In this post, which is likely the wonkiest one that I’ve ever offered at Cafe Hayek, I address the following question, which is posed to me in an e-mail from one “Clango” but here worded by me: “Why won’t the rise in workers’ incomes caused by the imposition of a minimum wage create enough additional consumer demand to prevent unemployment of any low-skilled workers?”
An economist more skilled and insightful than I am would undoubtedly offer a shorter, clearer, and more precise analysis. Nevertheless, if you’re interested in my answer and analysis, read below the fold.
Dear Clango:
Thanks for your e-mail. But I’m afraid that in it you say nothing to convince me that raising the minimum wage will not destroy jobs for some low-skilled workers.
You argue that a higher minimum wage will result in more consumer spending which, in turn, will result in higher demand for meals at McDonald’s, for groceries at Wal-Mart, and for other goods and services produced by firms that employ low-skilled workers. You assume that McDonald’s, Wal-Mart, and other employers of low-skilled workers will respond to these higher demands by continuing to employ their current complement of (now-higher-paid) workers.
The validity of your argument depends upon several questionable assumptions (such as, for example, the assumption that any net increase in low-skilled workers’ incomes will be spent chiefly on outputs produced by firms that employ lots of low-skilled workers). There is, however, an even deeper flaw in your argument.
If raising the minimum wage is not to cause any job losses – and if (as you argue) this avoidance of job losses is achieved because of the extra spending done by now-higher-paid minimum-wage workers – then the prices that firms that employ minimum-wage workers charge for their outputs must rise by amounts that raise these firms’ revenues such as to allow these firms to fully cover the higher amounts of money they pay in wages to their workers.
This outcome is impossible, at least under conditions of full-employment. To see why, consider the following example. Suppose that, before the minimum wage is imposed,
– the equilibrium price of apples is $2.00 per pound;
– the equilibrium quantity of apples sold each week is 1,000 pounds;
– apple suppliers employ lots of low-skilled workers;
Now let a minimum wage be imposed. This new minimum wage raises the cost of supplying apples. Economists portray this higher cost by drawing the supply curve for apples shifting to the left. See the nearby graph.
Suppose that with this new minimum wage in place,
– if 1,000 pounds of apples will continue, as before the minimum wage, to be sold each week, the equilibrium price of a pound of apples would have to rise by $0.50 – to $2.50 – in order to generate enough additional sales revenue to allow apple suppliers to cover the minimum-wage-induced rise in their wage bill. (Note that we must assume that 1,000 pounds of apples continue to be sold each week – that is, that 1,000 pounds of apples remain the equilibrium quantity – if a rise in the minimum wage is to have no effect on employment. If after the rise in the minimum wage apple suppliers reduced the quantity of apples they sold, they would need fewer workers for the production and distribution of apples. Hence, the rise in the minimum wage would cause some workers to lose jobs.)
To summarize so far: in this example, by assumption the minimum wage raises apple-sellers’ total cost of supplying 1,000 pounds of apples each week by $500. Therefore, if apple sellers are to continue to supply 1,000 pounds of apples each week, they must be able to sell each of these 1,000 pounds of apples at a price of $2.50 – which is $0.50 higher than the pre-minimum-wage equilibrium price of $2.00 per pound.
Of course, because the quantity of apples demanded falls when the price of apples rises, raising the per-pound price of apples from $2.00 to $2.50 will reduce the quantity of apples demanded.
But, says you (Clango), Robert Reich, and many others, the minimum wage will cause the demand for apples to increase – that is, cause the demand curve for apples to shift outward, to the right, as apple workers spend their higher incomes buying apples. (See the graph.)
If the minimum wage is to result in no unemployment of apple workers, the demand curve for apples must shift rightward so far that it intersects the new supply curve of apples (that is, the supply curve that reflects the higher labor costs brought on by the minimum wage) at a quantity of 1,000 pounds of apples per week and at a price higher than the pre-minimum-wage price of apples. Again, I assume that that higher price of apples is $2.50 per pound.
The graph shows the changes in supply and demand that are assumed in this example. Demand curve D is the weekly demand for apples prior to the imposition of the minimum wage, and the supply curve S is the weekly supply of apples prior to the imposition of the minimum wage. Demand curve DMW (the one to the right of D) depicts the demand for apples with the minimum wage in place and under the assumption that apple demand rises because minimum-wage workers use their higher incomes to demand more apples. Supply curve SMW (the one to the left of S) depicts the supply of apples with the minimum wage in place.
