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Why 95% of Traders Fail

The Minimum Wage Debate – So What?

Economics / Wages Apr 09, 2016 - 05:44 PM GMT

By: Andy_Sutton

Economics

There has been an incredible amount of posturing, debate, and arguing over the minimum wage situation – particularly surrounding recent events in California and New York where legislation was recently signed into law that would effectively double the nominal minimum wage over the next several years – 6 years in California, and 3 in New York City. The rest of New York will see the changes phased in over a longer period of time.

Instead of diving headlong into the useless arguing and name-calling, I think it is important to take a step back from the dogmatic rhetoric we hear on television, from the media, our legislators, and those in academia and take a hard look at the economics behind the idea of having a minimum wage to begin with. This going to take a bit of a leap for pretty much all of us since we’ve either grown up with a minimum wage in place or have had a job that paid minimum wage at some point – myself included.


I also understand that it is a political season here in the United States and with an economy that is more congested than the sinuses of half the Northeast population, talking about people’s bottom line is going to elicit some serious responses. People are going to react emotionally instead of rationally. So I’m not going to give my opinion. I’m going to try to remove myself from the debate and present facts and positions on both sides and let you – the reader – decide.

I am prefacing this examination of the minimum wage situation with the admission that there are many variables involved – well beyond the scope of this paper. Entire textbooks could easily be written just on this topic. The purpose of this paper is to bring about a better general understanding of the minimum wage, the more salient arguments for and against it, and the application of the laws of economics to the subject.

The Arguments ‘For’ a Minimum Wage – and the Increase

One of the biggest arguments for a minimum wage over the past several decades was that it was intended to create a ‘living wage’. Someone should be able to go get a job that pays the minimum wage and run a household off the proceeds of their endeavors.

Using the ‘living wage’ doctrine, it is easy to see why the wage MUST be increased. With a 2000 hour working year, even a minimum wage of $10/hour pays $20,000. This is before federal, state, and local governments cut themselves in for a piece of that already small pie. According to H&R Block’s basic tax calculator, a single person in this situation is going to pay around $1000 to the federal government, another $604 if they reside in Pennsylvania like I happen to, and another $200 to the local government (again, assuming they live where I do in PA). In totality, that’s nearly 10% of their wages. So they’re down to $18,000. Renting any decent apartment will eat up at least a third of this. Throw in utilities, vehicle expenses, food, clothing and so forth and it is pretty easy to see how even $10 is really going to be falling short of being a ‘living wage’.

I will quickly grant that every area is different. There are tax breaks, etc. You throw a second breadwinner into the situation, get a roommate, live with family, etc. and $10 is doable. There are too many variables to properly cover every single scenario in a book, let alone an op-ed piece such as this one.  But the federal minimum wage is only $7.25/hour. Suddenly, that $20,000/year drops to $14,500/yr. Still tenable? Probably not. $7.25 certainly isn’t a living wage.

The “Value” of the Minimum Wage Keeps Dropping

The second major argument for hiking the minimum wage is that frankly, our money just doesn’t buy what it used to. The dollar has lost so much of its value that consumers need more and more dollars to purchase the same amount of goods and services as they had previously.

There are statistics galore about the erosion in the dollar’s purchasing power and most of them are invalid. Here’s an example. Most people like potato chips. Let’s say that back in 2006 a bag of plain old potato chips was $1.79. I don’t know what the price is and when you see where I’m going you’ll understand that the price is actually irrelevant. That bag was 16 ounces. Today, you’ll pay around $2.50 for a bag of chips on sale, depending again on where you are, etc. The problem is, you’re not buying the same bag of chips. Many of the bags that used to be 16 oz. are now 12, 11, or even 10 ounces. You’re paying more and getting less. But when the ‘value’ of the dollar is calculated they ONLY look at the price. $1.79 to $2.50 in 10 years isn’t that bad they’ll say. What they should look at is cost per ounce. Ice cream is another big one. Orange juice another. If you do any amount of grocery shopping, you’ll know exactly what I’m talking about.

So where this interfaces with the minimum wage, is the data are distorted. The $7.25 is bad enough if you use the government’s measures of inflation. It gets even worse when you look at the actual purchasing power of the $7.25 – what it will actually buy.

