Another reason why so many Americans are still unemployed? Don’t blame low skilled immigrant workers, blame the state and federal governments!

Posted on May 14, 2010 by

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The Effect of minimum wage laws on the labor market

A July 2009 article in Time magazine recounts the history of the minimum wage:

The minimum wage was first instituted in Australia and New Zealand in the 1890s in response to frequent, bitter strikes and was adopted by Massachusetts in 1912 to cover women and children. With voters seeking a bulwark against the Great Depression, wage-hour legislation was an issue in the 1936 Presidential race. On the campaign trail, a young girl handed a note to one of Franklin Roosevelt’s aides asking for help: “I wish you could do something to help us girls,” it read. “Up to a few months ago we were getting our minimum pay of $11 a week…Today the 200 of us girls have been cut down to $4 and $5 and $6 a week.”

Roosevelt rode back into office in part on a promise to seek a constitutional way of protecting workers; in 1923, the Supreme Court had struck down a Washington, D.C., minimum-wage law, finding it impeded a worker’s right to set his own price for his labor. The first federal minimum-wage law, the Fair Labor Standards Act, passed in 1938, with a 25-cent-per-hour wage floor and a 44-hour workweek ceiling for most employees. (It also banned child labor.) Outside of Social Security, said Roosevelt, the law was “the most far-sighted program for the benefit of workers ever adopted.” Wages must ensure a “minimum standard of living necessary for health, efficiency and general well-being,” the act stipulated, “without substantially curtailing employment.”

Ever since, however, critics and supporters have slugged it out over the minimum wage: although some believe just like President Roosevelt that it ensures a minimum standard of living, some say that it destroys jobs by making it too expensive to keep workers.  Proponents of minimum wage laws argue that instead of killing jobs, the wage floor increases productivity and boosts consumer spending (Card and Krueger 1997).

The effect of minimum wage laws should be clear even to the least versed in economic theory among us.  Minimum wage laws are a mandatory increase in the cost of filling new positions.  When the cost of filling a job opening exceeds the value from filling that position, assuming rational behavior, businesses will choose not to post or fill new job openings.  Businesses are not charities; they only create and fill jobs when the total revenue generated by new workers will exceed the cost of employing those workers.  Why would any firm engage in non-profit maximizing behavior by raising their cost of production without an equal or larger increase in their output? It is easy to understand why workers who don’t have many skills or who are simply less productive will be left out of a labor market where minimum wage laws are enforced therefore contributing to higher unemployment rates.  Employers take a chance on new workers and offer them wages based on their expected return on the labor cost incurred in production.  Minimum wage laws create a disincentive to create jobs because there’s a very present risk that the new worker may not be skilled enough or productive enough to justify the additional labor cost.

Minimum wage laws were intended to raise the standard of living and yet they do the exact opposite.  High minimum wage laws deter businesses from employing those in the population who are considered “low skilled” workers and so instead of earning a market-wage that matches their particular skill-sets, they find themselves unemployed.  The minimum wage law reduces quantity demanded of workers, either through a reduction in the number of hours worked by individuals, or through a reduction in the number of jobs.  This result is supported by Economics Nobel Laureate Gary Becker and prominent economist Gregory Mankiw among many others who have made enormous contributions to the economic literature in the 20th and now 21st century.

The graph below represents a very simple illustration of the effects of a minimum wage on the labor market:

It is assumed that workers are willing to labor for more hours if paid a higher wage. Economists graph this relationship with the wage on the vertical axis and the quantity (hours) of labor supplied on the horizontal axis. Since higher wages increase the quantity supplied, the supply of labor curve is upward sloping, and is shown as a line moving up and to the right.

A firm’s cost is a function of the wage rate. It is assumed that the higher the wage, the fewer hours an employer will demand of an employee. This is because, as the wage rate rises, it becomes more expensive for firms to hire workers and so firms hire fewer workers (or hire them for fewer hours). The demand of labor curve is therefore shown as a line moving down and to the right.

Combining the demand and supply curves for labor allows us to examine the effect of the minimum wage. We will start by assuming that the supply and demand curves for labor will not change as a result of raising the minimum wage. If no minimum wage is in place, workers and employers will continue to adjust the quantity of labor supplied according to price until the quantity of labor demanded is equal to the quantity of labor supplied, reaching equilibrium price, where the supply and demand curves intersect. Minimum wage behaves as a classical price floor on labor. Standard theory says that, if set above the equilibrium price, more labor will be willing to be provided by workers than will be demanded by employers, creating a surplus of labor i.e. unemployment.

According to Current Population Survey estimates for 2006, 76.5 million American workers were paid at hourly rates, representing 59.7 percent of all wage and salary workers. Of those paid by the hour, 409,000 were reported as earning exactly $5.15, the prevailing Federal minimum wage. Another 1.3 million were reported as earning wages below the minimum. Together, these 1.7 million workers with wages at or below the minimum made up 2.2 percent of all hourly-paid workers. Minimum wage workers tend to be young. About half of workers earning $5.15 or less were under age 25, and about one-fourth of workers earning at or below the minimum wage were age 16-19.  About 1 percent of workers age 25 and over earned the minimum wage or less. Among those ages 65 and over, the proportion was about 2 percent.  Among the states, Alabama, Arkansas, and Oklahoma had the highest proportion of hourly-paid workers earning at or below $5.15 (nearly 4 percent). California and Minnesota had the lowest proportion earning the minimum wage or less (less than 1 percent).

