The Economics of Minimum Wage

From an economics perspective, the establishment of any government mandated minimum wage in a free market economy is indefensible. The labor market will naturally drive wages to where the employer and the employee agree on what the work is worth and how much the worker is willing to work for. As price is determined by the point where the producer and consumer agree, so are wages determined by the point where the employer and employee agree. The following graphic demonstrates this principle.

This company needs 1200 workers for its operation. The most the company can pay for that many workers is $10.00 per hour. There are 1200 potential workers who are willing to work for $10.00 per hour. The two sides strike an agreement. If the company were only willing to pay $8.50 per hour, only about 700 workers would work for that amount (see where $8.50 intersects with the supply curve marked “s,” then look down at quantity of labor). At the point where $8.50 intersects with the supply curve, the quantity of labor would be approximately 700 in this particular labor market. So, 500 workers (1200 – 700) would not work for $8.50, but would work for $10.00. Therefore the “equilibrium” wage where the employer and the employees agree is at 1200 workers for $10.00 per hour. Notice that the employer, according to his demand for labor (the demand curve marked “d”), would  be willing to hire 1600 workers if he could get them for $8.50, but remember that only 700 workers were willing to work for that wage.  Therefore, there would be a 900 worker shortage (1600-700) if the employer needed 1600 workers, but would only pay $8.50. This is how the open market place for labor works to align workers with employer needs.

Now, let’s throw into the mix a government mandated minimum wage increase to $12.00. Notice in the graph, that the supply of labor would be 1600 workers if they got paid $12.00 per hour. Unfortunately, the employer can’t afford even the needed 1200 workers at that rate and would have to scale back his work force to 700 workers in order to pay them $12.00 per hour. Of course, that would lower his productivity and ultimately be bad for the economy. The plant would be operating below capacity, and unemployment would rise. Therefore, from an economics perspective, artificially increasing the minimum wage, reduces productivity, causes loss of jobs, and reduces the total amount of money available to all consumers (700 x $12.00 is less than 1200 x $10.00). This is a simplified illustration, but it is valid for understanding the overall economic impact of an increase in minimum wage.

In the long run–over five years–the impact of a reasonable minimum wage increase may balance out as employers figure out work-arounds to hire more employees at the increased wage, and employees acquire new skills for better jobs. But, those work-arounds will usually include higher costs prices for the product and applying more technology in order to hire fewer workers for the same production output. This increases unemployment.

Analyzing the market using valid economic concepts as we have just done is termed “positive economics.” In American culture, we acknowledge a competing viewpoint of the economy termed “normative economics.” This is a study of what needs to happen in the market based on social needs. Normative economics considers the moral and ethical aspects of market activity that many think should take precedence over positive economics in some cases. Normative economics is what drives our progressive tax system that results in low-income families paying little or no income tax while higher income families pay more of the tax burden. It also drives the increases in minimum wage with the rationale that lower income workers need more to live than the free market dictates.

There is no positive economics, market driven rationale for government mandated wage increases. Appropriate increases will come naturally with free market interaction. But, normative economics considerations have historically raised the minimum wage by small increments every few years, usually as a political move. However, recently labor unions and the Democratic Party have been calling for a radical minimum wage increase to as much as $12.00 or $15.00. Doubling the minimum wage from the current $7.25 would shock our labor market and, therefore, our whole economy by causing mass layoffs and deep reductions in productivity. In many industries, entry-level jobs would be replaced permanently by new technology. A long-term balancing of such an upset would take decades. It would without a doubt cause inflation.

I encourage you to take some time to mull this information with reference to the graph. Then discuss it with friends and family so that more people will understand what is really involved in minimum wage increases. Share this post with others. Finally, vote accordingly.




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