Don't Raise the Minimum Wage, Eliminate it Altogether

Mainstream political party platform topics like abortion, immigration, and the minimum wage get a renewed focus every four years. The 2016 primary season is no exception with each commanding a great deal of media attention; although illegal immigration and the US accepting refugees from the Middle East are higher priority topics with voters, wage rates and the minimum wage is being leveraged handily. With several states already passing legislation to raise the minimum wage to $15/hour over the next several years, walkouts by fast-food workers, and a steady stream of narrative coming from the media on related topics such as the wage disparity between men and women, the nation is acutely aware of the coming changes. Many of these policies are being initiated based on emotion rather than on fact. The vision of the CEO’s and business owners as despicable self-appointed kings that sit high atop their corporate towers living the good life while the workers below live in poverty or some variant of that approach is quite common. Reactionary politicians seeking to gain voter favor for themselves and their Party rush legislation through their states, calling it historic and important. Yet, an outside observer like me sees this shotgun approach as troubling and economically unsound. Like so many other government programs, the laws of economics are ignored in the planning process.

In order to understand the skepticism of raising the minimum wage or even having a minimum wage, it’s necessary to review economic principles. Voters should understand the basis operating premise for a business, how that business determines its demand for labor, how the overall national labor market works, and how supply and demand for workers is related. Under the capitalistic system, markets are considered free, workers are considered mobile, and production and decisions around production are driven by market forces. These assumptions are not applicable for every single business, but generally describe the US working environment. For those new to economic theory discussions, I’ll explain some of the terminology. Also, one of the key visual aids of any economic discussion is a graph, actually many graphs, as they allow us to see how changes in one part of the economy affect to other parts. We also can see the balance points or what economists called equilibrium points. We’ll begin by looking at basic terminology, then look at individual firms, and finally the overall market.

Wages are compensation that workers receive for their labor in the form of salaries, bonuses, profit sharing, royalties, commissions, and a basket of fringe benefits, such as paid vacations, health insurance, and 401K match. The wage rate is the price per unit of labor; in America most workers are paid by the hour or paid salary. Since the focus of this piece looks at the minimum wage, the hourly rate of compensation will be used for the rest of the discussion. Wages can be viewed in two different ways, the real wage and the nominal wage. The nominal wage is the actual amount of earnings paid to an employee for work. The real wage is the amount earned in terms of dollars based on what it can actually buy. If a gallon of gasoline costs $3.00, we can say that the real wage value of $1.00 is approximately 1/3 gallon of fuel. Yet in inflationary times, when the cost of goods and services are rising, the value of the real wage decreases. For example, when the price of automobile fuel rose to $4.00 per gallon from $3.00 per gallon but wages stayed steady, the value of a dollar earned in terms of how much gasoline it could buy would decrease. The real wage value of $1.00 would be 1/4 gallon of fuel. This concept is important to understand and will be used further in the discussion. Inflation is defined as a sustained increase in the general overall level of prices for goods and services. As inflation rises, every dollar you own buys a smaller percentage of a good or service.

A business that produces products or services has two sides of their general ledger, the cost side and the revenue side. Costs can further be broken down into fixed costs and variable costs. A fixed cost is something that is independent of output, such as the rent or mortgage payment on the building or the expense from buying a machine. Even if the plant or business is closed, fixed costs will accrue at the same level. Variable costs are costs that vary with production and include wages, utilities, and raw materials used for the production process. Some variable costs may be referred to as mixed costs because they are partially fixed and partially variable, such as electricity. For most businesses, the amounts are minimal and those costs are treated as variable. Revenue is the amount of money a company receives during a fixed period from the sales of their goods or services. Revenue can be calculated quite easily by multiplying the number of items sold by the price they were sold for. In many companies, the term sales, means revenue. There are more complex formulas that larger companies use to calculate revenue that combine different income streams, credit sales, and other items. For this discussion, we’ll use the simple revenue calculation.

