Why Increasing The Minimum Wage Does Not Necessarily Reduce Employment
Alan Manning
Recent months have seen President
Obama make a renewed push to address inequality in the U.S., especially
via one policy lever he has focused on previously- raising the minimum
wage. For many, conventional economic wisdom states that raising the
minimum wage costs jobs, as employers are less willing to take on staff
at higher rates of pay. Alan Manning takes
a close look at the economics and the evidence of these claims, finding
that one of their basic assumptions, that labor markets are highly
competitive, does not hold. He argues that in light of this, and of
empirical evidence from academic studies of wages and employment, it is
very difficult to claim that wages have a significant effect on
employment in either direction.
A generation ago, the vast majority of
economists would have said that a rise in the minimum wage inevitably
costs jobs. It must, they would have said, if a basic principle of
economics – that the demand for labor falls as wages rise – is correct.
In the current debate over the federal minimum wage, many opponents of
the increase have argued that any rise poses too great of a risk to the
fragile economic recovery. However, recent research shows this truism to
be over-simplified and not reflective to the realities of the labor
market. Rather than automatically reducing employment, an increased
minimum wage presents mixed outcomes.
Until the mid-1990s, almost all studies
of the minimum supported the idea of an unwelcome trade-off between wage
regulation and employment. But the cozy consensus was shattered by the research of
two economists, David Card and Alan Krueger, then both at Princeton.
They argued that the actual evidence linking the minimum wage to job
losses was weak. More important, they offered new analyses concluding
that the minimum wage – at the levels observed in the United States –
had no effect on employment, and might even raise it! Their seminal
study compared employment in fast-food restaurants in two adjacent
states, New Jersey and Pennsylvania, after New Jersey raised its minimum
wage.
It’s important to bear in mind –
certainly Card and Krueger did – that there is still universal agreement
that employment is sensitive to a wage floor when it reaches some
level. But the two economists were equally convinced by their research
that, in the American context, modest increases in the minimum had no
effect on jobs.
To say the Card-Krueger research
generated controversy is an understatement. Its publication coincided
with a debate over raising the federal minimum wage, so the ensuing
academic dispute was inextricably mixed with politics. Other academics
testified to Congress that the Card-Krueger conclusion amounted to a
rejection of the economist’s version of the theory of gravity – and that
evidence of antimatter should be treated with great skepticism.
The battle lines haven’t changed much since then. For example, the White House’s 2013 fact sheet on increasing the minimum wage approvingly cited a study by
Arindrajit Dube, T. William Lester and Michael Reich, economists at the
University of California, Berkeley, comparing employment growth across
states (essentially a souped-up version of the earlier comparison of New
Jersey and Pennsylvania) and concluding that differences in the minimum
wage among states had no effect. This study has since been criticized by
two other economists, David Neumark of the University of California,
Irvine, and William Wascher of the Federal Reserve Board, who have long
been defenders of the conventional wisdom on the minimum wage. Their
arguments are technical, concluding that a better analysis of the same
data supports the old view that the minimum wage destroys jobs.
What is an outsider, especially one
lacking the economist’s statistical weaponry, to make of all this? I
think the simplest and most persuasive explanation for radical
differences in researchers’ conclusions is that the differences in
employment being measured aren’t large – and that it is often hard to
disentangle small effects from all the other forces affecting
employment.
In the circumstances, I think it is best
to focus on the studies with the most accurate, fine-grained data, and
increasingly those are studies with access to payroll information from
individual firms. In 2011, Barry Hirsch, Bruce Kaufman and Tatyana
Zelenska used data from
a chain of fast-food restaurants in Georgia. They analyzed the impact
of the rise in the federal minimum wage in 2007-9, exploiting the fact
that this rise had a bigger impact in low-wage regions (often rural
areas) within the state. They found clear effects on earnings, but no
effects on employment.
In spite of this accumulating weight of
empirical evidence, it is still very common to find economists falling
back on the argument that a minimum wage must cost jobs because demand
curves for labor inevitably slope downward. Faced with a conflict
between the evidence and 20th century economic models, they reject the
evidence rather than the theory – not an ideal template for scientific
endeavor. But there are, in fact, uncomplicated theoretical reasons why
the minimum wage set at the levels seen in the United States has little
or no effect on employment. Hence the problem may be with the economics
all too often taught as dogma.
The Minimum Wage – What’s wrong with economics 101?
