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Why Raising Minimum Wages Does More Harm Than Good

Updated on May 17, 2016

The Theory Behind Minimum Wage

Over the last several months, there has been a national cry to raise minimum wage. Proponents of the movement argue that the current minimum wage ($7.25 per hour is the Federal rate, although 29 states, plus D.C., have higher rates in place, ranging from $7.50 to $10.50) is a major contributing factor in rising poverty rates over the last decade. The math, in a vacuum, supports this. If one person who supports a household of three people works full time at the federal minimum wage, their yearly income is only $15,080, just over $5,000 under the federal poverty line (FPL). If minimum wage was raised to $10, or even $15, as California is trying to do, this yearly income all of a sudden jumps to $20,800 or $31,200 at the high end. When the FPL for a household of three is $20,090, it seems a higher minimum wage would do the trick.

Unfortunately, life -- particularly economics -- does not occur in a vacuum. As Newton's third law of physics explains, for every action, there is an equal and opposite reaction, and it's these reactions that cause this theory to not only be flawed, but counter-intuitive to its own objective.

Supply and Demand


Economic Reactions to Minimum Wage Increases

There are a number of economic principles in play when it comes to increasing minimum wage. The first and foremost is supply and demand. In a free economy with no price floors or ceilings (more on that later), supply and demand will meet at a price point called equilibrium. As the graph on the right shows, when the price of the commodity increases (along the Y-axis), the quantity demanded (X-axis) decreases. The opposite is true for supply. If I'm a farmer selling corn and the price of corn drops (Y-axis), I would forego producing corn in favorable of a more lucrative crop. But if the price increases, I'll forego less lucrative crops to produce more corn.

The same applies to labor. When the supply curve for labor shifts to the left -- requiring higher wages for the same quantity -- the market (demand) for those services decreases (shown at Equilibrium 2 in the graph below) . Sure, Equilibrium 2 has an increased price point of roughly 20 percent in this curve, but it's also lowered its demand by 10 percent. With all the outrage about the current increasing wage gap, it wouldn't seem ideal to raise the income of 90 people by people by 20 percent while taking away 100 percent of the income from 10 people.

The only way for the equilibrium quantity to stay the same is if the demand curve shifts to the right as well. This is where the first flaw of the minimum wage increase comes in. There are only a couple of realistic possibilities to make the demand curve shift. One is the rapid expansion of companies that utilize minimum wage workers (service industry, fast food, retail, etc). While the Bureau of Labor Statistics expects to see a lot of these occupations of among the top in job growth over the next eight years, very few are likely to offset a 33 to 100 percent increase in labor costs. The other option is the "suppliers" experience an increase in output price, i.e. higher retail value, or a decrease in input prices, which we can safely rule out in these industries. In other words, McDonalds, Wal-Mart and other minimum wage employers would be more than happy to offer more jobs with higher wages as long as they're seeing an equal, if not greater increase on the revenue side, which means higher prices for everyone.

Shifts in the demand and supply curves create changes in the equilibrium points.
Shifts in the demand and supply curves create changes in the equilibrium points.

So what actually happens if minimum wage is increased? First, it creates a price floor for each industry that's impacted. For example, if the equilibrium price for the fast food industry is $8 per hour and minimum wage is increased to $10 per hour, equilibrium ceases to exist. If equilibrium was 100,000 jobs at $8, but now the price floor mandates $10 per hour, your demand is going to be reduced to 80,000 while your supply is going to increase to 120,000, creating a surplus of 40,000 workers (all numbers being hypothetical, obviously). Now this doesn't mean that 40,000 people are all of a sudden unemployed, it does mean there are 40,000 people that would work for $10 per hour that don't have jobs (and in this example, 20,000 of them are newly-unemployed).

The surplus creates a profound effect on those who the minimum wage increase was trying to help, the largely unskilled (technically speaking) labor force. The reason being is that now, the labor field is more competitive. Menial, stress-free jobs* that were previously unappealing due to poor pay are now paying just as much as some of their more stressful, difficult counterparts. Why be a CNA, having to do a difficult job (both physically and mentally) that offers little satisfaction, when you can just push buttons on a register and hand Big Macs out the window for the same pay? Eventually, the overall talent pool will rise, pushing out those who were these out of necessity, not choice.

*Full disclosure: I worked in fast food for the better part of three years, including management. The only stress in that industry is self-induced.

Even if the labor market adapts and somehow keeps everybody employed, it's not likely that these minimum wage earners are likely to experience any more financial freedom. In fact, they're likely to be in a worse situation than they were before.

Suppose that every company that employs minimum wage workers runs as lean of a work force as possible; i.e. they're currently operating with the lowest amount of employees to continue operations. So if minimum wage is increased, they have no choice but to pay their staff the higher rate. Of course, these businesses exist for the purpose of making money (it may not be their end objective, but it's always part of the plan), so they won't just take a hit to their bottom line if they can help it. As a result, prices will rise, particularly on those that have an inelastic demand -- things people will continue to purchase irregardless of price. And they're likely to rise at a higher rate than the wages.