Another assumption we will be using is the fact that business owners will attempt to earn the maximum possible profit out of their business. In fact, in a highly competitive market, the only hope a business has to survive is to maximize earnings, and control costs efficiently. Earnings or profit is the difference between total revenue and total expense. Total Revenue includes revenue as defined earlier plus any investment or other sources of income the company has. Total expense is the sum of fixed costs, variable costs, insurance, taxes, and any other cost necessary to keep the company running. If the costs outweigh the revenue, then the company shows a loss, if it’s the opposite, they show a profit. There is a somewhat more complex definition of profit that Economists use. It’s the difference between total revenue and total opportunity cost. Total revenue has been previously defined while total opportunity cost is total expense, plus the value of the highest-valued alternatives to which resources could be applied to. For example, if a company has $50,000 in available cash to use for investment into its production process but could also use the same cash as an investment that returned 3% interest, there would be an opportunity cost. The opportunity cost is the loss of potential gain from using one alternative while another is available. To calculate it for this example, take the $50,000.00 X .03 = $1500. The $1500 is the opportunity cost of upgrading the plant instead of investing the money. In a profit maximizing company, this type of analysis steers spending. In our example, if the investment in the plant upgrades reduces overall costs by more than the opportunity cost of the investment, the plant gets updated as it will yield a greater overall profit for the business.

This basic review of wages, profits, and expenses will be incorporated into our analysis of how companies determine their demand for labor. The overall labor market for this example will be the entire nation. A simple definition of the labor market is the existing market where worker find employment, employers find potential employees, and wage rates are determined. Labor force participation or labor force participation rate is the number or percentage of people who are either employed or looking for employment. Any person not working or looking for work is not included in these figures. In times of extended recession, many discouraged people stop looking for work altogether. People leaving the workforce produce a skewed overall unemployment figure. Because the unemployment rate is often used as a political tool, it’s key for anyone doing a realistic analysis of the labor market to understand how it’s calculated. The unemployment rate is a measure of the percentage of people who are not able to find employment yet are still looking divided by the number of all individuals currently in the labor force.

A lack of employment opportunities is a big reason for people choosing to leave the labor force. The leading reason for labor force participation is the prevailing wage rate. When wages are high, more people want to work, thus increasing the supply of labor and when wages are low, people exit the workforce, reducing the supply of labor. In non-recessionary times this can be looked at by comparing work and leisure. Using an example of a semi-retired person as a test subject we can surmise that leisure time is optimal, thus retirement, but if wages increased enough the person might be tempted to rejoins he work force. The value of leisure reaches a point when it becomes lower than the value of wages which prompts the switch. Understand that just because wages are high does not guarantee employment. What it does do however is gives consumers of labor, or employers, a larger pool of candidates to select from to fill vacancies. With our basis understanding of labor force participation we’ll now look at how wage rates are determined understanding the key finding that individual companies do not set the wage rate; it is driven by the market.

The market is an aggregate of all companies within a given industry. Wage rates within an industry often differ due to geographic differences, such as in California versus Kansas. Other reasons could be regulatory in nature, such as requiring individuals working in a field to be certified or licensed. The market is considered to be perfectly competitive meaning there are many businesses operating offering similar jobs that require similar skill-sets. When we use the model of supply and demand to analyze the market, the rationale will become clear. The equilibrium wage rate is determined as being at the meeting point of the industry supply and industry demand curves. As we noted earlier, the labor force is constantly changing due to entry and exit which unless there was a huge change would not move the curves. Based on the previous points we‘ve established, we can create a graph. The graph below depicts the labor market. Supply (S) is the number of available workers (which rises as the wage rate climbs) while Demand (D) is the need for workers (which decreases as participation rates grow.) These two groups are plotted with wages (W) being the vertical axis, and Quantity being the horizontal axis. The intersection point or equilibrium point is the Market Wage (W1) and the amount of labor required to satisfy the market is the prevailing employment level (Q1 in this example.) There are going to be higher wages and lower wages paid in any market but the equilibrium wage rate, there are not labor shortages or labor surpluses; unemployment in a non-recessionary economy at this point is voluntary (the value of leisure becomes greater.) This does not mean that there is full employment as there are always going to be transitional employees which are collectively referred to as frictional unemployed.

