Minimum wages and predistribution: Extract from Economics in Two Lessons

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.

44 thoughts on “Minimum wages and predistribution: Extract from Economics in Two Lessons

  1. @Charlene MacDonald

    It is impossible, I think to provide a quick opinion for you because the difference between your understanding of silliness and sheltered workshops and other things of course, and the understanding of the world and it’s people to be found by reading this blog and the comments is incommensurable.

    Can you google “incommensurable”? And, just curious but do you find you get any satisfaction from posting comments here? I’d like to understand how that works for you, what motivates you. You are not even amusing. Sigh.

  2. I think you are being a bit unfair to Charlene. Considering….

    ….she makes a valid point.

    The economy involves everybody and it is as important to not over consider those on the right (those in command of wealth) as it is to not under consider those on the left (those with reduced capacity to work at an equal level with the general population).

  3. CM @23 The category you mention is precisely what is described in the para cited, and reformulated by BilB @22. Feel free to suggest your own further reformulation if you have one.

  4. Getting my head around the Predistribution concept I went here

    (apologies if it has already been linked) and what a bleak picture this portrays of our economic situation.

    Of course it is about globalisation and cheap goods. You have to ask the question “are cheap consumer products good for us?”. I think that sits well in a basket of questions such as “is gambling good for us?” and “is sugar good for us?” or even “are drugs good for us?”. Does living in a house fully twice the size of our parents really enhance our lives so much that it is worth jeopardising the future education and employment prospects of our children? and even worse jeopardising the future liveable environment?

    In order to understand the relationship of the minimum wage to profitability you really need to do some numbers. From my perspective as a manufacturer I look at the cost of labour against the cost of productive machinery. The guiding principle is that people are very inefficient deliverers of continuous performance, on the one hand, but are essential for flexible performance performing the multiplicity of tasks for which there are not machines economically available. A machine for production is always preferred over a person.

    A person on the minimum wage currently costs (17.29 per hour) around 39.4 thousand including compulsory super for forty hours (not including some loadings).

    A machine cost example of say cost 150 thousand will cost at 12% interest 18,000 py plus the capital repayments over 48 months at 721 per month plus the interest of 346 gives a weekly cost of 1067 as against a person on the minimum wage of 757. The machine cost equates to an income of 50 thousand per year (with comp sup but not including other loadings) which is not a particularly high income but it is the median income.

    An essential difference between a mechanical employee and a flesh and blood employee is that once the the 48 months of payments are finished its pay level drops to zero but the employee keeps working as many as 24 hours per day where as the flesh and blood employee continues to cost at a steadily increasing rate. So a good business model includes two fully automated (CNC) machines per flesh and blood employee.

    Where is the catch? The catch is in the ability to sell the productive output of those machines and that one person. And that brings us back to globalisation and cheap consumer products. Our global competitors have access to all of the same machines that we do and at a lower cost, and their labour is cheaper as well in many ways. Our only advantage is that we are (so far still) the originators of the products that we prefer to use. This gives us a very short time advantage to produce before our competitors see the products and flood our markets with cheaper copies.

    What defences do we have in manufacturing? Well patents and design registrations are our main line of defence after brand identity. But patents are BLOODY expensive. About 200,000 for international protection per idea for just 20 years with 5 yearly maintenance costs. Compare that to the cost of Copyright (100 years) the next time someone suggests that there should be no patents.

    Each industry sector has a different story to tell, but they are all variations of the same theme.

    We are fighting a losing battle protecting our living standard and quality in the globalised market, all in the pursuit of cheap goods. That is why I find it incomprehensible that the notion of an unemployment level linked global import levy fails to attract any discussion at all. Predistribution is an argument to find automatic mechanisms to protect incomes and basic living standards. An unemployment linked import levy is also such a device with a minimum cost and minimum disruption whose impact is felt in the exact same way as floating exchange rates, but is far more predictable.

    But back to the impact of a minimum wage increase on a business, considering how a manufacturing business reacts, there has to be a very significant shift in wages before a capacity loaded business reacts to wage movements as its turnover is linked to machine output, not labour cost. A manufacturer would adjust the hours of casuals first, adjust marketing efforts second, then in due course adjust prices before restoring hours to previous. IMHO.

    Services industries would take a different approach I expect, but as I do not have one I don’t know how they would react to varying labour rates. My experiences suggest that services industries have an steady progression to reduce service rather than reduce labour.

  5. I don’t fully understand your description of a job as a property right of the employer, and therefore your conclusion of a power imbalance. The property right is over the money which is paid as salary? And the employee has property rights over his/her labour which can also be withdrawn at any time for no reason? i.e the response to ‘you’re fired’ is ‘I quit’

    Worth elaborating? Higher transaction costs for employees or such?

    And in my view, defining monopsony and monopsony power is not worth the space and the jargon. As I think your text implicitly acknowledges, the example of fast food wages does not fit neatly into a literal definition of monopsony – there are lots of fast food outlets in the US.

    Would just relying on the more obvious concept of bargaining (market?) power be less confusing?

  6. There is some evidence that at least one large retailer is managing casual workers shift hours to be below the level at which compulsory super is payable to reduce costs taking on additional workers to maintain service. As I heard it.

  7. @Charlene MacDonald

    Workers in sheltered workshops should get at least minimum wages.

    This may not (does not) occur in rancid societies.

    The only conceivable groups for below minimum wage incomes are prisoners and capitalists who have failed.

  8. @Will
    Surely the power imbalance comes from the nature of employment: I agree to do what you tell me, for money. The “what you tell me” is more or less circumscribed by job descriptions, conventions about professional status, etc. But employment is quite different from “I agree to fix your plumbing for money”, in which the contract is for a specified service.

