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The economics of the minimum wage.

THE ECONOMICS OF THE MINIMUM WAGE

The Fair Labor Standards Act of 1938 established a minimum wage of twenty-five cents per hour and covered approximately forty-four percent of the work force. Since that time the act has been amended eight times, each amendment increasing the nominal minimum wage and also usually increasing coverage. By the late 1980's the minimum wage was at $3.35 per hour and covered over 90% of the nation's nonsupervisory workers.(1)

As indicated in Figure I, in real terms the minimum wage is currently at the lowest level in over 30 years, triggering demands for another increase, as it is commonly believed that such a policy will improve the lot of the poor. This spring President Bush vetoed legislation which would have increased the legal minimum to $4.55 per hour by October of 1991. The issue is not dead, however, and some Washington watchers expect a new bill to be introduced by early next year.

Most economists have very little inclination for minimum wage increases, as their discipline rather strongly suggests that direct interference with wages and/or prices usually hinders economic efficiency. This could only be justified by gains elsewhere, such as improvements in the distribution of income. But adjusting the distribution of income so as to help the poor is difficult, and trying to do so through the minimum wage has several disadvantages. For example, raising the minimum wage may decrease employment of unskilled workers,(2) reducing the national income as well as making it harder for the unskilled to move into the economic mainstream. Common sense suggests, too, that raising the incomes of the poor is more complex than passing a law requiring that wages be increased. If that were true it would be a simple matter to make everyone extremely wealthy by requiring that everyone be paid (say) $100 per hour.

The economic analysis of the minimum wage question hasn't changed appreciably throughout the entire half century of debate. Economists don't debate the minimum wage much among themselves, and to them the continuing debate by others reflects not the limitation of economic science, severe as that is, but rather indicates that what is known is comprehended by so few, and is so poorly used.(3) While I suppose one's ambition should have limits, this article is presented in the hope of improving public comprehension and use of elementary economic principles in this question of public policy. Part I describes some elementary economic theory as applied to the minimum wage, and Part II reviews some empirical evidence on the employment question as well as on the impact of the minimum wage on the poor. The article closes with a brief summary. Since this is an essay which purports to describe rather than develop principles, proofs are omitted.

Part I. The Minimum Wage and Competitive Labor Markets(4)

Economic analysis suggests that wage rates, like other prices, are determined by the interaction of buyers and sellers. If buyers wish to purchase more than sellers want to sell, buyers will offer a higher price in the scramble to acquire what they want. Price increases stop only when the price is high enough so that buyers wish to purchase only that amount which is available. In like manner, if there is a surfeit of labor, the wage rate will fall until the amount that firms wish to buy is equal to that which is offered. Such elementary common sense notions are what lie behind supply and demand analysis, but the ability to use these concepts properly usually requires a great deal of practice, as the analysis is more subtle than the simple ideas which underlie the concepts would suggest. To help avoid some of the worst errors it is probably worthwhile to define supply and demand curves somewhat more precisely, and to work through some of the direct implications of a legal minimum wage.

Formal analysis predicts, and empirical evidence confirms, that employers wish to hire more labor as the wage rate decreases. It is this relationship between the wage rate and quantity of labor that is called the demand for labor. In Figure II, it is seen that if the wage rate is [W.sub.m] the amount of labor firms wish to hire is [L.sub.d] , while if the wage is lowered to [W.sub.o], firms will wish to hire [L.sub.o] . Connecting these points with a line depicts a portion of the demand curve graphically. Since this curve slopes down as we move to the right on the graph, economists say the demand curve "slopes down and to the right."

The supply curve of (unskilled) labor shows how much providers wish to sell at various wage rates. If the price of unskilled labor rises, the amount of it offered for sale increases too, as is the case with almost all commodities. This is to say that the supply curve "slopes up and to the right." Analytical ease is sometimes facilitated by fixing the total supply of labor at a given amount, and in such cases the supply curve is drawn as a vertical line, as in Figure II.

Economists say that a market is "cleared" or is in "equilibrium" when the amount buyers wish to buy is the same as the amount sellers wish to sell. The demand curve shows how much buyers wish to buy, and the supply curve shows how much sellers wish to sell, so the market clears where supply and demand curves intersect each other. This occurs, in Figure II, at wage rate [W.sub.o] and hence [W.sub.o] is called the market clearing wage. Clearly, imposing a legal minimum at [W.sub.m] results in people wishing to buy a smaller quantity than is offered for sale. But use of the mechanism by which the market will clear, i.e., a lowered wage rate, is now illegal. Hence employment is reduced and disequilibrium persists.