Individual companies determine their demand for labor based on the prevailing market wage which we’ve just analyzed. In reviewing how a company produces their source of revenue and how their revenue is impacted by additions or subtractions to their individual work force will demonstrate their labor demand. In our earlier definition of a competitive market, we’ve outlined the fact that all things across the workforce are equal. As firms hire more workers, they see an increased output in production.

The amount of production added by the addition of one new worker is called the Marginal Physical Product (MPP.) The addition of new workers could increase average production initially, but eventually adding more and more workers would add less and less incremental production. This is known as the Law of Diminishing Returns. This law states that in a production process, as one input variable is increased, in this piece labor is the variable, there will be a point at which the marginal per unit output will start to decrease, as long as all other factors are constant.

Those new workers will also add cost to the production process in the form of wages, but by calculating the revenue made from the total produced product minus the total (now elevated) costs, the company can establish their total revenue. By doing calculations at multiple levels the company can see exactly how much additional revenue every worker adds; the value of this is called the Marginal Revenue Product (MRP.) The extra revenue added is a key part of understanding how the balance between profits and wages emerges. Since we’ve already determined the importance of profits there is no need to redefine it here. If we consider a fictional company that produces glass jars, assume that all costs are fixed except labor and that there is an established market price for selling glass jars. The market rate for glass jars is $10.00 each (yes, the glass jar business is very good in my made up world.) As we can see, the first worker makes 20 jars but by adding a second worker, they together make 22 jars demonstrating an increase in productivity. Yet, after more workers are hired, productivity decreases as each worker is added. Some possible reasons could be overcrowding on the production floor, the shape of production lines, and the speed of getting raw materials to feed the larger workforce, or perhaps something different. Regardless of the reason, the MRP is declining.

The Marginal Revenue Product also equates to what wage rate the company would be willing to pay for each additional worker. The actual wage it pays is the market rate, which we’ve previously demonstrated. The company is called a wage-taker; it takes the market wage as given. The market wage rate in a perfectly competitive labor market represents the company’s marginal cost of labor (MCL) or the amount the firm must pay for each additional worker that it hires. In order to maximize profits, the company can identify the right number of employees to employ and the right wage to pay them by some quick analysis based on the terminology we’ve just reviewed. The goal is to hire workers up to the point where marginal revenue product of the last worker hired is equal to the market wage rate, which is also the marginal cost of this last worker. To further demonstrate this, we’ll use the same fictional glass jar company and we’ll assume that the wage rate of bottle makers is $130.00 per day.

Using another graph to demonstrate this, the company will employ workers up the point where the marginal revenue (MRP) equals the marginal cost of labor (MCL), which is the wage rate (W). At a wage rate of $130.00 per day, the glass jar company will employ 5 workers because at this level MRP=MCL. The plot of the chart we used is shown on the graph. We can see how the addition of the second worker caused the curve to rise, and then more workers saw it fall. The decline is not proportional as we can see by the rough shape of the curve. The intersection point of the market wage (W) and our curve establish the company’s demand for labor.

We’ve seen how the supply of labor was determined by wage rates and the trade-off between work and leisure time. We’ve seen how an individual firm determines their need for labor in a profit maximizing company. Our next step would be to add all of the individual firms demand for labor together to form a market demand curve for labor. Since we’ve previously determined that the firm is a price-taker, the market supply curve for labor is a horizontal line. The labor supply is said to be elastic, or that the curve, in this case a line, will not change based on the actions of any individual firm. There are thousands of people available for employment and except in times of full employment, companies usually have unlimited hiring options. The more substitutes available the more elastic something is considered.

Since wages are determined by the demand and supply of labor, then changes in either the demand or supply of labor will in turn affect wages. An increase in demand or a reduction in supply will raise wages; an increase in supply or a reduction in demand will lower them. The entire curve shifts with an aggregate change either up or down. The impact of any real shift will conversely impact the level of employment. Our first graph shown below demonstrates how when there is an increase in the demand for labor (shown by the green curve) both wages increase (W1 to W2) and employment rises (Q1 to Q2.) Conversely as shown in the next graph, if there is a decrease in the demand for labor both wages and employment decrease. A decrease in the labor supply reduces employment but increases wages as shown in the third graph and an increase in the supply of labor increases employment but lowers wages as shown in the fourth graph.

