In certain circumstances, a minimum-wage law can make an economy more efficient. In other words, the economy can produce more goods and services to meet people’s needs from the same amounts of labor, capital and natural resources. That is why, on balance, I support the recent increase in Minnesota’s minimum wage, though I think indexing it to inflation is a mistake. I also support a modest increase in the federal minimum, though certainly not to the $15 or $18 levels called for by some.
I write this because a reader challenged my assertion that a higher minimum could, on balance, be beneficial for society as a whole. He argued such laws were “feel-good” legislation that would reduce employment and, among several other things, lead landlords to raise rents, thus wiping out any gains by minimum wage recipients. His challenge deserves a response.
Let me note at the outset that the discipline of economics is divided on the issue of minimum wages. This is in contrast to near-unanimity on benefits of international trade or the superiority of emissions taxes as a pollution control measure. The simplest economic theory predicts that a minimum wage will reduce the number of people employed and hurt efficiency. Some economists, even a few on the U.S. political left, oppose minimum wages or an increase from current levels for this reason.
However, there is much real-world research showing that a minimum wage, in the inflation-adjusted levels that have prevailed in the U.S. over the past half century, has little or no effect on employment. I think it’s safe to say that most economists agree with that. But most also see the minimum wage as a very crude instrument for reducing poverty and increases in it as virtually useless for spurring a sluggish economy. I agree with this.
(To see the range of responses of a panel of distinguished economists to two specific questions about the wage, go to http://goo.gl/knZCs8 or enter “IGM Forum” and “minimum wage” into a search engine.)
So what about my argument that a minimum can increase economic efficiency? And what about the counter argument, illustrated in nearly every textbook on the principles of microeconomics, showing efficiency losses from a minimum wage?
Who’s right?
These books generally argue that, if several conditions are met, an unregulated free market can allocate resources more efficiently than any alternative. Government intervention will make society worse off. I and most other economists think that is true.
But the key issue is whether the necessary conditions exist. These, listed in the same economics texts, include the need for many buyers and many sellers — so many that no single one has any ability to affect market prices. Also, everyone involved must have perfect information about all relevant factors. The good in question being sold must be a uniform resource or product. There must be no barriers to entry for the sellers and buyers involved. There must be no external effects either hurting or helping anyone other than the buyer and seller themselves.
If these conditions do not hold, then the conclusion that the outcome from supply and demand in a free market is optimal for society is not necessarily true. Obviously they don’t hold in most situations. Yet in many cases the outcome from a free market still is pretty good, both in terms of economic efficiency and fairness. But not always.
In labor markets, virtually all the conditions for an efficient free market fail to exist. Thus it is not surprising that the outcome might be waste and economic inefficiency.
Consider an analogy of regulating monopolies, such as electric utilities. The primary reason we regulate electric rates is that voters think utilities would charge unfairly high prices if not limited by regulation. That may be true politically, but economists know that an uncontrolled monopoly is inherently economically inefficient. It wastes valuable resources that might benefit society.
In the sixth week or so of any introductory microeconomics course, students learn to analyze monopolies, or markets where there is just one seller of a necessary good or service, with a graph. It clearly shows that a profit-maximizing monopoly will choose to produce a smaller output than is optimal for society and charge a higher price. There clearly are “dead-weight losses” to society.
One response is to regulate utility prices. Government-approved electricity or gas rates are a very crude instrument for addressing the market failure of monopoly. But they are better than doing nothing, both in terms of fair treatment of consumers and, more important, in terms of efficient resource use.
Most students then learn the parallel situation of “monopsony.” This is like monopoly, but involves only one buyer (or in the case of labor, one employer) instead of only one seller. A monopsony employer hires a smaller number of workers and is able to pay a lower wage than would be the case in a free market where all the pre-conditions were true. Thus there is economic inefficiency, the same sort of dead weight losses, as with monopoly in selling. And there is the inequity of workers being paid less than their contribution to the economy.
Now there are few cases of pure monopsony, with just one employer in a labor market. But there are high degrees of monopsony power in some specific businesses or in some geographic sectors, particularly rural areas. Econ theory and history both show this leads to inefficiency — wasted resources — and a less productive society.
Nor is monopsony by employers the only market failure. There is imperfect information and it is asymmetric, with employers often having more relevant information than job seekers. Bargaining power often is starkly unequal. There are external costs of benefits in some situations. And while the outcomes of these lapses from the ideal of perfect competition are not easy to show graphically the way monopsonistic or monopolistic power is, they generally work to the advantage of employers and help make labor markets both inefficient and unfair.
Just as limits on utility rates are a crude, but useful tool to deal with monopoly, a minimum wage can be a crude but useful tool to deal with monopsonistic power and other failures in labor markets. The outcome is far from perfect, but a minimum wage can result in an economy that uses resources more efficiently and is more fair.
But minimum wage levels must be set judiciously. Just as an electricity rate capped much lower than the cost of production would cause economic harm, so would a minimum wage set at too high a level.
But the minimum wages we historically have had, both in Minnesota and at the federal level, have not been far from what would prevail in a free market freed of the market failures listed. There are real costs, but the benefits outweigh the costs.
Partisans on both sides overestimate the importance of the minimum wage. It is a poor anti-poverty tool. And increases in it don’t change consumer spending enough to have a measurable effect on overall demand.
Similarly, while it may increase unemployment for a few specific groups, its overall effect on the number of jobs is small indeed. And the idea that an increase will be immediately gobbled up by merchants and landlords raising prices in response is simply preposterous. I know of no serious economist who bothers to make that assertion, even among those who oppose minimum wages more generally.