Should We Increase the Minimum Wage?

Today something happened that I think is great. I read something that changed or at least significantly challenged an opinion I've held for quite some time. I say that this is great because I think that the process of learning and growing intellectually requires that people be willing to defend but also challenge their opinions. When my opinions are challenged in a way I feel is sufficient, then I feel I've developed intellectually at least in some small amount. Today I stumbled across and read some research from the London School of Economics that challenged a belief I previously held about the effects of minimum wage hikes. Since this is currently a hot topic, I thought I would let you all know what I found.

I've held the belief for some time now that increases in the minimum wage are generally bad for the overall economy. My reasoning being, that in a competitive market, increasing the minimum wage is an ineffective and possibly dangerous way to transfer wealth. I don’t believe that transferring wealth per se is bad or immoral. If someone took a dollar from me and gave it to someone else, no economic value is created or destroyed. I simply lost something that I valued at a dollar, and someone else gained something that they valued at a dollar. In so far as this doesn't affect either of our behaviors, the world is no better or worse off than before. (Of course if this does change my behavior, possibly because it happens consistently or whatever, then that is a different story) Since we are not all born equal, some of us are fortunate enough to possess skills valuable to others and this enables some of us to earn a high wage, other aren't so fortunate. So it’s reasonable to me one can believe, on moral grounds, that some wealth should be transferred from the fortunate to the less fortunate. The tricky part is doing this transfer in a way that doesn't damage the economy as a whole. But let's get back to minimum wage increases. Any transfer of wealth must come from somewhere, and I believed for some time, that wealth transferred through wage control is likely going to come from the worst possible places; either other low wage workers who have to be let go so the firm can afford to pay the higher mandated wages, or from consumers, who must bear higher prices.

There is also a third possibility; the transfer of wealth could come out of firms’ profits. However if you assume markets are competitive and believe we live in the world introduced to college freshman in introductory economics courses, then this would mean that minimum wage hikes would cause some firms to go out of business, since in a competitive market, profits are driven to zero. This would cause the supply of goods to fall, prices to increase, until ultimately it is again the consumers and other low wage workers who suffer. Of course we don’t actually live in that world. The London School of Economics’ research paper I recently read showed, through some pretty advanced statistics, that when a minimum wage increase occurred (in the study they used one that occurred in London, in April 1999), that low wage firms, meaning firms whose average employee’s wages were significantly affected by a minimum wage increase, did not retain less employees. Further, prices did not increase, and as expected, low wage firms’ profit margins did fall, but the rate at which firms went out of business did not increase. That is a surprising result, prices didn't change, employment didn't change, profits fell, but firms didn't go out of business. This suggests an interesting conclusion, that even the low wage firms had sufficient excess profits to absorb the wage hike, and that the transfer of wealth came from firms excess profits. Excess profits meaning profits after covering the cost of capital from investors, not simply accounting profits.

As I mentioned, in a competitive market, excess profits shouldn’t exist, but of course, due to various market inefficiencies that exist in the real world, they do to some extent. Since excess profits generally go to shareholders and managers, for no other reason than the fact managers get to decide who keeps them. Therefore the research suggests that modest minimum wage hikes could be an effective method of transferring wealth from those at the top of the firm, to the bottom, when excess profits reach a sufficient level. Note that if managers required the income they receive from excess profits in order to accept or continue working their job, then that portion of the firm’s income wouldn’t actually be excess profit. This suggests an optimal minimum wage policy would be to set the minimum wage such that firms’ excess profits are driven to zero, easier said than done, but I think it’s an interesting starting point for discussing a controversial public policy.

This revelation of mine isn’t anything ground breaking, the paper I’ve been referencing came out in 2005 so I am sure someone has since rigorously tested some version of my hypothesis since then, and maybe sometime in between work and watching The Wire, I’ll further investigate the matter further and let you know what I find. Hopefully at the very least I’ve illustrated the benefits of being, as this blog aims to be, un-biased.

If you wish to read the paper I’ve be referencing, it can be found here.

http://164.36.50.178/lowpay/research/pdf/NMW_profits_and_prices.pdf

James Karol

February 6th, 2014