In the CPS report for the year 2007, among the States, Louisiana, Massachusetts, Mississippi, South Carolina, and Texas had the highest proportions of hourly-paid workers earning at or below the Federal minimum wage (at about 4 percent). The percentage of workers earning at or below the Federal minimum wage was lowest (1 percent or less) in Alaska, California, Montana, Oregon, and Washington.  In 2008, Mississippi, South Carolina, Tennessee, and Oklahoma had the highest proportions of hourly-paid workers earning at or below the Federal minimum wage (about 6 percent). The percentage of workers earning at or below the Federal minimum wage was lowest (1 percent or less) in Alaska, California, and Oregon. It should be noted that some states have minimum wage laws establishing standards that exceed the Federal minimum wage. 

On July 24, 2009, the federal minimum wage increased to $7.25 per hour. This is the final step of a three-step increase passed in 2007 when the minimum wage was only $5.15.

After a careful look at data from the US census bureau and the Bureau of Labor Statistics, it is interesting to notice that the states with highest minimum wage also seem to have the highest unemployment rates in the country.  Some may argue that correlation does not mean causation and that the unemployment rate may be cause by many other factors but it would be difficult to dismiss the fact that the price distortion caused by minimum wage laws may be among one of those factors.  States with the minimum wage laws above the federal minimum wage of $7.25, with California (minimum wage $8.00 and unemployment at 12.6%), Rhode Island ($7.40; 12.6%), District of Columbia ($8.25; 11.6%), Illinois ($8.25; 11.5%) and Ohio ($7.30; 11%) leading the way, all have unemployment rates at or above the national unemployment rate (9.9%) with the exception of Vermont, Maine and Alaska. Meanwhile states with a minimum wage below the federal minimum wage law are fairing much better in the labor market.

In conclusion, let’s revisit studies that measured the impact of increases in the required minimum wage.  All credible research has come to the same conclusion: raising the minimum wage hurts the poor. It takes away jobs, keeps people on welfare, and encourages high-school students to drop out. Policy makers should be clear on the consequence of higher minimum wages.  Supporters claim that raising the minimum wage is important for working families. Secretary of Labor Robert Reich often repeats the fact that forty percent of minimum wage workers are the sole source of income for their families. This is misleading because it relies on lumping single, non-family individuals with families. According to a 1995 study: Should the Federal Minimum Wage Be Increased? by Vedder, Richard and Lowell Gallaway, of the National Center for Policy Analysis in Dallas, Texas, only 2.8 percent of workers earning less than $5.15 are single parents. Only 1.2 percent of all minimum wage workers were adult heads of households with incomes less than $10,000. Fifty-seven percent of minimum wage workers are single individuals, many of them living with their parents.  In a 2003 paper published by the Bank of Japan, Japanese economists Sachiko Kuroda and Isamu Yamamoto also found that downward nominal wage rigidity, in other words forces that keep the nominal wage from falling or self adjusting with the supply and demand for labor such as a minimum wage law, always increase unemployment.  They also find that the effects on unemployment can be large or small depending on the rate of inflation.  A 2003 paper published by the Federal Reserve Bank finds that minimum wage laws have a negative effect on employment, particularly on youth employment.  That study also found that out of 17 OECD countries, restrictive labor standards amplified the negative effects of minimum wage laws.  Countries with less restrictive labor standards and less union coverage were able to minimize but not eliminate the effect of the minimum wage on unemployment rates.  A newer study published in February 2010 by Professor of Economics, Michael Hicks of the Center for Business and Economic Research, directly measured the effects of the last minimum wage increase to $7.25.  Professor Hicks as well as Professor Casey Mulligan of the University of Chicago, in different studies, found that the minimum wage reduces the demand for labor, but only if the minimum wage is above the market wage for unskilled entry level labor.  According to Professor Hicks research, the 2009 minimum wage increase accounted for roughly 550,000 fewer part-time jobs now than would have otherwise been the case without the minimum wage increases.   In the light of all the evidence, it is clear that minimum wage laws do not raise standard of living but it actually reduces it by leaving millions of Americans out of the job market.  In addition, minimum wage laws force employers to turn to illegal workers in order to meet their production needs at a wage that is determined by the market equilibrium price of labor if it happens to be below the minimum wage in that particular sector.

References:

Card, David and Krueger, Alan B. Myth and Measurement: The New Economics of the Minimum Wage, 1997.

Hicks, Michael J.  Who Lost Jobs When the Minimum Wage Rose? Center for Business and Economic Research, 2010.

Kuroda, Sachiko and Yamamoto, Isamu.  The Impact of Downward Nominal Wage Rigidity on the Unemployment Rate: Quantitative Evidence from Japan, Bank of Japan, 2003. 

Neumark, David and Wascher, William.  Minimum Wages, Labor Market Institutions and Youth Employment: A Cross-National Analysis, Federal Reserve Bank, 2003.

Neumark, David and William Wascher.  The Effects of Minimum Wages on Teenage Employment and Enrollment: Evidence from Matched CPS Surveys, National Bureau for Economic Research: Cambridge, MA, 1995.

Vedder, Richard and Lowell Gallaway.  Should the Federal Minimum Wage Be Increased? National Center for Policy Analysis, 1995.

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