Over time, the United States has experienced a rising demand for labor. The entrepreneurial opportunities, the availabilty of capital and or credit, and the access to cutting edge technology have collectively allowed the American market to grow. Education and specialized training has increased the value of human capital in America also. Because our nation presents such opportunity, it attracts immigrants, both legal and illegal, who seek an opportunity at a better life. As more workers enter the labor market, overall wages still increase, but by a smaller increment. Certain labor markets are protected from the effects of a growing labor supply; highly skilled occupations such as engineers, doctors, and airline pilots or professions which require licensing or certifications such as pharmacists or accountants are safer. Labor Unions and their representatives band together to create a system that limits entry into their trades while still continuing to provide good service but at higher wages.

Economists refer to these parts of the labor market as skilled labor positions; all others are called unskilled positions. The terminology is in no way meant to be derogatory; it simply identifies the fact that many jobs do not require any previous education or training. Most unskilled labor positions are paid on an hourly rate rather than a salary and many of those positions are part time, therefore when we are examining the unskilled labor market, we’ll use hours of labor demanded and hourly wages. With a free market economy, there would be no difference in the labor demand and supply curves regardless of which metric we measured it in, all things being equal. Yet when we introduce the concept of minimum wage, there are different outcomes.

A digression from the economic analysis to review the history of the minimum wage may help the greater understanding of the concepts we are about to review. The minimum wage was instituted in America by President Franklin D. Roosevelt with the signing of the Fair Labor Standards Act of 1938 (FLSA.) With America emerging from the Great Depression, people were being exploited, working in terrible conditions for paltry wages. Prior to this, economists argued against a minimum wage based on the theories we have earlier reviewed as it restricted a citizen’s right to set a price for their own labor. Yet the huge national levels of unemployment during the depression drove paltry wages even lower and poverty was commonplace, the President vowed to protect workers as part of his 1936 re-election bid.

The President won re-election and made good on his promise to establish a mandatory national minimum wage of $0.25/hr. in order to maintain a minimum standard of living necessary for health, efficiency and general well-being. Needless to say that this new law was welcomed as a godsend by the working poor, but was violently opposed by employers who argued that a minimum wage could hurt their businesses. The actual lettering of the law does not say that the minimum wage should equate to a living wage, despite the original rationale. After surviving a challenge that went all the way to the Supreme Court, the minimum wage was firmly entrenched as part of the American labor market from that point forward. Its perceived value in 1938 was extraordinary, and was a key factor for the economy to get back on track. With income being reinjected into the economy, all sectors soon became healthier. However from an economic perspective, a minimum wage, or any other fixed wage acts as an artificial floor in the labor market and contributes to unemployment. Furthermore, raising the existing minimum wage has a ripple effect which will also review.

Recall that an individual company determines their demand for labor based on when MRP=MCL. But when a minimum wage is added (Wmin) we can see that the individual firm now demands less labor (Qmin.) The results are that people who may want to work at a market wage cannot get hired because the firm cannot add extra employee without hurting profitability. This new floor wage becomes the default market wage and the real wage is determined by the minimum wage divided by the price level, not by the interaction between labor supply and demand. The minimum wage succeeded in paying those who are working a higher wage while increasing unemployment and our market is no longer in equilibrium.

We can once again turn to our graphs to see how raising the minimum wage creates unemployment. The labor market already unbalanced, or not in equilibrium will only get worse. Our graph below shows the effect of the minimum wage on a free market, with an unemployment gap obvious due to the artificial price floor, however if we raise the minimum wage from Wmin to Wnew, the demand for labor falls even further and the unemployment gap gets wider. The pink arrows on the graph demonstrate how the unemployment gap widens. Many companies will be unable to hire enough workers while remaining profitable and will close.

