A bit out of order, this is another draft extract from my book-in-progress, Economics in Two Lessons. It’s part of the chapter on income distribution, meant to follow the section on unions, and precede the Australia-US data point and the discussion of corporate profits [links to CT, but all published here also]. After this, I plan to conclude the “predistribution” part of the chapter with a discussion of intellectual “property”, then move on to “redistribution” through taxation and public expenditure.
As always, encouragement is welcome, constructive criticism even more so.
Minimum wages and predistribution
The most direct way for government to influence the distribution of market income is to set minimum wages.
The effects of minimum wages on the distribution of income has been the subject of a vast economic literature. Much of this literature starts from a simple (or simplistic) version of Lesson 1. The starting point is the assumption that the price of labor (that is the wage) is the product of a competitive market of the kind we discussed in Chapter 2.
If this is correct, then a minimum wage involves setting a price above the opportunity cost of labor. This means that some workers who would be willing to work at a wage below the minimum will remain unemployed, while potential jobs which yield less production than is needed to cover the cost of a minimum wage worker will remain unfilled or will not be created at all.
Even within this framework, workers may benefit from an increased minimum wage. Suppose for example that the minimum wage is increased by 10 per cent, and that employers respond by reducing the hours of work, for all minimum wage workers, by 5 per cent. In this case, workers would get 5 per cent more total pay, and work 5 per cent fewer hours, gaining both more income and more leisure.
Economists working in this framework point to a number of reasons to doubt this favorable projection. First, the gain to the workers here is associated with a larger increase in cost to the employer. Not only does the employer pay more and get less, but as shown in Lesson 1
Second, typical estimates of the change in hours of work associated with a given change in wages (referred to as the elasticity of demand for labour) are derived for small changes in the wage. Larger proportional effects might arise with a large and rapid increase in the wage.
Third, the idea of a uniform reduction in hours of work for all minimum wage employees is clearly unrealistic. More likely, many workers will experience no change in their hours (getting the full benefit of the increase) while others will lose their jobs, or fail to find jobs when they enter the market.
The third of these points is the most important. However, far from strengthening the case for an analysis based on Lesson 1, it undermines it. Hours of work are not a commodity that can be supplied and demanded so as to match prices and opportunity costs. Rather, each worker is typically matched with one job which largely determines their living standards. With the allocation of property rights to employers that normally prevails in the US, referred to as ‘employment at will’, the job is the property of the employer who can withdraw it at any time, for any reason, or none. Donald Trump’s catchphrase, ‘You’re Fired’ is the simple and brutal expression of this reality.
Because of this imbalance of power, Lesson 2 is just as relevant to the determination of wages as Lesson 1. In the absence of offsetting institutions like unions and minimum wages the imbalance of bargaining power will ensure that most of the benefits of the bargain go to the employer.
(except where they have to patch two or three jobs together, almost invariably ending up with worse terms)
Approaches based solely on Lesson 1 dominated the economics literature until the early 1990s. The central concern of this literature was to estimate the elasticity of demand for minimum wage workers. The elasticity of demand is the ratio of the percentage change in hours worked a given percentage change in the minimum wage. In the example above, where minimum wage is increased by 10 per cent, and that employers respond by reducing the hours of work, for all minimum wage workers, by 5 per cent, the elasticity would be 0.5 (that is, 5/10).
Economists working in this approach expected to find a moderately elastic demand for labor, and they did so. Econometric analysis undertaken in the 1970s and 1980s typically yielded estimated elasticities above 0 (no response) but below 0.5. However, over the course of the 1980s, the estimates tended to decline. Moreover, with the re-emergence of chronic high unemployment after the economic crises of the 1970s, the idea that wages could be regarded as prices emerging from a competitive equilibrium (for which full employment is a pre-requisite) became less and less plausible.
The debate changed radically in the 1990s. The biggest single event was the publication of research by two leading young economists, David Card and Alan Krueger. Card and Krueger examined differential changes in minimum wages in neighbouring states and found that they had no discernible effect on employment in the fast food industry. These estimates were subject to lots of reanalysis, the majority of which tended to confirm the original Card and Kreuger analysis.
More importantly perhaps, Card and Krueger shifted the terms of the debate to include the key point of Lesson 2, that market prices do not always reflect social opportunity costs. In particular they stressed the imbalance of bargaining power between employers and potential workers. This is reflected in what is called, in the jargon of economics, ‘monopsony power’. Monopsony is the other side of monopoly: literally interpreted it means that there is only a single buyer for the good or service in question, in this case labor hours. But more generally, monopoly and monopsony are relevant whenever one of the parties to a transaction has sufficient bargaining power to influence the price (in this case, the wage)
The central implication of the Card-Kreuger is that the primary effect of higher minimum wages will be to redistribute the benefits of the wage bargain from employers to workers, rather than to raise the opportunity cost of hiring to a level exceeding the private and social benefit.
Minimum wages are not a panacea. There must exist some level of minimum wages at which the wage is greater than both the opportunity cost of working and the social value of the output produced. At this point Lesson 1 would be more relevant than Lesson 2.
There is, however, no reason to believe that the current US national minimum wage of $7.25 an hour (far lower in real terms than the level prevailing 50 years ago) is high enough to produce such effects. A comparison with Australia, a country very similar in many respects to the US, suggests that an adult minimum wage of $15/hour could be achieved over time with few, if any, adverse effects on employment.