Bare-bones models of market behavior may
assume away important elements of reality. First, the increase in total
labor costs associated with a given increase in the legal minimum wage
is often considerably smaller than the numbers suggest. As the minimum
wage rises and work becomes more attractive, labor turnover rates and
absenteeism tend to decline. Moreover, the sacrifice associated with the
consequences of losing a job rises; so, arguably, workers are inclined
to work a bit harder and need less monitoring. Absenteeism and shirking
are not trivial problems in many low-wage labor markets, so one can
reasonably expect to see a material reduction in the associated costs as
the minimum wage rises.
Of course, an employer could voluntarily
choose to pay $9 an hour if net labor costs actually fell as wages rose
and one would expect some to adopt higher wages without government
prodding if it were, in fact, a win-win. So a reasonable guess here is
that these offsetting economies reduce, but do not eliminate, the impact
of a rise in wage rates.
Then there’s the gap between employer
perception and reality. Individual employers often view a rise in wages
(or other costs) with horror, assuming it will drive them out of
business. But they’re all too often implicitly assuming that they alone
will suffer the cost inflation – that changes in the minimum wage will
leave them at a disadvantage with respect to competitors.
In reality, businesses generally try to
pass a rise in the minimum wage (or sales taxes or anything else that
raises the cost of doing business for all) on to their customers. So
with fast food, one would expect firms to raise prices. In that
circumstance, the effect on employment is only through the effect of a
fall in sales of the product, which may well be minimal. Ask yourself:
do you eat fewer Whoppers if the price goes up a little at the same time
as the price of Big Macs (and Taco Bell Burrito Supremes) goes up a
little? Do you even keep track of the price changes?
Theory and reality reconciled
Actually, there is a more fundamental
reason why one cannot find the job losses predicted by standard-issue
economic theory. The key assumption, that labor markets are highly
competitive, is often wrong. The view of the labor market that underlies
Economics 101 is not one that many people would recognize. For in this
hypothetical world, losing a job is no big deal because finding an
identical job is no harder than discovering that the local 7-Eleven is
out of Coke and driving around the block to a Circle K for a six-pack.
But that is not most people’s experience of labor markets. The reality
is that competition for workers is not as strong as many economists
would have you believe. An employer who cuts wages will find that most
employees are unhappy, but that few will just walk out the door. It thus
follows that it may make economic sense for employers to pay workers
less than the marginal worker adds to revenues. This
completely alters one’s expectations about how a change in the minimum
wage will affect the labor market. In this world, a change will not
necessarily price the marginal worker out of his job.
Consider, too, that the higher minimum
will increase the supply of labor, so the firm may actually find it
easier to recruit workers. The bottom line: if one drops the assumption
that the labor market is fully competitive, an increase in the minimum
wage can lead to a decrease or an increase in total employment. The
direction can only be discovered through observation. And as we’ve seen,
the empirical evidence does not suggest much effect on employment at
the levels of the minimum wage seen in the United States.
Although many people find the stylized
account of how labor markets function that’s presented here to be
credible for skilled workers, they still doubt it is relevant for
minimum-wage workers – the archetypal teen mom flipping burgers or
bussing tables. Surely, the argument goes, there are so many potential
employers for this sort of labor that one should be able to switch jobs
easily. But the reality that some low-skill openings go begging actually
tells us that the constraint on employment may be as much labor supply
as labor demand.
Economists often have a blind spot on
this point. Indeed, I am baffled by their degree of resistance. For
example, last year Christina Romer, a former chairwoman of President
Obama’s Council of Economic Advisors (and an analyst with impeccable
credentials as a champion of the poor), wrote critically
of the proposal to raise the minimum wage, arguing that competition
between employers was sufficiently robust to push wages close to the
marginal product of labor. She seemed trapped in the view that the only
exceptions were cases in which large employers dominated a local market –
say, a coal mine in a remote corner of Appalachia. I believe that, in
most circumstances, the market power of employers derives from the fact
that it’s hard for workers to change jobs even when there are
alternative employers in abundance.
Consider an irony. The financial crisis
has rightly shaken the beliefs of many economists that financial markets
can do no wrong because they are disciplined by competition. But faith
in the competitive nature of labor markets seems unshakable in the teeth
of evidence to the contrary. Markets (labor markets as well as
financial markets) need to be regulated to work well, and the minimum
wage is a legitimate weapon in the regulatory arsenal. Next time you
read that minimum wages hikes inevitably destroy jobs – that you don’t
need an econometrician to tell which way the labor market blows –
remember that economic theory is no better than the veracity of the
assumptions on which it rests.
This article is based on a paper from the Milken Institute Review and was first published by USAPP@LSE.
