Another Minimum-Wage Clash

Politicians Have Less Control over Labor Markets Than They Think

Richard McKenzie teaches economics in the Graduate School of Management at the University of California, Irvine.

It happened again. Republicans and Democrats recently locked political horns over President Clinton’s proposed one-dollar increase in the minimum wage. The political partisans repeated past claims with self-righteous fervor, but once again were off base on the consequences of the increase. (The measure was defeated—this time.)

President Clinton and his Democratic allies argued that the proposal would be an unmitigated blessing for the country’s low-wage workers who deserve an increase in their take-home income. Bob Herbert, a columnist for the New York Times and an avid minimum-wage supporter, quoted approvingly a study from the Economic Policy Institute (EPI) which found that the last hike raised the incomes of 10 million Americans: “The benefits of the increase disproportionately help those working households at the bottom of the income scale. Although households in the bottom 20 percent (whose average income was $15,728 in 1996) received only 5 percent of total national income, 35 percent of the benefits from the minimum wage increase went to these workers.”

Herbert is convinced that such findings should give minimum-wage critics reason to eat their words. He reminds his readers of what Cato Institute chairman William Niskanen said during the last debate over the minimum wage: “It is hard to explain the continued support for increasing the minimum wage by those interested in helping the working poor.”

Despite EPI’s claims, the Republicans argued, as they have in the past, that if Congress raised the cost of menial labor, several hundred thousand jobs would be lost. Some employers would not be able to afford as many workers, and other employers could be expected to automate low-skill jobs out of existence. Opponents backed up their claims with equally sophisticated statistical studies that showed that some low-skilled workers should be made better off (those who kept their jobs) but only because other low-skilled workers would be made worse off (those who are unemployed). For example, the EPI commissioned a study of a $1.35 increase in the minimum wage in the state of Washington and found that by 2000, the increase can be expected to destroy 7,431 jobs, causing the affected workers to lose $64 million in annual income.

Both Sides Are Wrong

Both sides to the debate were once again wrong in their assessments of the minimum-wage increase because they both failed to recognize that employers are a lot smarter than the political combatants seem to think. Neither side seems to realize that Washington simply doesn’t have the requisite power over markets to significantly improve worker welfare by wage decrees, no matter how well-intentioned the legislation may be.

Why is this so? The simple answer is that the labor markets for low-skilled workers are highly competitive, which explains the low wages paid menial workers in the first place. Many employers of low-skilled workers would love to be able to pay their workers more, but they have to face a market reality: if they paid more, then their competitors would have a cost advantage.

When Congress forces employers to pay more in money wages, it also forces them to pay less in other forms, most notably in fringe benefits. If there are few fringes to take away, employers can always increase work demands.

Why would employers curb benefits and increase demands? First, they can do it, given that the minimum-wage hike initially will attract more workers and cause some employers to question whether they can hire as many workers unless adjustments are made. The forced wage hike also strengthens the bargaining position of employers, given that they can tell prospective workers, “If you don’t like it, I can hire someone else.” Second, the employers must cut fringes and/or increase work demands, or face the threat of losing their market positions to competitors who do so. Third, if employers don’t cut fringes and/or increase work demands, the value of the company’s stock will suffer, creating profitable opportunities for investors to buy the firm, change the benefit/work-demand policies, improve profitability, and then sell the firm at a higher price.

The net effect of the adjustments in fringes and work demands is that the cost impact of the minimum-wage hike to the employer will be largely neutralized. For example, when the minimum wage is raised by a dollar, the cost of labor, on balance, may rise by only five cents. That explains why studies have found that recent minimum-wage hikes have caused few (if any) job losses even among that group of workers—teenagers working at fast-food restaurants—whose jobs are most likely to be cut. Even the EPI study cited above shows a reduction in Washington state’s total employment of less than three-tenths of one percent for a proposed 26 percent increase in the state’s minimum wage.

This line of argument can also help us understand why workers who retain their jobs are unlikely to be any better off. They get more money, but they get fewer fringes and have to work harder for their pay. The only reason a sane employer would offer the fringes and reduced work in the first place is that the workers valued them more highly than they valued the money wages that they gave up to get them. And sane employers aren’t about to offer workers anything unless they get something in return, like greater production or a lower wage bill. When the minimum wage is hiked, therefore, the value of the resulting lost fringes and reduced work demands to the workers will be greater than the value of the additional money income.

Put another way, the workers who retain their jobs are made worse off (albeit marginally so) in spite of the money-wage increase. Employment in menial jobs may go down (albeit ever so slightly) in the face of minimum-wage increases not so much because the employers don’t want to offer the jobs (as traditionally argued), but because fewer workers want the menial jobs that are offered. Understandably, the voluntary quit rate among low-wage workers goes up, not down, when the minimum wage is hiked.

Seen from this perspective, the Economic Policy Institute figures on the added income received by 10 million workers are grossly misleading because they suggest that the affected workers are better off, which is unlikely.

Granted, economists might speculate that the job reductions have been small because the demand for menial labor is fairly constant, but that explanation makes no sense. The elasticity of demand for anything, including labor, relates to the number of substitutes: the more substitutes, the greater the elasticity. The problem with the explanation is that there is no labor group that has more substitutes than menial (minimum-wage) workers, especially now that firms have so much flexibility to automate jobs out of existence or to replace domestic workers with foreign workers by way of imports.

You can’t fool the market. It will outsmart the smartest of politicians.

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