If the coverage of the minimum wage is incomplete, then the result of increasing the minimum wage is not necessarily increased unemployment. For this analysis, we divide the economy into two sectors, only one of which is covered by the minimum wage. If, in Figure III, the minimum legal wage is [W.sub.m] employment in the covered sector will be reduced by [L.sub.mo] - [L.sub.m1]. Displaced workers either drop out of the work force entirely, or they find work in the uncovered sector. The increased supply of workers in the uncovered sector reduces wages in that sector to [W.sub.u]. The increase in employment in the uncovered sector will be less than the reduction elsewhere, as some of the displaced workers leave the work force, as indicated in panel c of Figure III by the shift in the supply of labor from [L.sub.o] to [L.sub.1]. There is no perceived unemployment, but it is clear that at least part of the income gains due to the minimum wage is at the expense of other unskilled workers, some of whom are no longer employed as a result of leaving the work force, and some who receive lower wages than they would if there were no minimum.

The above principles are derived through partial equilibrium analysis, by which we look only at markets affected directly. Clearly, however, when prices and quantities in one market are affected, other markets will be affected as well. General equilibrium analysis takes into account the effect of the minimum wage in all markets. While for our purposes almost all features of interest can be deduced from partial equilibrium analysis, general equilibrium considerations are important for determining the impact of the minimum wage on the distribution of real income. Of especial interest is the impact of the minimum wage on prices of final goods and services purchased by the poor. This analysis is necessarily quite complex, so suffice it to say that general equilibrium analysis suggests that prices of final goods and services will increase, but by an amount less than proportional to the increase in the minimum wage.

II. Empirical Evidence

This brief description of economic principles as applied to the minimum wage suggests that empirical evidence be gathered with respect to 1) the extent of reduced employment occasioned by increases in the minimum wage, and 2) the impact of the minimum wage on the personal distribution of income. Before turning to these matters, however, it is worthwhile to take a brief look at a commonly made mistake.

The prediction of reduced employment of unskilled workers if minimum wages are increased is not to be refuted by simple minded observation of what happens to employment following a minimum wage increase, as the impact of increasing the minimum wage must be isolated from other things which may influence employment levels, such as the business cycle. It is astounding how often this simple point is missed. For example, some combatants in the minimum wage struggle have argued that "only once in the eight times Congress has increased the minimum wage over the past fifty years has employment dropped, and that drop was the result of the 1974-75 recession and not the wage freeze."(5) Again, "Eleven of our states have higher minimum wage rates than our current (national) one, and in those states, unemployment is lower than it is nationally."(6) Such crude observations tell us absolutely nothing about the employment effects of the minimum wage, as straight thinking tells us that if we are to observe the impact of the minimum wage on employment all other influences on employment must be held constant. What is important is to compare what employment is with what it would have been had there been no increase in the minimum wage.

A. Empirical Studies: The Employment Question

Since it is to be expected that any employment effects of the minimum wage will be felt by the unskilled, most empirical studies have concentrated on teenagers, who hold about one-third of all minimum wage jobs.(7) Comparing the prediction of economic theory with real world facts is usually best accomplished through a statistical technique known as multiple regression. This technique organizes data in such a way that relationships between, for example, wage rates and employment, can be examined rigorously. There have been over two dozen regressions based on time series data which have appeared in the economics literature.(8) A typical study will attempt to determine whether there is a correlation between the percentage of teenagers employed, and 1) a minimum wage variable, 2) an indicator of aggregate economic conditions (like the unemployment rate for males aged 20 and above), 3) perhaps a time trend, and 4) other variables such as the proportion of youth in the armed forces. The minimum wage variable is usually defined so as to include the extent of coverage, e.g., the ratio of the minimum wage to the average manufacturing wage weighted by the proportion of workers covered.

These studies are virtually unanimous in supporting the proposition that increasing the minimum wage will decrease teenage employment. There is some variance with respect to the magnitude of the employment reduction, but most studies indicate that a 10 percent increase in the minimum wage results in a one to three percent reduction in teenage employment.(9) Increasing the minimum wage from $3.35 to the recently proposed $4.55, a thirty-six percent increase, would thus decrease teenage employment by between 3.6 and 10.8 percent. With approximately 5.7 million teenagers working, that translates into a reduction in employment of between 200,000 and 615,000 teenaged workers. Because of the phenomenon of dropping out of the labor force, unemployment increases will be somewhat smaller.