Incidentally, this is the main reason the minimum wage needs to be raised periodically – our money is losing value. This is not my opinion, it is the main reason cited by economists and policymakers when arguing for minimum wage hikes.

Low Minimum Wages are Actually Subsidies for Business

I included this one because it came up on quite a few lists of arguments for raising the minimum wage, but in fairness, this is a two-edged sword and I’m going to cut with the other side in the next section of the article.

The premise behind this argument is that if our hypothetical worker discussed above makes less than a living wage, he or she is going to turn to the government for assistance. This is almost assuredly true. Something will have to be done. They’ll need a roommate, help from parents, credit cards, or help from the government. They’ll need assistance. Most likely it’ll end up being all of the above.

So our hypothetical worker applies for government assistance. The argument is that now the government is basically paying these people. If the minimum wage were a living one, the business owner(s) would be paying the person instead. Proponents of higher minimum wages will argue that having too low a minimum wage places a burden on the taxpayers. A recent UC Berkeley study stated that taxpayers pay around $243 billion each year to subsidize fast food workers alone. This money is paid because those people don’t make enough at their jobs and apply for government assistance. The argument is that raising the minimum wage will cut into that $243 billion in subsidies.

And the Rest…

The three arguments above were selected out of several lists because they were the ones that had merit. The remainder of the arguments for an increased minimum wage were of the variety of ‘So and so said it should be done’. Whether it was Nobel laureates, university professors, the government bureaucrats, churches, or politicians. The last is somewhat hilarious because this is an election year. It is well accepted by pretty much everyone that politicians will say whatever they think will get them elected. If they thought that legalizing goat racing in Honduras would pave a path to the Oval Office, they’d advocate it.

The bottom line is that ‘because I say so’ is not a valid argument for any policy, hence the discounting of many popular arguments for raising the minimum wage and the absence of those arguments in this piece.

Part II – The Arguments Against

After reading the above it might seem downright cruel that anyone would be against raising the minimum wage. It has already been demonstrated that $10/hour is not going to cut it, especially in areas where there is a high cost of living. Good examples of this would be New York, particularly in the 5 boroughs, California (oddly, where the recent legislation came from), and most other urban areas.

The Minimum Wage is a Price Control

At its barest level, the minimum wage is a price control. People don’t often think of it this way. They’ll understand the state minimum price on things like cigarettes or milk, but don’t understand that labor also has a price. The minimum wage is merely the price of labor, but understand that price and cost do NOT mean the same thing. The price of labor is what the company pays the employee. The cost is the total financial and economic burden of carrying that employee on the payroll. These are two very different concepts.

I am including a link to a paper I authored sometime ago on partial equilibrium analysis because the minimum wage is a prime example of a situation where this analysis comes in handy. It’s a somewhat long read, but if you really want to understand what is going on economically, it’s well worth the time in my opinion.

In a free market, price controls are generally avoided because they create what is called a total welfare loss – somewhere. It might be the employee, the firm, the general public, or some combination of those actors. Anytime there is disequilibrium between supply, demand, and price, there is an inefficiency. Where there is inefficiency, someone loses. So, by definition, price controls create loss. This is a fact of economics and of nature. Now, great meandering by statisticians, economists, etc. has been done to move that loss around or to make it appear as though it is being shuffled, but the fact is it cannot be eliminated. The nice thing about advanced economics and mathematics is that we can quantify the amount of the loss; or at least attempt to. This is where the Berkeley study mentioned above was going. They attempted to quantify the amount of the subsidy paid out by the government (taxpayer) as a result of the price control.

Take a look at the graphic above. If you look at the intersection of W0 and L0 you’ll see that represents equilibrium. Put more simply, supply=demand at a particular price level. Can there still be unemployment even if the price of labor as at equilibrium? Absolutely. Firms can still close, even if there is equilibrium with regard to the price of labor. There can be labor shortages too if new firms open. Keep in mind also that there is not just one equilibrium; there are many. The supply/demand dynamics for fast food workers are completely different than those of NASA rocket scientists. So, following the logic, there will be many, many equilibria. The point here is to convey a general understanding of how equilibrium works.

