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Minimum Wage Distorts Reality

A price control is a legal price established by the government that forbids the selling of a good or service above some maximum or below some minimum price. It is an example of triangular intervention—the state coerces two parties to exchange at a certain price. The direct consequence of the effective maximum price control is for a shortage to emerge as quantity demanded exceeds quantity supplied. Secondary effects will include a queue of buyers, non-price rationing by the sellers, misallocation of resources, and malinvestment. This article, however, will focus on a minimum price control.

There are two types of minimum price controls: effective and ineffective.

An ineffective minimum price control will occur when the state legislates a minimum price which is below the equilibrium price. In this case, there will be no effects attributable to the legislation because the good or service is already trading above where the government mandates it must. Thus, there is very little analysis for the economist in this situation.

On the other hand, an effective minimum price control establishes a mandatory minimum price above the equilibrium price. This scenario distorts market processes not only for that particular good, but also for related markets.

The direct effect of an effective minimum price control is for a surplus to emerge. Because the price is higher than what it would be on the market, this induces more suppliers to enter the market. At the same time, the marginal buyers will exit the market in search of substitutes once the higher (non-market) price goes into effect. As a result, the quantity traded of this good will fall in response to the higher price. If the good in question is labor, say in the case of an effective minimum wage law, a surplus of labor will emerge. Consequently, only the most productive workers that earn the minimum wage will retain their positions. The rest would be forced into unemployment or illegal compensation.

There are numerous secondary effects that would likely emerge from an effective minimum wage law. The New York Times recently highlighted some concerns of business-owners about a minimum wage hike–an idea being pushed by Mayor Bloomberg. But there is a deeper economic analysis of this issue that should accompany any discussion of a minimum wage.

First, sellers will misallocate themselves into the market with the minimum wage law. If the law is universal, those that were voluntarily unemployed will experience a rise in the opportunity cost of leisure. In our current system, there is a minimum wage on all industries except agriculture. The short-run effect is to have labor leave agriculture for the mandated higher wage industries.

However, due to the surplus of labor in all other industries, many workers will opt for employment at the lower wage that agriculture offers. Some workers will view this as preferable to being unemployed. Thus, the long-run affect is to further reduce the wages in agriculture because of the increased supply of labor. The minimum wage law has affectively reduced all non-minimum wage industries.

The surplus which emerges in response to minimum wage leads to further secondary effects: queuing and non-price rationing schemes. Queuing implies that labor is literally “lining up” to apply for a job. For instance, a company might have two openings for which they have 100 applicants, and of these 40 might satisfy the marginal revenue product requirement.  On the market, this problem would be solved as workers find wage rates that match their respective marginal revenue products.

Without the ability of wages to fall to match these marginal revenue products, employers can exercise non-price rationing in determining who to employ. Racist employers might now select employees on the basis of skin color, sexist employers on the basis of gender, etc. On the market, this discriminatory behavior would be punished by falling revenue if an employer chose to entertain his prejudices more strongly than considerations of profit and loss.

An additional secondary effect that is likely to emerge is the black market. Rather than accept unemployment, many workers will opt to receive lower wages “under the table.” An unfortunate side-effect of this situation is for sweatshops and other substandard work environments to emerge. In order to increase profit, employers can cut on costs, and this includes amenities and safety precautions that are commonplace on the legal market. Furthermore, sweatshops and unsafe working conditions are likely to persist because there is no legal redress for the workers. After all, there very labor has been criminalized. Many workers are willing to work in these conditions because they perceive them as superior to the alternative of unemployment. In short, minimum wage laws allow for property to go undefended.

Undesirable cultural effects may also arise out of minimum wage legislation. Empirically, young, uneducated males are those that have the lowest marginal revenue products. As a result, this demographic is most likely to experience higher than average unemployment rates in the face of minimum wage legislation. There is a tendency for these young, unemployed, restless individuals to form gangs and earn an income through plunder and theft instead of production. Racial discrimination by employers only heightens the tendency for gang formation. While this observation is not derived praxeologically, it has strong empirical backing. The rise of gangs in the United States is strongly correlated with minimum wage laws.

In industries subject to minimum wage laws, there will tend to be a form of malinvestment of scarce, societal resources. This will come in the form of over-capitalization. In the face of minimum wage legislation, firms will increase their investment in capital goods in order to raise the productivity of their workers so that the higher wage rate may be justified. The hope is that the capital goods will raise the discounted marginal revenue product of each worker by enough to justify the higher wage.

In fact, unions employ this argument to lobby for higher wages. On the surface, it seems plausible that minimum wage legislation has positive effects because it increases productivity and therefore increases the number of goods and services available to all members in society.

However, this analysis ignores what is unseen. The capitalization argument does not account for what investment would have occurred in the absence of minimum wage legislation. This foregone investment would have been more productive to society, by definition, because it would have occurred at the dictates of consumer demand instead of the dictates of politicians wielding coercive force. If the government forces a shift in investment, on net, wealth is being destroyed. The goods that would have been produced are more valuable the goods that are being produced.