A cautionary note is perhaps wise. It is common knowledge that teenage unemployment rates are very high, in the 20 percent range for whites and about double that for blacks. While the minimum wage rate undoubtedly contributes to this, it also is clear that one should look elsewhere to find the major cause of this high level of teenage unemployment. This is so because while changing the minimum wage does affect employment, the effect is not so dramatic that this by itself will explain the high unemployment rate. This is consistent with the casual observation that the reduction in the real minimum wage since 1981 does not appear to have been very successful in reducing teenage unemployment.

B. Empirical Studies: The Minimum Wage and the Poor

The relation between the minimum wage and the distribution of income is much less tight than is generally supposed.(10) There are two major reasons for this. First, most minimum wage workers are not in low income families. In 1985, about 70 percent of minimum wage workers were in families with incomes above 150% of the poverty line.(11) Table I shows earlier data which indicates that in the mid 1970's individuals earning the minimum wage or less were spread quite evenly across the income deciles, which again suggests that by far the greater portion of minimum wage workers are in nonpoor families, and often are second or even third workers in a family. Second, many of the poor are in families which have only a marginal attachment to the work force. For example, there were no workers in forty-one percent of the 7.6 million families in poverty in 1983.(12) Consistent with these observations is the fact that a small proportion of total household income in any decile comes from low wage workers, as shown in the final column of Table I. [Tabular Data Omitted]

The impact of increasing the minimum wage on the real incomes of the poor was rigorously examined by Johnson and Browning.(13) The gains and losses which would have occurred in 1976 had the minimum wage been increased to $2.80 from $2.30, a 22 percent increase, were simulated. A brief description of the benefits and costs is given in the paragraphs below.

Direct benefits are relatively easy to identify, as they accrue to individuals who remain employed at the higher wage. The cost of increasing the minimum wage is more difficult to identify and place in the income distribution. Of course the immediate cost is borne by employers of unskilled labor, who experience an increase in production cost and a reduction in profits. In the longer term less unskilled labor will be hired, as it will tend to be replaced by skilled labor and capital, with consequent changes in the price of these inputs. However, such replacements cannot reduce costs to their former level, and so prices of final products will be increased.

It is important to realize that raising the minimum wage creates no new income.(14) In fact, if employment is reduced there is a reduction in national income, as the country has less output. Hence, gains made by any individual or group in the country must come at the expense of someone else. While difficult to determine precisely, general equilibrium considerations suggest that the burdens of the minimum wage are borne proportionately to income. This is precisely the case insofar as the increase in the minimum wage is reflected in higher prices for final goods. Under this assumption the net gains by income class under various demand elasticities are given in Table II.

Table : Table II Net Gains by Income Class, After Marginal Tax (Millions of Dollars)
Income Net Gains of Income Class when Percent of
Decile Elasticity is: Households
 0.0 0.2 0.5 that gain*
 1 $206.2 $156.9 $82.8 15.5
 2 200.6 145.9 63.7 14.6
 3 173.7 117.2 32.7 13.9
 4 138.0 79.4 -8.4 13.0
 5 103.8 42.6 -49.8 14.2
 6 43.6 -15.2 -103.4 13.9
 7 -29.2 -86.6 -172.7 12.4
 8 -82.6 -141.2 -229.0 13.2
 9 -189.6 -241.1 -318.3 12.4
 10 -516.7 -556.2 -615.5 11.2
Total +47.8 -498.3 -1317.8 13.4


Change in

Tax Revenue -47.8 -466.1 -1175.0

Reduction in

Nat'l Income 0.0 964.4 2492.8

Source: Johnson and Browning, op. cit. Table 4, p. 210. *For the zero elasticity case only.

Clearly, there is some net transfer of income to those in the lower deciles of the income distribution. However, the gain is quite small, as in no case is the net gain more than 2 percent of initial disposable income in the decile.

Johnson and Browning also point out that the effect within deciles is important. The last column in Table II shows the proportion of households that gain from the policy. For example, in the lowest decile, only 15.5 percent gain, while the remaining 84.5 percent lose. This is because most of the poor are not in the labor force, and as a result share in the cost of the minimum wage policy, but do not participate in the gains.

