Minimum wages: Do we need them?

Alok Ray | Updated on March 12, 2018 Published on May 07, 2013

Textbook wisdom cannot always be relied upon, while confronting real-world policy issues.

Look up any standard undergraduate textbook in microeconomics. It would tell you that interfering with the market mechanism by imposing a minimum wage — and by the same token raising it — is bad policy. This would increase unemployment, which means loss of income for a larger number of low-income people, while benefiting only those lucky to get a job at that artificially set high wage. Thus, it would also increase inequality in income distribution within the labouring class.

Yet, in the US — the so-called citadel of free market — President Barack Obama has recently proposed to raise the federal minimum hourly wage from $7.25 to $9 and to allow its automatic adjustment by linking with inflation.

The proposal is being supported on the ground that it would reduce income inequality by raising the income of low wage earners from janitors and nannies to hamburger flippers at restaurants.

So, who’s right?

Nominal versus Real

The Nobel-Laureate economist Paul Krugman — whose best-selling undergraduate textbook on economics, incidentally, also contains the conventional wisdom — has supported the rise in minimum wages, though with a qualification.

He argues that the proposed rise in minimum wage is small and will not have any adverse effect on unemployment, even while serving to improve income distribution.

In fact, inflation-adjusted minimum wages in the US have been falling. Even the proposed $9 rate would be lower than the 1960s and 1970s minimum wage in real terms. In addition, labour productivity has gone up considerably over this period, which could have raised even the minimum real wage without raising costs in the economy. Only if the minimum wage were raised to, say, $20, at one go, would unemployment among low-skill workers go up and the textbook conclusion hold, says Krugman.

There has been empirical work on the impact of minimum wages on employment in the US, where different states have prescribed these at different levels. There is no clear evidence that higher minimum wages have raised unemployment, when the effects of other factors across different states are taken into account.

If unemployment among low-skill workers does not go up, what would, then, be the possible impact of higher minimum wages? Surely, wage costs per hour would go up. But the supporters argue that it would not increase production costs and, hence, prices of final products, if accompanied by sufficient improvements in labour productivity.

But that raises the question of how gains in labour productivity come about. If more machines are used per worker, labour productivity does go up. But that may also adversely affect employment, if total demand and, therefore, total production (determined by demand) remains the same.

Macro in micro

But on the other hand, if higher wages also translate into higher demand — here we move from microeconomics to macroeconomic impact — then the former may not really increase unemployment. This is the position which the proponents of higher wage are basically taking, especially when the US economy has not yet come out of a recession and demand is a major constraint on growth and employment.

Others supporting higher minimum wages believe they would actually improve labour productivity through higher effort put by workers and lower labour turnover — in other words, greater retention of already trained workers. This argument has found favour even with companies such as Costco, which, unlike Walmart, supports raising minimum wages.

Other possible channels of adjustment by businesses could be ‘wage compression’ — i.e., lowering wages of workers with higher skills to contain costs — and passing on part of the burden of higher wage costs to consumers in the form of higher prices.

Those opposing higher minimum wages emphasise that even assuming unemployment does not rise among low-skilled workers — the best case scenario, according to them — it would be at the cost of higher-skilled workers and consumers.

Note that the less skilled workers in the above case would be better off even with the resulting higher inflation. This is because the percentage increase in production costs and prices would be less than the rise in wage for such workers, given that wage costs are only a fraction of the total production cost.

To the extent their real wages increase even while unemployment among them does not go up, these workers as a class would be clearly better off.

Would raising minimum wages lead to more outsourcing of jobs to lower wage countries? Well, most of the jobs that cooks, nannies, janitors or helpers to the elderly do are in the nature of ‘touchy-feely’ jobs, which are not possible to do over long distance. So, that fear is largely unwarranted.

Would it reduce inequality? The opponents argue that many people earning low wages have other family members working at higher wages.

Hence, their total family income may not necessarily be low. While that may be so for some people — like the children of relatively well-off parents who supplement their allowance by working part time at McDonalds — there is no doubt bulk of those working at minimum wages come from poor families.

So, higher wages would predominantly benefit families at the low end of the income scale.

Don’t burden firms

The dominant Republican Party position is that a better way to benefit these people would be through higher earned-income tax credits, under which the government basically pays a wage subsidy to low-income households.

In other words, the cost of paying a higher wage should be borne by taxpayers rather than business people.

That would keep their costs down, avoiding any adverse effect on employment and profits.

The advocates of minimum wage hike, on their part, aren’t against earned-income tax credit, but regard it as a complement, and not substitute, to higher minimum wages.

They favour a policy package, which includes a decent inflation-indexed minimum wage that helps keep the family of a person working full-time (at minimum wage) above the poverty line, while simultaneously subsidising education and training facilities for their members to enable them over time to find employment above the minimum wage.

The dissenters, however, underline the possibility that such ‘decent’ minimum wages would only remove the incentive to go for higher education, leading to more school dropouts.

It would, thus, be counterproductive for achieving the long-term objective of improving the employability and the earning capacity of disadvantaged families.

There are a few economists, though, who say that if the hike in minimum wages results in slightly higher prices, it is not bad since the current inflation rate in the US is very low.

Some even welcome this development, as it would reduce the real value of debt for many heavily indebted families and businesses, thereby helping to stimulate household and business expenditure in recessionary times.

The above debate shows how the accepted wisdom of standard textbooks has to be a lot more nuanced, when one confronts real world policy issues.

(The author is a former Professor of Economics, IIM, Calcutta. Views are personal)

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Published on May 07, 2013
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