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May 13, 2015 / Gabriel

Questioning the Wisdom of Minimum Wages

The minimum wage is advocated as a well-intentioned means to increase the earnings of the poor, but a deeper look at the economics and demographics behind it indicate that such legislation isn’t necessarily the proper means to achieve those ends. Here’s why.

Higher Price, Lower Demand

As it is imagined, raising the minimum wage forces employers to pay all of their entry-level employees a higher wage than before, thereby raising their standard of living. This is true only if employers have no adverse reaction to changes in the cost of entry-level labor.

Imagine for instance a government-mandated 20% increase in the minimum cost of magazine subscriptions. Should the magazine publisher automatically assume that not a single subscriber will unsubscribe after such a rate hike? Or that they will sign new subscribers at exactly the same rate as before? What if it’s a 50% rate increase?

Price elasticity

It’s an economics concept that everyone understands: as the cost of something increases, demand correspondingly decreases. The extent by which demand is affected by changes in price is called price elasticity. For some things, the price elasticity is very sensitive: a small change in price will have a major impact on demand (e.g. a 20% increase in magazine subscription cost might cause 50% of subscribers to cancel their subscription). For other things, there is less price elasticity (e.g. a 20% increase in subscription cost might only cause 2% of subscribers to cancel). But absolutely anything that has a price has some price elasticity, without exception. Including the price of entry-level labor.

Employers, like consumers, respond to prices. As the cost of entry-level labor increases, some employers will continue to pay for that same labor at the higher wages, but some will not, either reducing hours, cutting jobs, changing the way they do business or forced out of business. And of course the greater the increase in labor costs, the greater the impact on employment: a $0.01 increase in the minimum wage will have very little impact, whereas a $10 increase would likely lead to significant layoffs and bankruptcies.

So the first question anyone should ask about any proposed hike in the minimum wage: how much will it increase unemployment? To claim that it will have no impact on net employment would mean that wages could be increased to any hourly rate without ever causing a drop in demand for that labor. In other words, someone claiming that there is no price elasticity to entry-level labor is arguing that raising the minimum wage to $20 or $50 or $100 per hour would have zero impact on employment, which is not credible. Minimum wage laws above market rates are not about if they increase unemployment, but by how much they do so.

“The true minimum wage is zero—the amount an unemployed person receives from his nonexistent employer.” — Milton Friedman, Nobel Prize winner in Economics

The government well understands this tradeoff as well. For instance, the Congressional Budget Office recently estimated that the latest proposal to raise the minimum wage from $7.25 to $10.10 per hour would cause 500,000 current minimum wage workers to lose their jobs. A worthwhile price to pay for those that will now earn more? Perhaps, although there is a questionable morality to intentionally robbing the worst off of their income and livelihood in order to benefit others. It’s easy to play God with abstractions, but what if it were your job being sacrificed?

Where the Money Comes From

When it comes to where the money will come from to pay higher minimum wages, it is typically assumed by its proponents that businesses will simply reduce their profits a little to pay the workers more. The reality, however, is that the vast majority of businesses–and especially those that rely on minimum wage labor–run on thin margins. The average profit margin for all businesses is around 8% and small businesses–those that fuel job and economic growth–typically fall under that.

According to the Bureau of Labor Statistics, half of all minimum wage jobs are in the restaurant industry, which has an average profit margins of 2 – 6 percent. Not oil or drug companies or Wall Street banks, who have essentially zero use for entry-level wage workers. Labor makes up a disproportionate amount of a restaurant’s costs, with non-managerial labor typically in the 20 – 25% of revenue range. The math is simple: if you were to force restaurant wages up by 20%, that would add 4 – 5% in total costs and completely wipe out the average restaurant’s profit margin. The only way for most restaurants to stay in business would be to raise their prices. Assuming they stay in business after doing so, it’s inescapable that they’re not the ones paying for the wage hikes–the customers are.

In the vast majority of cases, a hike in the minimum wage is not a transfer of additional money from businesses to employees, as its proponents imagine, but a transfer of money from customers to employees. And the latter is not necessarily the more disadvantaged group.

Minimum Wage Does Not Equal Poor

One of the biggest misconceptions is that minimum wage earners represents “the poor.” There’s actually very little overlap between the two.

