Minimum Wage Laws Create Unemployment

This insight is always important, in that the unemployment created by this pernicious legislation always attacks the poor and the unskilled, precisely the people who can least afford it.  But it is even more crucial to understand this economic law in the age of pandemic, for two reasons.  One, the unemployment rate has now skyrocketed to gargantuan proportions thanks to government shutdowns.  Two, the Democrats are attempting to impose a $15-per-hour minimum wage on all businesses that receive government relief packages, now and for the future, even after COVID-19 is no longer a threat.  Let us, then, more clearly understand the pernicious effects of this unwise legislative enactment.

What determines wages?  At what level would wages register were there no laws on the books regarding this matter?

The long answer is that Discounted Marginal Revenue Product, DMRP, or productivity for short, determines wage levels.  What is that?  Many people talk about productivity, and we all know, roughly, what it means, but what are the exact specifications of this concept?  It is all about how much you add to the firm's bottom line.

If the business receipts rise by $5 for every hour you are on the shop floor, or behind the counter, or pushing a broom, then that is the level of your productivity. We posit, here, that the reason for the increase in sales is due to your efforts.

Wages tend to equal precisely that amount.  If you are paid only $2 per hour, the employer can earn a profit of $5 - $2 = $3 per hour.  But this cannot long last, no matter how much the firm favors this sort of situation.  What will tend to disturb this state of affairs?  One source is other businesses, who would be more than willing to pay you $2.01, or $2.02.  They would reason that they would prefer to "exploit" you to the tune of $2.99 or $2.98 rather than have your present employer do so at the rate of $3 per hour.  Where will this hypothetical bidding process end up?  In the neighborhood of $5, when no more profits can be made.

Another source is you yourself.  After hours, you can approach other business firms and offer to work for them for more than your present $2 salary.  You may demand, say, $2.25.  If this other company is smart, namely profit-seeking, IT will hire you for that amount, since it will still clear $2.75 from your labor.  This process will continue all the way to $5 per hour, in equilibrium, since at that point there is no further room for the wage to rise.  But this assumes there are no (transactions) costs of the bidding.  If these are low, then there is a tendency for the wage to approach closer and closer to the $5 level.

But suppose this process overshoots, and someone pays you $7 per hour.  This, too, is not a stable situation, since any firm foolish enough to do so will lose profits to the tune of $2 per hour.  Bankruptcy is just around the corner if we generalize from this mistaken hire.

Accurate assessment of employee skills is important for successful employers.  If a firm overestimates labor productivity, it will lose money, and if it errs in the opposite direction, it will face grave difficulties in attracting a labor force in the first place and retaining it afterward.

The Jeremy Lin case is a good illustration of the difficulty in measuring productivity.  As a basketball player at Harvard and Chinese at a mere 6'3", scouts severely underestimated his skills.  But as an undrafted bench rider for the New York Knicks, he was allowed into the game before his usual "garbage time" allotment and did very well in terms of points scored and assists given out to his teammates.  This gave rise to the phenomenon of "Linsanity."  The point here is that even highly talented assessors of productivity can err.  When they do, they pay a price for their mis-assessments.

What boosts productivity?  Human capital (skills, education) and physical capital (machines, technology).  Mexicans in their own country earn less than equally skilled Americans since they work with the aid of less physical capital.  When they enter the U.S. labor force, their wages rise, since they can now work alongside more and better plant and equipment.  What determines which nations have the most capital?  Adam Smith said it very well in his 1776 (that is not a misprint) book, The Wealth of Nations: economic freedom is the key.  Try to pluck the golden goose too much, and it reduces the egg supply.

What will be the economic effect of a minimum wage of $7.25 (the present federal level stipulated by law) on a worker with productivity of $5?  It is simple.  He will have the greatest difficulty in finding a job in the first place (only those who overestimate his productivity will hire him), and he will all too soon be fired if he is lucky enough to be initially hired.  Firms will make a loss of $2.25 from keeping him on the payroll.  This analysis is based on the fact that demand curves for labor (and for everything else without exception) are downward sloping: the higher the price or wage, and the less of the offered good or service will be purchased or hired.

It is no accident that the unemployment rate for black teens is quadruple that of adult whites.  The former cannot not over the high bar placed in the way of their first obtaining and then keeping a job.  The minimum wage is not a floor under wages, raising them as it rises.  Rather, it constitutes a bar over which the unskilled all too often cannot jump.  And the higher it is, the harder it is to hurdle over it into the land of employment.

The reason this cohort of the labor force has recently been doing so well in terms of reduced unemployment (before the advent of the coronavirus) is because inflation has been reducing the real value of the wage mandated by law.  It was set at $7.25 in September 1991; in those dollars, it is equivalent nowadays to only $3.82, given an inflation of about 90% since that time.  Ordinarily, I would not say this, but thank God for inflation.

Everyone in his right mind realizes that the higher the price, the less will be purchased.  No one doubts this for cars, beans, shoes, music lessons — but when it comes to hiring workers, good sense flies out the window.  Those who are pushing the "fight for $15" are not total economic illiterates.  But they are suffering from a sort of economic schizophrenia.  When Bernie Sanders and his followers want to reduce the incidence of coal, plastics, gasoline, they know full well to raise their prices usually via taxes.  When they want to encourage the use of electric cars, higher education, health care, they act as if they all have a Ph.D. in economics: they favor lowering prices, even to zero.  Why, then, the failure to apply this to the labor market?

One hypothesis to account for this puzzle is that labor is nearer and dearer to their hearts than any of these other items. They make the same mistake — are you listening, Bernie, with regard to rent control?  I posit that they just cannot think straight when it comes to home and hearth.  Or perhaps it is akin to what psychologist call "compartmentalization" or an "ideé fixe."

But I am not really an economic psychologist who can cure dismal science schizophrenia.  I'll leave that to others, wiser than me, to better account for this strange phenomenon.  I here content myself with merely pointing it out.