wage. This half of the post will focus on how economists view minimum wage from a theoretical perspective and how those theories comport with data from the field. This has enormous consequences for human welfare; but, since I understand it is not simple to make the connection, I break it down in two posts. In this post I will attempt to be somewhat non-technical, not venturing beyond intuitive explanations of the different theoretical and empirical exercises (Nevertheless, there will be *some* jargon)

The standard framework to discuss the minimum wage in Econ 101 begins as follows:

  1. At high wages firms demand less labor and at low wages firms demand more labor, 
  2. Workers are willing to supply lots of labor when the wage is high but not willing to supply much labor when the wage is low. 
  3. The intersection of labor-demand (firms) and labor-supply (workers) determines the "equilibrium wage".

When the equilibrium wage is considered unfair people sometimes advocate for a minimum wage.* Usually, the minimum wage is above the equilibrium wage. This makes sense because if wages for certain labor pools had a high equilibrium wage an increase in the minimum would have zero effect on the equilibrium wage. The graph from Econ 101 looks something like this,

You can see there are more workers willing to supply their labor at the new minimum wage than firms demanding labor at that wage. This means there are a surplus of workers and increased unemployment. These results hold for more sophisticated models too. For example, in labor economics "matching models" where firms post vacancies and workers search for jobs this result of increased unemployment still holds. The logic behind these models is similar to the standard framework: If firms receives equal production from workers but must compensate more then less vacancies will be posted.

These standard models suggest that in the long run firms will substitute low skilled workers for machines, outsource work to other areas, cut back on benefits, etc. The competitive pressure from other firms in the market (who are also attempting to cut costs) necessitate these decisions. All else equal, if firms did not make adjustments their business would suffer losses.

There are theories however where the minimum wage does not increase unemployment. In fact, one theory suggests it will have zero impact on unemployment or that it will increase employment! The model that suggests this begins with firms having what economists call "monopsony power".

To get a handle on this idea I want you to imagine you are a bidder on ebay.

Would you rather be the sole bidder for your beloved item or would you prefer there are several bidders? Life is good if you're the sole bidder because you can place a low bid without competition from others. A monopsonistic labor market is similar. Firms can offer low wages because there are not other firms offering higher wages. In cases like this the minimum wage could prove helpful. (To see how this might be true visit this blog post from Dave Henderson)

This discussion about monopsonistic power brings us to a junction from theoretical exercises to data exercises. This is fitting since the monopsonistic model that justifies the minimum wage was employed following the a controversial and landmark empirical study.

Most minimum wage empirical papers either confirmed the standard theoretical result or failed to find a negative influence employment. However, in 1993 David Card and Alan Krueger (CK henceforth) posted a working paper that was later published in the most prestigious economics journal: American Economic Review. The paper focused on fast food businesses along the Penn. and NJ border as a "natural experiment". In 1992 NJ increased its hourly minimum wage from $4.25 to $5.05 (the treatment group) while neighboring fast food restaurants in Penn. had received no change in their minimum wage (the control group). CK's statistical methods were not iron-clad but were careful and convinced a number of scholars in the profession. Across time, the number of economic scholars who *did not think* an increase in the minimum wage had negative employment effects: 1978: 10% /// 1992: 21% /// 2000: 26.5%. The impact has been more intense among labor economists.

From a logical standpoint this is curious. There should be a negative impact on unemployment. Consider the following:
If there is no negative impact on unemployment for increasing the minimum wage from $4.25 to $5.05 why not increase minimum wage to $10/hr? $50/hr? $1,000/hr? and so on. 
I do not mean to be flippant but merely to demonstrate using reductio ad absurdum that there must be something else that these economists have in mind. Demand curves slope downward, right?

On the other hand, the monopsonistic model would suggest that the minimum wage should be increased up to the point where wages *would be* if the market were more competitive (ie, there were more bidders competing against you on ebay). But, do you think McDonalds, Burger King, Chick-Fil-A, etc. have significant market power when it comes to hiring labor? Perhaps there are industries where firms have such a large market share that workers furnish wages below their contribution to the firm. However, and I will leave this question to the reader, does the fast food restaurant seem to be monopsonistic? That is, does each fast food restaurants exert enough control over the market that it can dictate wages?

In fact, there are two crucial questions to ask when taking this monopsonistic view of the labor market. First, is the labor market in question monopsonistic? False indentification of this fact could lead to people losing their jobs and others never being hired. Second, supposing the labor market is monopsonistic who has the *correct* knowledge of what the competitive wage should be? If this correct wage is not implemented then we might develop problems that are worse than the problems we have at present.

To better understand other reasons economists might support a minimum wage see surveys Dan Klein and his co-author conducted here. There has been a massive tug-of-war between the two sides of this debate. From a logical standpoint I am unconvinced that minimum wage has no impact on unemployment. I think Bryan Caplan articulates a stance I would feel comfortable with in this blog article.

I do not believe that monopsonistic markets are ever-present (however I do plan to read this book which suggests they are numerous).

Another possible reason that CK did not find a negative employment effect is not monopsonistic labor markets but time lags. One famous labor economist, Mark Isaac knew, made the simple point that when the minimum wage increases employers do not say, "Whelp! That does it! Let's get rid of these employees." Instead, employers grin and bear the increased costs until some future point where economic forces like competition or economic downturn prompt them to make cuts. This kind of time lag is difficult to capture.

What is also difficult to capture are the people never hired because minimum wages are higher. One way to attempt to measure those "never hired" is to look at employment growth rather than employment levels. This brand new study on NBER demonstrates that the minimum wage has a negative influence on job growth.  

One more episode in an ongoing saga. If it were not so important (the human side - which is the topic of my next post) it would not be worth wading through all the different arguments.

*An interesting post for another time would be to explore how this perceived unfairness emerges and how price-ceilings (maximum prices) and price-floors (minimum prices) relate to just-price theory. There has already been a blog post done on this but I'm not a good enough Aquinas scholar to know whether this is a good depiction.

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