According to the Bureau of Labor Statistics, 2.28% of American workers earn the minimum wage. Of those, half (48%) are under 25, and these 16 – 24 year-olds live in households with an average family income of $66,000. That’s nearly double the national median household income and three times the national poverty line. These minimum wage earners aren’t anywhere near poor–they’re middle class teenagers, college students and young adults just starting out in the job market.

 Minimum Wage by Age

And what of minimum wage earners over 25? Their ranks dwindle very quickly as they age (over 70% of minimum wage earners are under 35), and their average household income is $42,500 a year, well over the national median and nearly double the poverty threshold. Half of them are working part-time, and two-thirds are white, mirroring national demographics. In other words, the typical profile of minimum wage workers over 25 is of second earners in mostly young, middle class households.

Are there any 25+ year-old minimum wage earners living below the poverty line? Yes, about a quarter of them are–roughly 13% of all minimum wage earners. That’s about 387,000 workers, or 1.3% of the 30 million American adults stated to be living in poverty. That makes for next to zero overlap between minimum wage earners and the poor. In fact, the biggest problem for the poor isn’t their wage level but lack of jobs: 67% did not work during the past year. And of those that worked, 3/4 didn’t have a full-time job. The poor need a larger supply of available jobs, not less.

 Minimum Wage Venn 3

Minimum wage jobs are primarily a stepping stone to better employment opportunities for the young, or a part-time work opportunity for second income earners. These types of jobs are not meant to be a career nor the primary means to earn a living. These jobs are also not the home of the nation’s poor, 98.7% of whom aren’t minimum wage earners.

More importantly, entry-level jobs are the entry point into the job market for teenagers with as of yet no marketable skills or job experience, a gateway to better opportunities. Most top income earners once started with such employment back in their teens. The higher the first rung of the employment ladder, the more out of reach it becomes for many, robbing youths and new members of the labor force (e.g. financially disadvantaged immigrants) of valuable job training and experience.

And what happens to teens and young adults with no money or viable job prospects? Priced out of employment by minimum wage laws, they’re faced with a choice between poverty, black market labor (with no employment protections), or crime. In other words, minimum wage laws aimed at helping the poor are in fact likely to be inadvertently contributing to their perpetual disadvantage, locking inexperienced teens and young adults out of a viable entry point into the legal job market where their skills–and income–could grow over time. Instead of a path to prosperity, this creates a systemic, perpetual cycle of poverty and crime.

“The net economic effect of minimum wage laws is to make less skilled, less experienced, or otherwise less desired workers more expensive — thereby pricing many of them out of jobs. Large disparities in unemployment rates between the young and the mature, the skilled and the unskilled, and between different racial groups have been common consequences of minimum wage laws.” — Thomas Sowell, economist and Senior Fellow, Stanford University

Helping the Right People

The impulse to do something to help the poor is right and noble, but on that front good results count far more than good intentions. If the goal is to provide the actual poor with more direct income, a tax credit (such as the EITC) is by far the simplest and most direct means to do so, targeting the exact income ranges and family situations to provide taxpayer-funded assistance to those who actually need it. Trying to artificially do so via a legislated minimum wage, which affects just 1% of the country’s working poor and whose benefits–to the extent there are any–fall mainly to teenagers in wealthy families, is both ineffective and likely counterproductive.

Asking the Right Questions

Honoring the noble motives of those who favor an increase of the minimum wage, the above economic and demographic considerations nevertheless prompt the following important questions:

1) What is the price elasticity of entry-level labor? (i.e. how much will the proposed rate hike increase unemployment)

2) Why is it morally right to eliminate the livelihood of some so that others may financially gain?

3) What does the additional unemployment do to the long-term health of the overall economy?

4) Why is a forced raise that primarily benefits teens and young adults from wealthy families better than the same money given directly to people who actually need it?

Are there possible answers to all of these questions? Sure. Minimum wage policy is one of the most fiercely debated topics in economics, with highly respected economists, research and empirical evidence on both sides. One need look no further than the hundreds of economists openly against or in favor of minimum wage laws, each with Nobel Laureates.

But one thing is clear: it’s a topic–and legislation–that warrants a lot more intelligent thought and respectful consideration than most of its advocates give it. On both sides.


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