Why the Minimum Wage is Ineffective and Costly

[Note: I was going to post about this topic later in time but given the fact that 19 states just increased their respective minimum wage amounts, I thought it would be especially relevant and interesting today.]

I don’t know about you, but every time I hear somebody praise the minimum wage or recommend that it should be increased, I inwardly (or sometimes outwardly) roll my eyes. That’s not to say I don’t understand this policy’s appeal to many individuals. However, once you look beneath the surface and see how this policy really works and some of its real but hidden consequences, it clearly possesses a host of problems. Based on this policy’s appeal to a wide variety of individuals, I want to offer a non-comprehensive summary of this policy and some of its inefficiencies and costs. I’m going to start this post with an outline of some ways that people might view and justify a minimum wage.

An Unrealistic (But Maybe Common) View of the Minimum Wage

I can’t say the ideas expressed in this section are based off of a single person’s opinion or the opinion of the majority of the minimum wage’s supporters. I do imagine, however, that these are some (potentially common) ways that people might think about and justify this policy.

  1. An increased minimum wage means that all (or most) low wage workers will benefit from a higher income.
  2. An increased minimum wage means that unemployed individuals will be more motivated to enter the job market, will obtain good jobs, and will be better off.*
  3. Companies are greedy and have reserves of money that they can and will open (if legally forced) to pay higher wages to their employees.

While there may be some degree of truth to each of these claims, these views have significant flaws, which will be expounded upon in the rest of this post.

The Reality of the Minimum Wage

What exactly is the minimum wage? The minimum wage is a wage floor or a legal minimum price for many types of labor.** It was designed to help the working poor by enforcing that companies pay a “living wage” (in other words, enough money to live on). In terms of market operations, a minimum wage increases the price of labor without any corresponding increase in the value of labor. (This is a significant disconnect which I’ll talk about more later.)

The fact is that companies (for the most part) seek to make profits and operate in a very competitive environment. Thus, it is hard to justify paying the same people a higher wage in order to do the same task. You might think that for the most part companies can and will just swallow the extra cost, but think about it from your perspective. If the price of a good that you consume increases significantly, do you continue to consume the same amount of that good as before? Unless you absolutely need that good, you likely try to cut back on your consumption and/or find alternatives. Like you, companies tend to be rational, think at the margin, and behave according to universal economic principles. So when price increases (imposition of a minimum wage), quantity demanded (desired number of employees) decreases.

Ways That Companies Respond to a Minimum Wage

Assuming that firms will not just accept these increased labor costs, how exactly do they attempt to cut costs in the face of a minimum wage?

  1. Hire less people. Whenever possible firms will try to replace workers with machines, kiosks, or just try to get more work out of a fewer number of laborers.
  2. Decrease fringe benefits for employees. Just because a company has to pay a certain hourly wage does not mean that they must continue to offer benefits such as employee discounts, paid time off, etc.
  3. Black market activity. Really desperate firms can break the law and try to hire workers at an illegally low wage rate.***
  4. Increased prices for consumers. In the face of higher operating costs companies will seek to share the burden with consumers in the form of higher prices. This will have varied results depending on particular products, markets, etc., but it leads to the potential for making a whole lot of people significantly worse off.

Some Additional Costs of the Minimum Wage

I’ve been quite negative regarding the minimum wage up to this point. I do want to be clear that this policy has at least one benefit: those low income workers who retain their jobs do indeed get to enjoy a higher wage rate. But what are some of the costs that society incurs in order to obtain this single benefit?

