Wednesday, July 29, 2009

Can Higher Minimum Wages Increase Employment?

The debate over minimum wages, after having been more or less dead for quite some time, has again been revived to a limited extent after last week's increase in the federal minimum wage in America from $6.55 per hour to $7.25 per hour. This was the third and final 70 cent increase decided in 2007 when minimum wages was only $5.15 per hour.

Most people, and that includes me, thinks that minimum wages (unless they're so low that they will have no impact on anyone) will increase real wages for some low productive workers, but will also make other low productive workers unemployed. However, because the federal minimum wage was so low to begin with (and because many states had already imposed a higher minimum wage) it seems likely that both the wage increasing and the job destroying effect will be small.

However, as anyone who has studied neoclassical labor economics in Universities know (if they paid attention), there is actually a theoretical scenario where (allegedly) higher minimum wages can increase employment of low productive workers.

For those of you who haven't taken such courses, or didn't pay attention, I'll give a brief summary of the theory:

In a perfectly competitive market, any minimum wage above the marginal value of some worker's work effort will increase unemployment as employers will not find it profitable to hire these workers. However, if the market is not perfectly competitive and employers have a monopsonic market position then this supposedly changes.

Monopsony, in case you didn't know is like monopoly, only it is the buyer, and not the seller who has the advantage. In this context Monopsony is more strictly defined as an employer whose marginal cost of labor (the increase in labor costs caused by the decision to hire a worker or several workers ) is significantly above the direct labor cost (the amount of wages/salaries and benefits paid to the worker plus payroll taxes).

If the employer is in a perfectly competitive market, where the decision to hire or not will not affect wages, then the marginal cost of labor will be equal to the direct labor cost. But if the market is monopsonic, then a decision to hire more workers will have a higher marginal cost of labor than the direct labor cost of these additional workers. The reason for that is that if the company in order to attract more workers must pay them a higher wage than they paid their previous workers, then this will supposedly also force them to pay their previous workers more. As a result, the marginal cost of labor for these new workers will be higher than the wages and benefits that the new workers received.

To illustrate this with a numerical example, take a company with say 1,000 workers earning $5.75 per hours. Assume then that the company wants to hire 200 more workers but that this will require them to pay say $6.50 per hours. Assume further that the company would then have to pay the old 1,000 workers $6.50 per hours. Assume further that the extra value of these new workers would be $8 per hours.

If the minimum wage was say $5.15 per hour, then the additional workers would bring in $1,600 per hours while costing directly $1,300. But since the hiring of these new workers would also mean that the old workers would have to pay $750 extra, the company would lose $450 by hiring these workers.

But if the minimum wage was say $7.25 per hours, then the additional workers would still bring in $1,600 per hour while costing directly $1,450. However, since the cost of the old workers wouldn't increase in this scenario (The company needed to pay $6.50 per hour to attract the new workers and since the $7.25 pay would meet that requirement and since the old workers already earned that amount no need would exist to raise their pay).

So the conclusion is that with a $7.25 per hour minimum wage 200 more people would get a job than with a $5.15 per hour minimum wage.

When you first hear about it might seen like a sophisticated and also plausible theory. It is also correct-assuming two strict condititions:

1) That everyone at a company must receive basically equal pay.
2) That the decision to enter/leave a market is ignored.

The first condition seems very dubious to say the least. Most companies have individual wage/salary negotiations. If one worker is more productive and/or some other alternative job offer that other workers don't have, then it is likely that management will pay him more than others. Because workers often differ so much they are partially "monopolistic", canceling out the "monopsonistic" powers of the employers.

The second condition is simply outright false. But if the marginal product of workers is $8 an hour and their pay is $7.25 why would any entrepreneur want to leave the business or abstain from entering? Because business have a lot of other costs, you know like rent, interest, the cost of input goods etc. These fixed costs (from the point of view of hiring decisions) have to be covered by the gross profit earned from workers. With a $5.15 minimum wage, the gross profit is $2,250 per hour (($8.00-$5.75)*1,000). With a $7.25 minimum wage, the profit is only $900(($8,00-$7.25)*1,200). In all too many case this much lower gross profit will be too low to cover these fixed costs, putting these companies out of business.

So, I think we can clearly establish that the increase in minimum wage will destroy a great number of actual and potential businesses. Now many will wonder if it can be established whether this effect will be smaller or greater than the potential increase in employees in companies who will still have gross profits large enought to survive.

There are two reasons for believing that the job destroying effect will be larger. First of all because as noted above the monopsony assumption in determining wages is unrealistic. And secondly and more importantly because the effect of reduced gross profits will mean fewer suppliers, which directly or indirectly will raise prices which in turn will reduce demand for these products.


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