The Unintended Consequences Of Raising The Minimum Wage.
Some policy proposals seem worthwhile on the surface but might have the opposite effect of what is actually desired. Such is the case with raising the minimum wage. Sometimes digging a little deeper and looking past the hype and populism lays bare the flaws and unintended consequences of a proposed policy change.
Politicians want to be regarded as being a force of good for society, but more often than not their “efforts” are limited to rhetoric only. Once in a while, they launch a proposal that on the surface seems to only be beneficial — to a considerable number of people. And that, of course, helps increase their popularity. But when looked at more closely the proposal might — when put into law — carry with it unintended consequences. So much so that they even hurt the ones the policy is actually trying to help.
I believe such may be the case with President Biden’s proposal to more than double the federal minimum wage. Who can be against that, right? So many people will see their wages double, by decree, without any effort on their part. Who in their right mind questions such a generous act of policy? The question to answer is whether minimum wage earners really benefit from such a measure.
Demand for labor
In economics 101 we learn that when the price of a good or service increases the demand for it will drop. There may be some exceptions to this law, but for most regular goods it holds true. So, we know that when the price of labor increases the demand for that labor will decrease. By how much depends on the price sensitivity of the demand. If demand is more price-insensitive — inelastic in economics parlor — then the drop in demand will not be that big. The drop in demand will increase the more sensitive demand for labor is to changes in the price of it.
Let us assume that labor demand for lower-skilled workers is inelastic, i.e. the increase in price will not change demand that much. How can raising the minimum wage be a bad policy in this scenario? Well, for one thing, it doubles the cost of that type of labor for companies, but we will get more into that later. For now, let’s focus on the effects it might have on the pool of low-skilled workers.
Even though the demand for labor may not change much, the supply of it will. That is higher-skilled individuals will now compete with the lower-skilled workers for the same jobs. Individuals that did not actively seek work before because they found the wage to be low relative to their skills, will now actively enter the job search market. Companies will now have the opportunity to choose among a larger pool of potential candidates. And if it can now hire higher-skilled workers for the same pay, who will stand a better chance of finding a job? Companies will simply not hire new employees whose current skillset and productivity do not justify a wage rate equal to the increased minimum rate.
Notwithstanding a doubling of the cost, managers will not massively fire minimum wage workers from one day to the next. But the rate at which they hire will certainly decrease and, at the same time, the incentive to automate the lower-skilled job functions will also increase. So, while an increase in the minimum wage might not have a significant effect when performing regression analyses on the level of (un)employment, it will certainly have an effect on the growth rate of employment. The latter will be lower than it would have been without the increase.
Increased heterogeneity in the pool of potential hires — which gives firms a more diverse set of criteria on which they can “discriminate” — and an incentive for automation are the first two factors that hurt most those workers that the policy intended to support. A third and more subtle factor has to do with the price sensitivity of labor demand and a different kind of incentive.
If labor demand for minimum wage work is not sensitive to prices, those already employed in such jobs will see their wages double. No effort needed on their part. In other words, while the lower wage might still have carried an incentive to increase one’s skills and rise up the ranks through on the job training and development, a doubling of the wage does anything but increase that incentive. Quite to the contrary, rather than stimulate higher skill development, such a policy has the effect of keeping people trapped in their low skill situation. The incentive to upgrade their skill will simply have been eliminated, especially when the rise in their wages is 100%.
We should also keep in mind that people are not some fixed data points in a dataset. Individuals that worked minimum wage jobs in the past are not the same people that are currently employed in those jobs. Unexperienced workers start at minimum wage, but as they gain more experience they can work their way up the ranks. And while not all workers will succeed — as it is with everything in life — doubling the wage eliminates the incentive or even the opportunity for those who could and would. By gaining experience and moving higher up the hierarchy they may very well reach positions that pay much more than the newly proposed minimum wage much faster.
Teenagers and students that take on lower-paid jobs to earn some extra pocket money or to save for college education are similarly deprived of that opportunity.
Product demand
As I have said above, an increase in the minimum wage raises the cost to the company. Depending on the price sensitivity of its product demand, some of that increase can be transferred to customers and ultimately consumers in the form of higher prices. The price elasticity of the goods and services the company produces will be a determining factor in how much of the extra cost it can shift.
But one must keep in mind that raising prices of end products in competitive industries is not self-evident. At higher prices, customers will shop elsewhere, probably abroad, ultimately leading to the possible bankruptcy and closing of the (domestic) company and the consequent unemployment of its workforce. For some that unemployment may be temporary, for others it might be long-lasting.
As lower-skilled labor is often found in competitive industries raising prices is often not an option. Suppose, however, that the company does have some leeway, what are the consequences of higher prices for its end products? First off, unit demand will fall, but an increase in the price may partially or wholly recuperate the loss in revenue. Secondly, depending on the type of products the company sells, higher prices for its products may especially hit the lower-income classes harder, undoing much of the rise in wages they now enjoy.
Most probably though, the company will not be in a position to raise prices, at least not significantly enough to undue the rise in its operating costs. That increase in costs will leave less cash available for investment in capital goods. And it is through the investment in and production of capital goods that labor productivity increases and as a result also wages — not only for the lower-skilled. This channel of rising wages is thus severely hampered by decreeing a doubling of the minimum wage.
Ultimately, no more wealth can be distributed than is produced. Labor, as a whole, cannot be paid more than it produces. As Henry Hazlitt put it “Real wages come out of production, not out of government decrees”.
All in all, governments might be doing more harm than good by raising the minimum wage, especially among those it primarily wants to help. But is that not often the case when governments choose to interfere in the economy? Often well-intended, more often hardly thought through.