Almost everyone knows that net profit is a major metric when it comes to business evaluation. What's lesser known is that profit margin -- the percentage of revenue that ends up as profit -- is of almost equal significance. For example, if McDonald's had yearly revenue of $1,000,000, expenses of $900,000 and profit of $100,000, they would have a profit margin of 10%. When evaluating future periods, McDonalds' executive, Board of Directors and investors would expect the company to not only maintain, if not increase, that $100,000 net profit, but also the 10% profit margin. So if a minimum wage change increased McDonalds' expenses to $1,200,000, they aren't likely to increase prices to generate revenue of $1,300,000 -- maintaining their $100,00 profit. Instead, they will be more likely to increase it to $1,333,333 in order to keep their 10% margin.

The effect of the wage increase will vary by industry and situation. In situations where there is room to trim staff, jobs will start to disappear. When that isn't an option, prices will increase. In industries where labor is a large part of their operating expenses (fast food, service industry) will likely see the largest price increases, depending on how inelastic their demand is. Industries like retail, where cost of goods sold is the principle cost driver, will see less change. Either way, the overall price for goods will increase and jobs will decrease, adding more strain on the economy.

Going back to our example of raising minimum wage from $7.25 to $10 per hour (38 percent increase), let's conservatively estimate that the increase in wages will result in 10 percent of jobs being cut and prices in those industries increasing by 5%. Assuming half of those price increases are factored into to the FPL along with a 2 percent inflation rate, our FPL of $20,090 for a household of three has now increased by 4.5 percent to $20,994, $194 above the full-time wages of somebody making $10 per hour. So now, not only is that family still technically below the poverty line, but we've eliminated the incomes of 10 percent of the people who were already struggling make ends meet.

Effects Aren't Limited to Minimum Wage Workers

There is another group of people all too familiar with struggle who are hurt by an increased minimum wage. Small business owners already have a tough enough time trying to generate enough business while competing with chains and national brands. An increased wage rate could be crippling to many of them.

According to research published by the Small Business Administration, about half of all small businesses fold within five years, and only about one-third make it 10 years or more. Many of these businesses already rely on thin work forces paying low wages. Even the smallest increase in operating costs can send small business into a tailspin. Combine this with the fact that many of these businesses are financed with life savings and loans and you've got several thousand additional households on the brink of being impoverished.

What Should Happen?

Pop quiz hotshot! You are charged with developing a solution for the minimum wage issue. WHAT. DO. YOU. DO?

First off, lets deal with the white elephant in the room. Minimum wage occupations, by and large, are not meant to be primary sources of income. They usually involve no technical skill and are typically used by those already being supported who want some discretionary income (students, spouses, etc). At the very most, they're a way to minimize financial damage in between jobs. By focusing on minimum wage as a way to lower the poverty rate we neglect the larger problem at hand: the education and skills of those in the work force.

The only realistic way to reduce the poverty rate is to make our work force more valuable, whether through technical training or better/higher education. The latter option becomes a less likely option each year as the cost of attending college continues to spiral out of control. There could be ways to implement new scholarships and grants for those who really need them, but the cost is too prohibitive to have a broad reach and finding acceptable ways to fund and select the scholarships could be troublesome. Technical training provides a quick, effective way of providing skills to employees, but time and willingness could be a problem if the person is already working full time.

In my opinion, the best option is to provide technical training early. High school is already filled with too many "filler" classes that provide little value to the student outside of another credit to be used for graduation. Remove these classes and start adding (or even requiring) technical training classes like auto mechanics, construction/shop, CNA prep, etc. Give the students skills they can use to find a decent job without needing a college education. Some may go on to get a quality college education in something completely unrelated, but for those who don't, it could provide the means to life a quality life.

The big issue comes with funding these new classes. It's no secret that the public education system is already severely underfunded in our country; trying to add more expensive classes to the schedule would seem like a non-starter. However, using companies or industries that either abuse minimum wage or would benefit from the increased labor pool as a source of funding could be an option.

One option is to institute a separate payroll tax on any hourly wages that are within a certain range of the federal minimum wage that would go to this fund. For example, any wages that are below $8.00 per hour would occur an additional payroll tax of 1.5% by the employer. It may not seem like a lot, but if ten billion dollars in wages are taxed, that's an additional $150 million to fund the school programs.

Another option would be to get funding from national labor unions whose trades would be taught in schools. After all, unions need members to survive, and more members means more money. This likely wouldn't lead to a lot of funding, but could help in other ways. Aside from gaining some funding, whether it be from the local or international unions, programs for volunteering and assisting the programs could be implemented to improve the quality of the classes.

Minimum Wage

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Unfortunately, neither of these options are likely ever going to be proposed. Instead of instilling skills that would lead to financially-stable employment, we would rather boost the pay for jobs that are intended to be used by high school students or as a stop-gap. We are trying to increase the worth of certain occupations by force, rather than demand. And when this happens in a society run by capitalism, it ultimately ends up hurting those who it was trying to help.


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