Why Raising the Minimum Wage is a Bad Idea

John C. Goodman
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Posted: Sep 06, 2015 12:31 AM
Why Raising the Minimum Wage is a Bad Idea

Hillary Clinton has a solution to the problem of low wages: Government should make them higher. Paul Krugman, writing in The New York Times, endorses the idea. There was a time when Krugman dismissed rhetoric like Clinton’s as economic quackery. These days he’s trying to sell the same snake oil as the politicians.

As I wrote in a column at Forbes, here is what economists know about the labor market: Employees tend to get paid their marginal product – the value they add to final output.

In a competitive market this is almost a truism. Wages are not a gift. They are not at one level, but could have been substantially higher or lower. They are what they are because of the employees’ skills and the market value of what they produce.

Now suppose that were not the case. Suppose there was a firm that paid employees more than their marginal product. That would mean the firm is collecting less from customers at the margin than it is paying out in wages. The firm can try to raise prices to cover the deficit, but then it would lose sales to rivals whose costs are lower and it would eventually go out of business. Or it could cover the deficit with lower profits. But then the investors would fire the manager and hire someone who gets the wages right and provides a market rate of return.

Suppose that there was a firm that paid employees less than their marginal product. In that case, rival firms would hire the employees away – since they are worth more than what they are being paid.

To summarize: a firm that pays workers more than they are worth cannot survive because it cannot match the prices and the rate of return to investors of its rivals. A firm that pays workers less than what they are worth, cannot survive because it will not be able to retain its employees. Competition in the marketplace tends to determine wages; there is a definite logic to what people are paid; and it has nothing to do with miserliness or generosity.

Also, economists know there is no free lunch. If one person has a gain – in the absence of any increased production — someone else must endure a loss. And we know a lot about those losses. For example, when government forces employers to pay higher wages, employers react by reducing other types of spending on their employees – less training and fewer fringe benefits, such as health insurance. On balance it appears that employees are left worse off. After a survey of the literature, economist Richard McKenzie wrote:

[I]f the minimum wage were raised to $10.10 an hour, for example, the estimated 16.5 million workers earning between $7.25 and $10.10 could lose nonmonetary compensation more valuable than the $31 billion in additional wages they are expected to receive.

In defense of Hillary, Krugman writes:

[E]mployers always face a trade-off between low-wage and higher-wage strategies — between, say, the traditional Walmart model of paying as little as possible and accepting high turnover and low morale, and the Costco model of higher pay and benefits leading to a more stable work force. And there’s every reason to believe that public policy can, in a variety of ways — including making it easier for workers to organize — encourage more firms to choose the good-wage strategy.

But here’s the thing. What works for Costco workers may not work for Walmart workers. And in any event does any rational person think that government should make decisions about these tradeoffs rather than competitors in the marketplace?

The other day The New York Times had two contrasting editorials on its op ed page. One, by Paul Krugman, called for a higher minimum wage and other labor market interventions. The other, by the chairman of Starbucks and his wife, Howard and Sheri Schultz, noted that:

[There are] 5.6 million people ages 16 to 24 in America who are not employed or in school. While some have lost hope in this population … we believe these young people represent a significant untapped resource of productivity and talent. With the right support and training, they can benefit our businesses and our communities.

The Schultz’s have formed a foundation and with the aid of other foundations and high profile companies their goal is to “provide jobs, internships and apprenticeships to 100,000 young people over the next three years.”

Although they don’t say so, their editorial clearly implies that the wage that is paid to these youths doesn’t really matter. What matters is they learn the life skills of showing up for work on time, following orders, conducting themselves in appropriate ways, etc. If they learn those skills, their wages will rise through time without any help from government.

Krugman, Clinton and others on the left say there is no economic harm in raising the minimum wage and in adopting other polices that close off job opportunities for those at the bottom of the income ladder. In making this statement they are ignoring the social costs. The Schultz’s write:

[T]he cost of youth disconnection — including health care, public assistance and incarceration — was $26.8 billion in 2013 alone. Quite literally, we can’t afford to do nothing.

And then there are the personal costs, which do not easily lend themselves to calculation in terms of dollars and cents.

I suspect these costs are not of much interest to either Krugman or Clinton.