If we assume that politicians continue to champion the minimum wage increase, despite it being an unsound approach economically, there are other factors that must be considered. The most important is the ripple effect, which can be explained by an example. An artificial shift in the minimum wage, even over time creates wage rate disparity within individual firms. Suppose a worker with two years of experience in a job was earning a dollar or two over minimum wage, but because of the political wage increase now would make the same as a brand new hire. So, in order to avoid an all-out uprising, employers are forced to increase the wages of all employees up the ladder. Another byproduct is that the better firms will post starting wages above the minimum wage to attract the better candidates. This across the board wage increase seems like it would be very positive for the bottom 20% of the workforce, increasing their standard of living and their level of disposable income. Economists who support wage equality have attempted to determine the positive ripple effect value, but nothing concrete has emerged. Business owners on the other hand see this ripple effect as a nearly unescapable conundrum. Small business owners are the most susceptible to this concern since they already work on thin profit margins. Nationally franchised restaurants run their operations with multiple profit centers, which can help sustain wage increases, but smaller owner-operator places cannot. They can either raise prices, which could drive their business away or they can close up shop. Since owners need to stay open to make a living, the only possible outcome in a net inflation of retail prices nationwide. Everything will simply shift from an economics standpoint and the economy will operate at similar, albeit higher levels.

Some industries have difficulty increasing prices as consumers will find substitutes. The restaurant industry is one of those segments. We’ve already seen multiple restaurants closing in cities where minimum wage increases have been initiated and it’s just the tip of the iceberg. Consumers will simply reduce out of the house eating frequency and opt for staying home. The same logic holds true with many other industries, such as car washes, entertainment such as movies, mini golf, sporting events. Many service industries not mentioned will also face similar challenges. The manufacturing market will also see more movement overseas to produce products with cheaper labor. The global market provides global substitutes which we can already see the impact of with much of our heavy industry leaving the confines of our borders to foreign lands.

The last topic for consideration is what role technology will play as a way for owners to reduce operating costs. Robotic or non-manned sites are already starting to emerge in some segments. Consider the Redbox DVD rental kiosk, the self-service fuel station, and the airport lounge where customers order via iPad – these are all examples of how a human workforce can be reduced. It would be easy enough to have a fast food restaurant where customers enter their own orders on a touchpad, or a fully automated carwash, or customer service handled by web-based technology. This option is no longer a wish, but could become a reality very soon and once it’s begun, there will be no going back.

Also as a sidebar, what does raising the minimum wage to a point where people with no education can make a living do for the overall health of America’s human capital? Colleges and trade schools will see reduced enrollments, education will lose it some of its value and instead of discussing a wage disparity in twenty years we’ll be discussing an education or intelligence disparity. When non-participants manipulate the economy, there are consequences. Politicians do not decide what’s best for the overall health of our nation and their meddling is on the brink of doing permanent damage to the best system left in the world. Unemployment will not be fixed with this practice. Prices will increase. The standard of living may appear to improve for the bottom wage owners in the short run, but as market forces adjust, and they will, those bottom wage earners will be right where they started but with higher wages and higher expenses. No productivity is added to the economy by this artificial wage increase, so no economic benefit will exist. The amount of taxes people pay will increase, the number of people on Federal assistance will stay the same or increase, and really the only winner will be the politicians who were re-elected because they promised voters something that they couldn’t actually produce.

The purpose of this rather lengthy piece was to bring sound economic theory into the debate on minimum wage. Of course, there are Economists that will think differently and make other assumptions or identify perceived social benefits as indicators of success or failure. It may surprise many readers to learn that then concept of minimum wage and its employment effect is the most studied economic principle in the field. It’s highly debatable and I expect some differing theories to be presented in contrast to what I’ve provided here. I’m quite positive about the discussions this topic will bring and welcome all different opinions. I’ve spent weeks putting this information together and I’ve presented it in a non-threatening way to anyone’s political leaning. This is not a theatrical sounding board to denigrate or inflate any candidate, but a real world discussion on real world facts, potential outcomes, and theories.

Ralph Schwartz

BA Economics, University of Pittsburgh

MBA Marketing, University of Wisconsin-Milwaukee