Minimum-wages - Ivry Man (IM) asks Dr. Know (DK) for his Opinion

Ivry Man encounters Dr. Know sitting on his usual park bench, feeding the pigeons.
DK	Hello Ivry, how nice to see you again.
IM	You too, Dr. Know, particularly since there is something I wish to discuss with you, to get your estimable opinion on.
DK	Of course there is - why else would Lewin be writing this?
IM	I am sorry, I don’t understand.
DK	Never mind. What did you want to discuss with me?
IM	Well, as you probably know, our president is proposing that Congress enact an increase in the minimum-wage from $7.25 an hour to $9 an hour.
DK	Indeed, I am very much aware of this.
IM	It seems to me this is a very worthwhile initiative, wouldn’t you agree?
DK	Why do you think so Ivry?
IM	Well, there is the recession you know, many workers at the bottom of the pay spectrum are suffering. It seems to me it is tough to live even on $9, never mind $7.25.
DK	You are assuming that poor, low paid workers will benefit from this law?
IM	Yes, of course. That is whom the law is meant to help, isn’t it?
DK	I am not so sure.
IM	(now getting visibly agitated). I might have known you would have an annoyingly contrary opinion. What is your problem with this law?
DK	Well, how is it that you help someone by making it more difficult for them to sell their labor?
IM	What do you mean?
DK	Look, someone who has a job and is being paid $8 an hour, is regarded by the employer as worth at least $8 an hour to him. In other words, the employer judges that the worker adds at least $8 an hour to the revenue of the firm. Otherwise the worker would not be paid that amount. In general, a worker will not be paid more than the amount he is estimated to add to the revenue of the firm. Now if you come along and say to the employer, “if you want to employ this guy, you have to pay him at least $9 an hour,” the employer may not consider the worker worth $9 an hour – so he will have to fire him. How have you helped this poor worker? He had a job that paid $8 and now he has no job.
IM	Oh, Dr. Know that is just silly. I am surprised at you. The worker won’t be fired. The employer needs him in order to produce the product.
DK	Hmm, well yes. Maybe it is silly of me. But I still don’t see it. You say he needs the worker to produce the product. But, Ivry, have you not forgotten that the worker is employed at a loss. He is now paid $9 an hour yet he adds less than this to revenue, say $8 an hour. So the employer is losing $1 an hour by employing him.
IM	Maybe not. Maybe he was always adding even more than $9 to the revenue of the firm and because of competition he was paid less than he was worth.
DK	Ok, that is a possibility. But surely not for all of the workers. Do you want to argue that all those workers currently earning the minimum-wage, $7.25, are really worth $9 or more?
IM	Certainly. Everybody knows how workers are exploited.
DK	This borders on the absurd my friend. But for the sake of the discussion, let me grant this. Still, as a result of imposing the higher minimum-wage, the cost of producing the product has now gone up. Surely the employer-producer cannot afford to produce the same number of units of the product. Less will be produced and fewer people will be employed.
IM	No, not at all. The price of the produce may go up a bit. No big deal.
DK	A higher price means less will be sold, so less will be produced and fewer people will be employed.
IM	No, no, this is just an excuse. Consumers need these products.
DK	Really? So consumers will just pay the higher price induced by the increase in cost of production (as a result of the increase in wage costs)?
IM	Yes.
DK	Does this not mean they will be spending less on something else? So someone else’s production will come down? So employment will fall somewhere else?
IM	No, wages are higher now so they can afford to pay more.
DK	My dear Ivry you are arguing in a circle. You can’t deduce an increase in expenditure as a result of a mandated increase in wages paid. They have to be paid by someone who will have less to spend on something else. You can’t manufacture more spending by mandating an increase in wages paid. This is like squeezing a balloon and arguing that there will be more air in the balloon as a result.
IM	Whatever you say Dr. Know. But anyway, even if consumers will spend less on something else as you say, the main point is that these rich companies can take the increase out of their substantial profits, right? Then we don’t have to worry about a decline in demand. The price of the product can remain the same.