  1. Increased prices for consumers. As noted earlier, firms will not bear the burden of higher costs alone, and will share these costs with consumers in the form of higher product prices. Especially for those with smaller incomes (i.e. the poor), this increase in prices has the potential to cause significant harm.
  2. Disemployment of the poorest, most unskilled laborers. When firms are determining who to layoff they will likely get rid of the least skilled, most unproductive workers. Sadly, these are the exact individuals that the minimum wage seeks to help. This policy suffers from a significant disconnect between policy goals and actual outcomes.
  3. Fewer training opportunities. As noted earlier, the minimum wage creates an increase in price without a corresponding increase in value of labor. It makes sense to think that a worker earns low wages or remains unemployed because he/she is unproductive, untrained, or of little value to potential employers. Thus, the more education and training that low income workers can get, the higher wage they can demand. (It’s amazing that all of this can occur without the government intervening to adjust and distort the market… but I digress.) However, if the cost of labor is higher, and firms choose to hire less workers, then opportunities to gain work experience and training decrease significantly.
  4. Potentially fewer incentives to work. Those who remain employed at a higher wage rate might actually be incentivized to work less or not at all. Higher income leads to more taxes and less welfare, so there is a real possibility that the costs of working at a higher wage rate will outweigh the benefits to many individuals.
  5. Increased personal discrimination by employers. Whenever there is a surplus of a good, some sort of rationing mechanism must be in place in order to determine who can obtain the limited supply of said good. Without price to ration goods, employers are free to hire or not hire individuals based on personal characteristics, rather than productivity or other legitimate reasons. For a policy that seems to bear merit based on arguments of equity, this is a disturbing side effect.

Some Policy Alternatives to the Minimum Wage

At the end of the day, this policy intends to improve the lives of heads of households among the working poor.**** Having noted many of this policy’s problems, what are some better, alternative policies? After all, it would be less than productive to point out all of the problems with this policy without listing at least some potential alternatives.

  1. Lower or eliminate payroll taxes for unskilled, low income workers. FICA and state income tax withholdings can significantly decrease the incomes of the working poor. Why not give this concentrated group of hurting individuals a tax break?
  2. Expand or create policies similar to the Earned Income Tax Credit. The EIC is a remarkably effective form of welfare that provides low income, working individuals with a direct reduction in tax liability. It is a concentrated benefit (goes to individuals with an income below a certain amount) but also provides labor incentives (since you must be employed to get it).
  3. Enact contingent welfare policies. These types of programs would provide welfare to workers based on completion of training or some other achievement.
  4. Utilize wage subsidies. Government would, through these types of programs, provide employers with money to give directly to low income workers.

While it is unlikely that any of these policies would perfectly solve social employment problems in our country, they are worth at least considering. Each suggestion has its flaws, but succeeds at least in providing the target group of workers with benefits tied to labor incentives.

Conclusion

I hope you found this post to be informative and helpful. It ended up being pretty long so I hope I didn’t bore you too significantly. This post was HEAVILY influenced by my Intermediate Microeconomic Theory course taught by Dr. D. Eric Schansberg. So for further (and more eloquent) thoughts on these issues, I would point you towards his book Poor Policy: How Government Harms the Poor. Another useful reference book might be our class’ textbook: Microeconomics: Theory and Application by Browning and Zupan.

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Like always, if you have thoughts of consensus or disagreement, please leave a comment or send me an email. I’d love to hear how you’ve thought about or been impacted by these policies. Thanks for reading!

 

Additional Notes:

*This effect likely occurs to some degree but is not really beneficial for two reasons: a) Research shows that generally labor supply is quite inelastic (meaning that increased wages do not lead to significant increased amounts of willing workers). b) And just because individuals and willing and able to work does not ensure that employers will hire them. Without a simultaneous increase in demand for labor, an increase in willing workers, according to this line of thinking, would actually lead to higher unemployment.

**It’s important to note that not all jobs are even covered in minimum wage legislation. 75% of unskilled workers have jobs that are not covered by the minimum wage, such as tipped workers, seasonal workers, farm workers, etc. Clearly this policy fails to impact the lives of many individuals in the specific category (unskilled, low income) that it attempts to better.

***Economic theory would suggest that a minimum wage would create a surplus of available workers, so there would likely be individuals who would be willing to work at lower wages and would be motivated to not turn these firms in to the government.

****It’s also worth noting that the minimum wage impacts not just heads of households. Individuals like high school student seeking to make some extra gas money are impacted in the exact same way as low income, unskilled heads of households. This policy is too broad and impacts a number of individuals who are not the primary target.