Sunday, August 30, 2009

Minimum Wage, Maximum Unemployment



On July 24th, 2009, the federal minimum wage rose from $6.55 to $7.25 per hour in the third and final step of a law passed in 2007. Before the law was enacted, the minimum wage was $5.15 per hour. The $2.10 increase in the minimum wage represents a nearly 41% increase in the wage paid to unskilled labor in less than three years. Is it a coincidence that the unemployment rate is now the highest it has been in 26 years? Let's take a look, shall we?

The minimum wage is, of course, a price control. Price controls essentially fall into one of two categories: price ceilings and price floors. In an earlier post on ObamaCare, I discussed the plan’s reliance on price ceilings to control costs which, inevitably lead to rationing. Governor Palin’s metaphoric use of the term “death panels” is a brilliant way of explaining what must happen when price ceilings are imposed: the product or service to which the price ceiling applies must be rationed.

With minimum wage, the government employs a price floor which is the exact opposite of a price ceiling. A price floor is defined as a government mandated minimum price below which legal transactions can’t take place. In other words, the government believes they know better than the collective wisdom of the market and thus they pass a law preventing the price from falling to its equilibrium level. An uncomplicated graph of a price floor appears below.



The “market price” is that price which would occur absent government interference and can be found to the left of the intersection of the blue supply and demand curves. The “market quantity” is the amount of transactions which would occur absent government interference and this is found directly below the intersection of the blue supply and demand curves. Note that the price floor is above the market clearing price. Market forces are such that the invisible hand of the market wants to push the price down to the market price. However, the price floor prevents that from happening.

Now instead of looking at a price floor generically, let’s apply the concept to the price of unskilled labor. We will assume that the market price of unskilled labor is represented by the “market price”. The amount of workers who would be employed at that market price is the “market quantity”. Now, a politician who is ignorant, unscrupulous, or more likely, both, decides to impose a minimum wage. The minimum wage or "price floor" is represented graphically by the red horizontal line at the top of the graph.

The biggest and most important effect of minimum wage laws is the unemployment rate for unskilled workers must rise. Prior to the minimum wage, the amount of unskilled workers employed is represented by the “market quantity” as discussed above. However, when the minimum wage is imposed, the amount of unskilled workers with jobs falls to the amount represented by the red dashed “quantity demanded” line, found below the intersection of the price floor and demand curve. At this higher wage, more people will want to work. In other words, the quantity supplied (of unskilled workers) will rise. However, this is irrelevant.

What is relevant is that the amount of workers employers want to hire at the higher wage will fall. Put another way, the quantity demanded (of unskilled workers) is lower. When a situation exists where supply exceeds demand, economists say a surplus exists. In this case, we have a surplus or "excess supply" of workers. In layman’s terms, an excess supply of workers is called unemployment. The difference between “market quantity” and “quantity demanded” is the amount of unemployment caused by the imposition of the minimum wage.

Another effect of minimum wage laws (and price floors in general) is the creation of a black market. Some employers and workers will get together and create a situation where the employer pays the employee a lower rate under the table. This is a fairly common way to get around price floors. However, this type of arrangement can be difficult to apply on a large enough scale to appreciably affect the real economic cost of the increase in unemployment caused by the minimum wage.

We can also look at the minimum wage from a non-graphic point of view. Intuitively, a worker can’t be paid more than his or her productivity. Today’s federal minimum wage is now $7.25 an hour. However, when you factor in the payroll taxes, unemployment insurance, and other costs an employer must pay, it really costs an employer closer to $9.00 per hour to hire a minimum wage worker.

Suppose you own a small business and are considering whether or not to hire a high school kid at a cost of $9.00 per hour. What must that high school kid do for you? The short answer is this. His productivity must justify that cost. In other words, he must contribute at least $9.00 an hour to your bottom line. If he doesn’t, the simple fact that he’s breathing air and taking up space in your business is costing you money. Small businesses, who account for the vast majority of minimum wage workers, operate on a very thin profit margin to begin with and simply can’t throw money away and expect to remain in business.

The practical effect of minimum wage laws is to prevent workers whose productivity is less than the minimum wage from participating in the legal economy. Think about that.

It is well known among economists that minimum wage laws negatively impact the very people they are intended to help: those with little or no marketable skills. Every time the minimum wage rises, the unemployment rate for America’s youth rises along with it. Minimum wage hikes tend to have the greatest negative impact in the minority community.