Now, pay particular attention to the W1 line that is parallel with the x-axis. This represents the price control: the minimum wage. In this case, it is above the equilibrium wage. If you have a good understanding of this concept, you’ll understand that there is no point to setting the minimum wage price control below the equilibrium. Such an exercise would be pointless. If such were the case, what we would see is there would be nobody making minimum wage; almost everyone would be making more. We’ll get back to this point a bit later.

Now, take a look at the above chart with the filled in red area. This represents the inefficiency or ‘welfare loss’ referred to above. This is the waste if you will, that is created by the price control. What is more important is that if you look at where the supply and demand lines intersect W1, you’ll notice that supply is greater than demand. This means the price control has created a labor surplus for this particular equilibrium. If we are talking about the fast-food worker, employers are not going to demand as much labor at the higher price. Given the same cohort of workers as before the price control, some will likely lose their jobs. In that case, the worker bears the brunt of the shaded in area of inefficiency or welfare loss. It is also important to note that supply and demand ‘curves’ are rarely linear as is shown. The straight lines are used for simplicity’s sake and to help illustrate what is going on.

Now let us go a level deeper into why the above is the way it is. Let us discuss price versus cost. For those of you with business backgrounds, think of the profit maximizing function where marginal cost equals marginal revenue. If we are talking about labor, an employer will only add another unit of labor (employee) when the revenue gained from adding that worker is at least the same as the cost the employer bears for employing that worker. If the revenue gained from adding that worker is greater than the cost, the employer may well hire yet another worker. Now, do all employers sit down and actually figure this out? Most definitely not. But from an efficiency standpoint it makes no sense to hire a worker when it’ll cost more to employ that worker than the revenue the worker will bring into the firm.

So again, looking at the minimum wage worker, we are talking about doubling their rate of pay. But what is the effect of doubling the price of labor on the total cost of employing that worker? It is generally accepted that the actual cost of having an employee is 125 to 140% of that employee’s wage. Studies at MIT and the Department of Labor are generally in agreement on this range. The range is so broad mostly because of the non-mandatory benefits that many employers provide like health insurance, vacation, bonuses, etc. and the cost of all of those items vary greatly. Put in the terms used thus far in the article, the cost of the employee is 1.25-1.4 times the price of the employee. Using the example of a $15/hour minimum wage for fast food workers and a 25% premium for the mandatory programs like FICA, Medicare, Unemployment, and Worker’s Compensation, the cost of carrying a worker is $18.75/hour. If the employee can’t generate that much revenue for the firm, then there is no point in having that worker.

Based on the above, one might ask the question – can anyone at McDonald’s or Burger King generate that kind of revenue at the current prices these establishments charge for their products? Remember that labor is only a portion of the cost of producing a Big Mac. There are raw materials costs, building rents, taxes, and general overhead as well. The point here is that just because the minimum wage doubles, the price of a Big Mac doesn’t need to double to cover the increase in wages paid, all else remaining the same.

The Minimum Wage Only Applies to a Small Percentage of Workers? Yes AND No

This is where things get interesting. According to the US Department of Labor, the number of workers earning the prevailing minimum wage (or less) in the US in 2014 was 3.9% of the workforce. There seems to be this perception that a huge proportion of workers are paid the minimum wage and that simply isn’t true. However, let’s take the person making $8/hr. How much better off are they than someone making the $7.25/hour statutory minimum wage? I know, 75 cents an hour, but really, they might as well be included in this group too. And you can run that logic up the flagpole to the $10/hour and even $15/hour levels and you’ll catch more and more folks.

This is where the whole ‘living wage’ doctrine falls short because it is very subjective. What exactly constitutes a ‘living wage’?  How much per hour? Nobody can really say because it is subject to perceptions and opinions. What one actually needs versus what one thinks they need comes into play. It is impossible to base any type of scientific study or experimentation on something so ersatz in nature.