DK	Not at all Ivry, not at all. Let me make three important observations. Firstly, it is not at all clear that firms that employ many workers at or near the minimum-wage are high profit firms. Most are probably not. Many firms may go out of business. Many will not be started. Who knows how many lost jobs this represents? Actually no one knows. It may be very large.  Secondly, even for those companies that have large profits, and, somehow, elect to reduce their profits while keeps their production the same at the same product price (most unlikely!), even for them there are consequences. The reduction in profits means a reduction in the rate of return for investors in these companies, and, over time, this means that funds going to them will decline relative to other investment prospects. So, one way or another, those companies intensive in the employment of minimum-wage level workers will decline relative to those who employ more highly-paid workers. Thirdly, you are dramatically underestimating the effect of an increase in the lowest paid workers. To increase the minimum-wage from $7.25 to $9 an hour is a more than a 20% increase! To argue that this will not seriously affect production is highly implausible, especially if the number of workers earning this wage is significant. But, even if this is a small proportion of the workforce, it will have a wider impact. All firms employing hourly workers have a wage-structure based on seniority, experience, qualifications, etc. Someone already paid $9 an hour, before the minimum-wage increase comes into effect, would need to be bumped up to reflect their relative position on the wage structure once those paid less are brought up to the $9 by the minimum-wage hike. This effect will concertina all the way up the wage-scale. Everyone on the scale would have to have their wages increased! The implication is a very much larger increase in the payroll, and, therefore, in the costs of production.  Bottom line – if the firm does not employ low-wage workers there will be little or no effect. If the firm employs a significant proportion of low-wage workers it will raise the cost of production and result in a decline in size and employment for those firms. You cannot get water out of a stone Ivry. Changing the law to mandate a higher wage does not change the reality of who is productive and who is not and why people are poor in the first place. All it does is take away the power of the least productive workers to compete for jobs by offering to work for less.
IM	As always Dr. Know, your logic is compelling and disturbing. If what you say is true why do we have minimum wages? And what are we to do? Does this mean that there is nothing that can be done to help low-paid workers and poor people in general?
DK	We have minimum-wages, and continue to increase them, probably because the public at large does not know what they really do, and the members of those groups that do know how they work, like labor-unions, use minimum wages as a way of ensuring that workers cannot compete with them by offering to work for less. it is a form of protection for those who already have jobs, and whose wages are higher as a result of minimum-wages and the concertina effect I described.  What can we do about poverty? Look, people are poor in the first place because they lack productive resources, usually human resources – qualifications, production-skills, language-skills, etc. They are not poor because employers capriciously refuse to pay them their worth. Employers will tend to pay as little as they can get away with in a competitive labor market. What protects workers is competition for their productive services, not minimum-wages. Workers will tend to be paid their opportunity cost – what they could earn elsewhere. So the best way to help them is to improve their productive skills.  The best way to help workers – and to generally alleviate poverty, is to create employment opportunities for workers. Thus, economic growth is the key to a long-term cure for poverty. Most discussions about this are not about poverty, they are about inequality of earnings, and one should not confuse the two issues. The best route to increasing earnings of everyone remains economic growth – though this may not satisfy some social engineers who are more concerned about gaps in earnings between people. Some people feel strongly about the existence of a safety-net – providing a minimum-income for poor families. The best way to do this is through a negative income tax. This is a policy that would guarantee a minimum income to families (the details would depend on what tax-revenue could generate and what policy-makers decide is desirable). This minimum would be unaffected by decisions to work – it would be guaranteed no matter how much or how little the family members worked. This is the simplest, least intrusive way to provide a safety-net.
IM	But wait a minute. Does this not provide a disincentive to work? Why work if you are guaranteed a minimum whatever you do?
DK	Yes, indeed. The greatest incentive to work is starvation. So make up your mind. Are we willing to let people starve? If not, a negative income tax has the least disincentive to work, because you do not lose your subsidy by working - you get to keep your net-of-tax earnings over and above the subsidy. (This policy would face the problems that all state policies face - trusting the bureaucrats who administer it to do the right thing and know what to do. I am not optimistic about that. But it would be preferable to the many corrupt and ineffective entitlement programs we now have). I suppose you could strengthen the incentive to work by tying welfare to work as well. President Clinton’s welfare reforms did some of this. Now President Obama is trying to abolish this.  (looks at his watch) One final point Ivry – before I have to go. In the absence of state anti-poverty initiatives there would be many more private charitable initiatives – like there used to be in the past. We should not discount the benefits of this. Now I have to go.
IM	So soon? I wanted to ask you more about tax policy.
DK	No doubt a subject for another day, always a pleasure my friend. Be well, be happy – he rises and walks off in the direction of the … .