In this example, the minimum wage causes the weekly incomes of low-skilled apple workers as a group to rise by $500 (and, hence, the weekly wage bill of apple suppliers as a group to rise by $500), all on the assumption that apple suppliers continue to produce and sell 1,000 pound of apples weekly.
Note also that, in this example, before the minimum wage was imposed, apple-suppliers’ weekly total costs = $2,000 and their weekly total revenue = $2,000 (= $2.00 x 1,000). After the minimum wage is imposed – and under the assumption that the minimum wage so increases minimum-wage-workers’ demands for apples that the total demand for apples rises in order to ensure that there is no reduction in apple production – apple-suppliers’ weekly total costs = $2,500 and their weekly total revenue = $2,500 ($2.50 x 1000).
But with the minimum wage – and with apple suppliers enjoying a resulting increase in the demand for apples that allows them to continue, as before, to sell 1,000 pounds of apples weekly despite the minimum-wage-induced higher costs of producing apples – how much of the apple-suppliers’ weekly revenue of $2,500 is paid by minimum-wage apple workers?
Remember, by assumption the minimum wage causes these workers’ collective weekly income to rise by $500. It’s this extra $500 that these workers spend in full buying apples.
But these minimum-wage workers must spend more than $500 weekly buying apples if the minimum wage is not to cause apple production (and, hence, employment in the apple industry) to fall. The reason is that apple buyers who are not minimum-wage workers – and, hence, who got no raise when the minimum wage was imposed – will buy fewer apples as a result of the higher price of apples.
In the graph, the weekly quantity demanded of apples along the pre-minimum-wage demand curve falls from 1,000 lbs. to 550 lbs. as a result of the price of apples rising from $2.00 to $2.50 per pound. (I assume, reasonably, that the demand for apples over the price-change range $2.00 to $2.50 per pound is elastic.*)
For simplicity of exposition, assume further that, prior to the imposition of the minimum wage, apple workers demanded no apples. They were too poor to afford such a luxury. So demand curve D is made up exclusively of the apple demands of non-apple-workers. The hike in the price of apples will cause the quantities of apples demanded by these consumers to fall from 1,000 lbs. per week to 550 lbs. per week. Therefore, the total amount that these consumers pay weekly for apples falls from $2,000 to $1,375 ($2.50 x 550). But under the assumptions made here – which are the assumptions necessary to ensure that the minimum wage causes apple demand to increase by enough to prevent apple production from falling – the total amount that consumers as a group must spend each week on apples is $2,500, meaning that minimum-wage apple workers must spend weekly on apples, not just the $500 of extra weekly income they earn because of the minimum wage, but $1,125! ($1,125 = $2,500 – $1,375)
From where does this extra amount, $625, above $500 come? I have no idea.
The only people in the economy who, by assumption, have higher incomes as a result of the imposition of the minimum wage are minimum-wage workers. So perhaps this extra spending on apples comes from minimum-wage workers in other industries. Maybe. But those other industries are in the same predicament as is the apple industry: as in the apple industry, when the minimum wage rises in those other industries total spending on the outputs of those other industries must rise by enough to ensure that there is no reduction in output in any of those other industries. So if this extra spending on apples come from minimum-wage workers in other industries, outputs in these other industries necessarily falls, thus destroying jobs in those other industries.
…..
The bottom line is that increased spending of money by workers does not, at least under conditions of full employment, create more real output. Yet the minimum wage raises employers’ real costs. With an increase in real costs, but with no increase in real output anywhere in the economy, something must give. Some employers, in at least some, if not all, of the industries in which minimum-wage workers are employed, will find their real costs rising without any increase in real revenue to offset these rising real costs. If those firms are unable to offset the higher cost of the minimum wage with reductions in workers’ fringe benefits or with extracting more output per hour from low-skilled workers, the result of the imposition of a minimum wage, or of a minimum-wage hike, will inevitably be a reduction in the outputs in these industries and a corresponding loss of jobs for some low-skilled workers.
……
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* What if the demand for apples over this price-change range is inelastic? I leave it as an exercise for the reader to figure out the employment effects. (Hint: the consumers who were the demanders of apples even before the imposition of the minimum wage cannot spend more in total on apples without spending less in total on other goods and services.)
