Minimum Wage, Minimum Pain

A democrat’s favorite tool, a laborer’s safety net; an employer’s nightmare, an employee’s happy meal. Proponents call it a ‘source of equality’, antagonists call it a ‘business buster’. Yes, I’m talking about the minimum wage. What are its implications and what are its future prospects?

Before the 1990s, when theoretical economics was on the rise, the idea of having a minimum wage wasn’t so appetizing. Many microeconomists charted diagrams showing that a placement of a price floor resulted in increased demand and reduced supply, leading to a shortage in the labor employed. This justification sounded convincing enough but a lot changed post 1990.

In 1990, David Card and Alan Krueger of America’s National Bureau of Economic Research presented evidence that past minimum-wage increases did not have the expected effect on employment in the U.S labor market. Theoretical backing had been transcended by empirical evidence. A good paradigm for this would be Britain. Despite having a minimum wage at around 40% of median wage, Britain has managed to keep employment level at nearly the same level as it did before it had the price floor. Fascinatingly, the income gap between the rich and the poor has also reduced as a result of this.

Now you might be curious as to why this may be happening. The primary reason why theory has failed in this context is because it is based on the assumption of ‘ceteris paribus’ (all else equal). In other words, the above mentioned diagrams did not take into account business cycles, frictional employment, inflation, tax credits etc. They’re oversimplified models after all.

With rising demand pull inflation, prices increase, thereby lifting profits. When profits increase it would only make sense to increase disposable income so as to balance this effect. The best way to do this is by raising the minimum wage and empirical evidence supports this. When there is a recession, profits plummet and the demand for labor becomes more elastic. Hence it would make sense to lower the minimum wage to let businesses operate above their marginal total costs. This too has been supported by evidence. Whether you like it or not, the minimum wage does play an important role in a functioning economy.

The appeal of having a minimum wage is catching on. Even Angela Merkel, the chancellor of Germany, has expressed interests in implementing a nationwide minimum wage. This, coming from a country which gave birth to the idea of ‘sticky wages’, is interesting. A flexible labor market coupled with a progressive minimum wage has, almost always, produced positive results (Britain being an example).

Are there any dangers related to this? Yes, of course. While gradual increases or decreases in the minimum wage can be potentially viable, dramatic increases or decreases can be potentially disastrous. Changes of this scale will make employers base their judgments on elasticity causing quasi-theoretical results. And with the current rate of technological improvement, automation is being seen as a future source of employment. With increasing wage rates, the opportunity cost of hiring more people is rising, and sooner or later employers might turn towards automation to satisfy their production needs. But for now, minimum wage is minimum pain.

(Photo credit: http://watchdog.org/118490/minimum-wage-union/)

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