    Before the contract of employment is signed, I agree it’s about bargaining power. The employer is the monopoly supplier of the job you are applying for; you are almost certainly not the only applicant.

    BTW, “asymmetric information” has been profitably mined by Stiglitz in the efficiency wages theory, positing an asymmetry about conscientiousness in the worker’s favour. But information asymmetries surely work the other way too. A job applicant does not know in advance exactly how a prospective employer will use the power ceded to him. In a big organisation, supervisors may be good or bad, and may change. The employer may loot the pension fund, sell out to Bain, etc etc.

  9. @James Wimberley

    Yes, employers will do all sorts of odd things to their employees, meaning in many cases things inimical to employee health. Being an old fellow (61), my work history goes back to days of poor workplace regulation. Many things I was asked to do as a young worker were obviously unsafe for myself and others.

    1. I worked as a labourer in a gravel mining operation without safety helmet, breathing mask, ear muffs or visibility vest.
    2. I later drove heavy machinery in the pit with no operator ticket.
    3. I was tasked to move heavy machinery on public roads with no operator ticket or other licensing or permission.
    4. I cleaned out fibro dust, full of asbestos, from inside filter silos at James Hardie with an ill-fitting filter mask over a beard. Yeah, I know what that could mean for my future now.
    5. I was told to throw building debris from the sixth floor on a building site and just “make sure nobody is underneath”. Ironically, I threw some stuff over (enough to kill a person in a hardhat from six floors up) and the foreman who had told me to do it walked around the corner. The falling debris missed him by less than two meters.

    In those days I was callow enough to do whatever I was told. These are just a few examples. I could write 10,000 words about my early work experiences. The moral of the story is that you simply cannot trust any employers to do the right thing, ever. They have to be forced by stringent state regulations, inspections and harsh penalties to do the right thing. This applies across the board, to workplace health and safety and all other issues. When owner-employers are not properly controlled they ALWAYS exploit and endanger workers. I can attest to this from a great deal of personal experience.

  10. @Ikonoclast
    Thanks for this. My employment history was considerably more sheltered than yours (three desk jobs over a lifetime) so my perspective was necessarily heavy on theory. Confirmation from the experience of others is gratifying.

  11. @James Wimberley

    Even some desk work jobs had their moments in the “old days”. I worked briefly in the NAB, Bowen Hills, a little branch opposite Qld Newspapers in those days. On one occasion, as a mere batching clerk, I had to accompany a teller across the road with the Qld Newspaper payroll. I was given a pistol to protect the payroll. I had no training whatsoever, had never even held a gun before. I remember thinking, as I stuck the gun in my pocket , “What’s the point? I am NEVER going to use this.”

    I can tell plenty of genuine stories about employers. I worked on a sheep and wheat farm in WA in 1975 in the wheat planting season. I was paid $60 a week plus board and lodging. An aboriginal lad of about 16 working on the next farm got board and lodging but no pay.

    Note: I just checked minimum wage for 1975. I see that the farm rate was $1.80 an hour. At my guess I worked 60 hour weeks (with no overtime pay), so I got $1.00 an hour plus full board and lodging. I lived with and ate with the family. The food was good and the tea terrible. They made their tea on bore water.

  12. My friends son works hard for no pay on a dairy farm in North central Victoria where his dad works 7 days a week most weeks (no penalty rates, no employment contract). The son is getting training and experience -in this case there is no agreement for any eventual paid work. Dairy was rated by The Weekly Times newspaper as the hardest work in the rural sector . He is 16 years old and left school this year due to being a bit of a misfit there. He is a good boy ,a good learner and a hard worker ,but perhaps a bit too sensitive for these times. Due to the specific nature of their particular product ,and the special market for it ,their dairy is not caught up in the current financial crisis but it is still hard work for less than average money .

  13. @sunshine

    Yes, the work-for-no-pay thing is becoming more and more entrenched in current socioeconomic culture. Quite a few young people are now expected to work for no pay as interns, unpaid trainees and unpaid apprentices. This is an addition to people being expected to do extra hours for no pay and/or for illegal low wages.

    This is what happens when you take the pressure off employers to be honest and treat workers fairly. But modern parents face a tough choice (as do small businesses and small farmers). In some cases, they have to accept their kids doing a year or so of unpaid work just to get a foot in the door for employment. Of course, this really means the entire system is wrong. We need to set minimum wages for all legal work ages, to make unpaid work and unpaid training illegal and to implement a government job guarantee where the federal govt is an employer of last resort at the minimum wage.

  14. I always wonder why the results of the new economics of the minimum wage are confined to the minimum wage.

    If large wage increases result in little unemployment, why not have large wage increases for everybody?

  15. @Jim Rose

    The studies are mostly done in the US, where the minimum wage is the only wage fixed by law. But that reminds me, there is a fair bit of US literature on the effects of (de)unionisation, which I need to cite.

  16. @Jim Rose

    Wage increases for everybody – up to a level approximated by average productivity (in $ terms), would boost final consumption expenditures so many businesses currently threatened would remain viable and presumably less interested in attacking penalty rates and employment.

    Wage increases for everybody, provided new regulations are created to regulate credit, will enable those with heavy debt burdens to reduce debt. Increased tax revenues may allow tax cuts elsewhere.

    Once wages are equal to the value they produce in society, many social and economic problems are resolved.

    The only problem is that Australian fair wages are undercut by imports from ragimes based on unfair wages.

    So you can increase wages, up to a point, but you need consequential changes as well.

    Focussing on minimum wages really only moderates the current tendency for increasing inequality – an this is all our Keynesian capitalists can offer.

  17. You could compare California, with min wage of $10, with just about anywhere in the US – they all have lower wages and lower performing economies.

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