Economist Walter Williams draws on his own life experiences to explain why this is the case in the following video he made in the 1980s. (Note: Dr. Williams’ minimum wage discussion ends exactly 3 minutes into the video. However, the remainder of the video is also very good. Some of you may be familiar with Mr. Williams work as one of Rush Limbaugh’s substitute hosts. He is, in my opinion, the best of Rush's substitute hosts)



The overall unemployment rate is the highest it has been in 26 years. There are several reasons for this, among them the 41% increase in the minimum wage since 2007. The rise in the minimum wage in July couldn't have come at a worse time. In an article for Forbes on the day of the increase, Bruce Bartlett explains why:

Even though the nation is suffering a crisis of unemployment, with the national unemployment rate at 9.5% , the federal government has nevertheless mandated that it will go higher because, starting today, the minimum wage rises from $6.55 to $7.25 per hour.

If there could ever be a worse time to raise the minimum wage, it's hard to imagine it. Businesses everywhere are desperately trying to cut their labor costs. At many companies workers have accepted significant pay cuts so that their employers could avoid layoffs. But this option is not available to businesses employing large numbers of minimum wage workers. Since they are legally prohibited from reducing wages they have no choice but to lay off workers.

The left has many arguments in support of the minimum wage but none make any economic sense at all. The most common “argument” my liberal friends advance in support of a minimum wage is that it is an anti-poverty tool designed to help workers receive a “living wage”, whatever that is. In advancing this so-called argument, they completely miss the point that ultimately workers can’t be paid more than their productivity. Businesses which pay their workers more than their productivity will not be in business long. When they go under, they will provide no jobs at all.

Walter Williams wrote an excellent article in 2005 on the folly of the minimum wage in which he destroyed the argument that the minimum wage as an anti-poverty tool:

The idea that minimum wage legislation is an anti-poverty tool is simply sheer nonsense. Were it an anti-poverty weapon, we might save loads of foreign aid expenditures simply by advising legislators in the world's poorest countries, such as Haiti, Bangladesh and Ethiopia, to legislate higher minimum wages. Even applied to the United States, there's little evidence suggesting that increases in the minimum wage help the poor.

What Dr. Williams is saying, in effect, is there's no free lunch. Read the rest of his article here. It's well worth the effort.

The living wage argument is intrinsically silly. I recently asked a liberal friend who espouses the living wage theory if he thought $7.25 is a living wage? He said no, it should be higher. I then asked him if we should make it $50 so that everyone, assuming a 40-hour week, would be making at least $100,000 per year. He didn’t think that was a good idea. Apparently somewhere between $7.25 and $50 there is a magic wage which the government should decree for unskilled workers. Thomas Sowell wrote an article a few years ago about the fallacy of the living wage argument.

Where does Barack Obama stand on the minimum wage? While it's true he did not sign the law that mandated the July 24th increase, he enthusiastically backed and voted for the scheme in 2007. He did nothing to attempt to delay the ill-timed increase of July 24th. In fact, Obama is on record saying he wants to raise the wage still further to an unbeleivable $9.50 an hour then index it to inflation so that it rises every year ad infinitum. Such a move will guarantee a permanent underclass of unemployable workers who will either be on welfare, forced to consider the underground economy, or worse. Unlike Governor Palin, Barack Obama has never run a business. Only someone who has never had to meet a payroll would advocate such a job and business killing measure as this.

Mr. Obama’s desire to index the minimum wage to inflation is based on another fallacious justification for the minimum wage. The fallacious justification to which I refer is the theory that we need to keep raising the minimum wage so that it keeps up with the cost of living. This is a red herring. First, to even get into this discussion is to tacitly agree with the premise that a minimum wage should exist in the first place. It shouldn't. Second, tying wages to the cost of living makes as much economic sense as tying wages to, for example, the number of times I changed my socks in the past year.

The only variable to which wages can legitimately be tied is productivity. Ultimately, no business can pay a worker more than his (or her) productivity as discussed earlier in this post. Passing a law which requires an employer to pay an employee more than his or her productivity is to guarantee that employee a trip to the unemployment bureau. Cost of living is irrelevant. You can't pay someone more than they're worth.

Back in the 1970s, the late, great Milton Friedman was interviewed on the subject of the minimum wage. Even though the interview is over 30 years old, the basic laws of economics haven't been repealed in the interim. I’ll end my post with a short video of Dr. Friedman's interview in which he discusses the issue.

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