Finally, it should be observed that if there are disemployment effects we can get some measure of the inefficiency of the minimum wage policy. If the elasticity of demand for labor is zero, there are no measured costs of inefficiency, but under the most realistic measure of the elasticity, i.e., about .2, the inefficiencies are substantial. Ignoring the reduction in aggregate tax revenues, for every dollar in cost borne by people in the upper half of the income distribution, the poor benefit only to the extent of 52 cents.(15) And even this 52 cents overstates the benefits insofar as the reduction in tax revenues reduces the flow of government services to the poor.

CONCLUSION

This article has described the economic analysis of the minimum wage, pointing out that a legal minimum above the market clearing wage will reduce employment, especially of teenagers and other unskilled workers, and will also reduce the national income. Increasing the minimum wage also results in very limited improvement in the incomes of the poor, as most minimum wage workers are in nonpoor families, and many poor families have no workers at all. This implies, of course, that raising the minimum wage is an inefficient way to help the poor. Such inefficiency is illustrated by estimates which indicate only 52 cents in benefit for every dollar of cost.

It should go without saying, of course, that the above analysis and information is not conclusive with respect to the desirability of increasing the minimum wage. Some individuals may believe that a 52 cent benefit per dollar of cost is enough to justify the policy. Each individual must decide this for himself, as economic analysis can only indicate what the benefits and costs of a policy are, not whether the policy is, in the final analysis, wise. (1) Originally limited to workers directly engaged in interstate commerce, minimum wage coverage has expanded to include all but executive, administrative, and professional people, the self employed, and employees in firms with less than $362,500 in sales (Wall St. Journal, April 13, 1989). (2) Ninety percent of economists agree, with some provisions that minimum wages increase unemployment among young and unskilled workers. See J.R. Kearl, Clayne L. Pope,

Gordon C. Whiting, and Larry T. Wimmer, "A Confusion of Economists," American Economic Review, 69 (May 1979): 28-37. (3) A despairing economist once lamented that he sometimes thought that only economists, and not all of them, understood market processes. (4) Standard textbook expositions include discussions of noncompetitive labor markets, but available empirical evidence better supports the competitive model. Hence the discussion of noncompetitive markets is omitted. (5) WSJ, March 24, 1989. (6) Ibid. (7) Ralph E. Smith and Bruce Vavrichek, "The Minimum Wage: Its Relation to Incomes and Poverty." Monthly Labor Review, June, 1987. p. 29. (8) The best is still Charles Brown, Curtis Gilroy and Andrew Kohen, "The Effect of Minimum Wages on Employment and Unemployment," Journal of Economic Literature, June, 1982, XX #2. P. 487-528. A less detailed but more recent corroborative work is Charles Brown, "Minimum Wage Laws: Are They Overrated? Journal of Economic Perspectiaves, Vol. 2, #2, Summer 1988. pp. 133-145. (9) The ratio of the percentage change in employment to the percentage change in the wage rate is known as the elasticity of demand for labor. In this case this elasticity is between -.1 and -.3. (10) The first good study to get a handle on this was Edward M. Gramlich, "Impact of Minimum Wages on Other Wages, Employment, and Family Incomes," Brookings Papers on Economic Activity, 2, 1976, pp. 409-451. (11)See Ralph E. Smith and Bruce Vavrichek, "The Minimum Wage: Its Relation to Incomes and Poverty," Monthly Labor Review, June, 1987. p. 27. (12) "Characteristics of the Population Below the Poverty Level: 1983," Current Population Reports, Series P-60, No. 147, Table 25, p. 99. (13) William R. Johnson and Edgar K. Browning, "The Distributional and Efficiency Effects of Increasing the Minimum Wage: A Simulation," American Economic Review, March, 1983. pp. 204-211. (14) A few economists have argued that the minimum wage can produce a "shock" effect, whereby employers react to the minimum wage in such a way to increase productivity. There are good reasons why this probably doesn't happen, See Donald Mcloseky The Applied Theory of Price, 2nd ed., 1985 (Macmillan, New York), p. 455. (15) The sum of the net benefits in the lower half of the income distribution is $542 million, while the sum of the costs in the upper half is $1040.3 million. Dividing one by the other yields the 52 cents.

PHOTO : Figure I Minimum Wage in Current and Constant (1988) Dollars, 1939-1988

PHOTO : Figure II Supply and Demand for Labor

PHOTO : Figure III Employment Impact of Minimum Wage
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Author:Johnson, Dennis
Publication:South Dakota Business Review
Date:Sep 1, 1989
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