Every intervention includes both winners and losers. Otherwise, there would be no intervention at all. Workers with a higher marginal productivity that are thus able to retain their jobs will gain in wealth because they now earn a higher wage. Those that are unemployed, find lower wages, or worse working conditions will be harmed in wealth. Producers will be harmed in wealth because there costs have increased. They are also harmed in utility because they have been coerced into exchange. Consumers will also be harmed in utility because the supply of goods will shrink due to additional costs for producers.

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5 Responses to Minimum Wage Distorts Reality

  1. Keith Worrell March 13, 2012 at 12:37 pm #

    I disagree that gang formation in the presence of minimum wage laws can not be derived praxeologically. Simply, gangs are not merely sub-marginal markets for labor that is otherwise illegal, but an entire black market social fabric. In consideration of Hoppe’s argumentation ethics in advocacy of the adoption of Capitalism and Private Property, many young people can be disenfranchised by the potential offered to them by the lawful society. Little different than what is offered by a military career; it is a different foundation upon which a person may build the life that will be able to meet their future needs.

    Each of these choices carry their own risks and potential for which those on the margin of the lawful society may rationally choose to explore.

  2. libertas March 15, 2012 at 8:53 pm #

    Thanks for the comment. You may be correct that gang formation can be derived praxeologically (I haven’t thought about the issue or done any research on it). Nonetheless, there is a strong empirical correlation between minimum wage and gang formation that many non-Austrian commentators have observed.

  3. Eric Evans March 17, 2012 at 11:23 am #

    “Undesirable cultural effects may also arise out of minimum wage legislation. Empirically, young, uneducated males are those that have the lowest marginal revenue products. As a result, this demographic is most likely to experience higher than average unemployment rates in the face of minimum wage legislation. There is a tendency for these young, unemployed, restless individuals to form gangs and earn an income through plunder and theft instead of production. Racial discrimination by employers only heightens the tendency for gang formation. While this observation is not derived praxeologically, it has strong empirical backing. The rise of gangs in the United States is strongly correlated with minimum wage laws.”

    Yikes.

    The minimum wage does necessarily price the lowest orders of labor out of the market, but that does not have a significant correlation to gang formation per se. As a matter of fact, many of the people who would either create or join a gang are not unemployed by its typically understood definition because they are not looking for ‘legitimate’ work in the first place.

    The idea that gangs form for the purpose of committing crime is largely not the case; most gangs form in areas that already had high rates of crime. The key point that is usually missed is that these areas also have next to no police presence, much less protection. The most common reason people in these areas form gangs is to protect themselves from crime, not to commit it. Even if they do eventually turn to crime it is by getting involved in the drug trade, which is more akin to the black market than to “plunder and theft”.

    But obviously even that can’t tell the whole story of why gangs form; you also have to explore the question of why the areas they live in are the way they are (high rates of poverty, high rates of crime, extremely inadequate public services, etc.). Suffice it to say, there are complex sociological aspects to gangs and gang formation that economics, insofar as only the minimum wage is concerned, is ill-equipped to address. As far as a single target for economists to point at, the best one is probably welfare, which creates a strong incentive for (and indeed rewards) failure.

    I’m also not sure where you got racial discrimination by employers, unless you meant to say the people who can’t get the jobs perceive such discrimination; such overt discrimination barely exists. The minimum wage is the racial discrimination, not just in practice but in intent. If you haven’t had a chance to read it, I would suggest having a read of this recent article from The Freeman, Eugenics: Progressivism’s Ultimate Social Engineering. Another excellent resource is Walter Williams’ book South Africa’s War against Capitalism.

    But otherwise a good article.

    • Keith Worrell March 21, 2012 at 1:34 pm #

      As you said, people often join a gang because they are looking for protection. This is not mutually exclusive with looking for legitimate work. Of people that I have known to turn towards distribution of black market goods or other work opportunities offered by gangs, they tended towards that work as a means of getting by while looking for legitimate work. Being a gang member does not define the type of human being a person is, though it may seem that way under the law in many respects.

      Obviously, the lifestyle choice of becoming a gang member or forming a gang does not revolve around the minimum wage rate, but we can know that were a policy proposed to raise minimum wage to help kids get out of gangs, economics can demonstrate that such a policy would be wholly misguided.

      Sociology and Economics are two different schools of thought, and either could throw red flags in their analysis of public policy without the need to consult the other. As I understand, sociology says that people tend to work to have their needs met by societies norms to the best of their ability before looking for alternative means. (Austrian) Economics says that people act purposefully towards ends desired (people are not random, thought is involved). Criminalization of certain types labor through price controls is going to stress a person away from normative behavior, not towards it. Under these circumstances, the rewards/risk relationship of joining or not joining a gang is changed.

      The seeming necessity to join a gang for survival increases as rewards begin to outweigh the risks. If the market clearing price for your labor is so low that society would make your work illegal, the relative risk/reward relationship of gang membership drops. The rest is left up to will.

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