The problem with doubling the minimum wage is now you’re not just talking about the 3.9% who currently make minimum wage, you’re talking about everyone up to $15/hour in the case of NY and CA. Obviously that is going to involve a lot more workers. Take the person currently making $14/hour. They’re making almost double the current minimum wage. When this goes into effect they’ll get a $1/hour ‘raise’. Keep in mind, the $14/hour worker might very well be the manager that supervises minimum wage workers and now they’ll be making the same amount of money. So the firm is going to have to bump the manger up accordingly. But now the manger makes more money than the district manager and so forth. What is likely to happen is that such a dramatic hike in the minimum wage over such a relatively short period of time will cause a wage-price spiral, especially if the federal minimum wage was raised, thereby affecting everyone. Firms will have to cover their increased costs somehow. The ability of firms to raise prices is going to be determined by the elasticity of demand for their products, among other factors such as regulatory inhibitions like those found in healthcare, etc.

Minimum Wage Jobs Are Not “Career” Jobs – The ‘Living Wage’ Argument Nullified

Many people who read this paper will be able to say that they started their first job as a teenager making minimum wage, your author included. While the argument can be made that someone needs to flip burgers, there are plenty of teenagers. Note the graphic below:

Please pay attention to the explanation of ‘near minimum wage workers’. These are folks who are essentially making less than $10.10/hour. Without passing judgment on anyone it must be noted that the vast majority of these workers are working jobs that are meant to be ‘starter’ jobs and that is the role these jobs have traditionally played in the economy. In fact, nearly half of all minimum wage workers are between the ages of 16 and 24 according to the Department of Labor.

The fact that there are people who are working in beginner’s jobs’ due to layoffs and the need for additional household income, etc. is more an indictment of the general health of the USEconomy and really has very little to do with the minimum wage situation at all. By and large, minimum wage jobs don’t exist to pay a ‘living wage’, they’re a place for young people to start out, learn the responsibilities of employment, save for college, and so forth, not to support a household.

3.9% is Telling Us Something Regarding the Minimum Wage

To elaborate from above, the fact that just 3.9% of workers are currently making the minimum wage, from a supply and demand perspective, demonstrates very strongly the fact that the wages for the vast majority of workers are already higher than the price control and are already in fact close to or at equilibrium. There is a perception that businesses are too frugal and don’t want to pay people and that this needs to be remedied by government interference via a price control. If that were really true, we’d expect to see a much, much higher proportion of the workforce trapped at the minimum wage level. Again, referring to the chart above showing the kinds of jobs in the $10.10 and less range, they are starter jobs for the most part. Or at least should be.

In fact, if the federal minimum wage ends up being increased to $15/hour, the proportion of people making minimum wage will go up dramatically. If business adjust proportionately and increase up their corporate food chains to compensate for this interference, something will have to give. Layoffs are a real possibility and in fact very likely. A switch from use of human workers to automation is another possibility. Increased prices are virtually guaranteed. Another point that needs to be mentioned is the increase in government tax revenues as a result of a doubling of the minimum wage in CA and NY. Obviously the federal government will benefit from this too and that reality probably accounts for many of the calls from Washington DC for dramatic increases in the minimum wage.

In Conclusion

In summary, probably the most important take-home from this discussion is there is a significant, but not overbearing, cohort that is trying to live off of jobs that were historically performed by young people and those looking for casual income. The loss of the majority of the manufacturing base in the United States needs to be included in this discussion. For the most part, this discussion is not taking place. The evisceration of the goods-producing base has been a national policy for nearly 30 years and it is long overdue that those responsible be held accountable. Another crucial piece of this discussion stems from the loss in purchasing power of the dollar. The policy of dollar devaluation has been systematically and publicly pursued by the federal reserve over the past 100+ years. This has been done without shame, regret, or accountability. If the United States were to return to a system of honest money (gold and silver or at least gold and silver backed), a minimum wage increase would not only be unnecessary, but the idea of a minimum wage in the first place would be pointless as well.

By Andy Sutton

http://www.my2centsonline.com

Andy Sutton holds a MBA with Honors in Economics from Moravian College and is a member of Omicron Delta Epsilon International Honor Society in Economics. His firm, Sutton & Associates, LLC currently provides financial planning services to a growing book of clients using a conservative approach aimed at accumulating high quality, income producing assets while providing protection against a falling dollar. For more information visit www.suttonfinance.net

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