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The minimum wage is a bad idea

LiveMint logoLiveMint 12-05-2014 Prashanth Perumal

While economists of various persuasions bicker over many issues of importance, the law of demand has largely remained a rule beyond doubt. That was until David Card and Alan Krueger showed in their 1994 study of the minimum wage law in New Jersey that the law enacted in 1991, quite surprisingly, increased employment in the state. Or, in other words, the study claimed that the increase in the price of labour led to an increase in demand for it, as against conventional wisdom predicting a drop in demand. This kicked off a series of empirical studies in the following decades supporting the case for minimum wage.

While none of the studies, to be fair, openly discredit the fundamental law of demand, they use a variety of creative arguments to justify minimum wage. Although the findings of these studies have been challenged by other empirical studies, the theory justifying the minimum wage is worth considering on its own merit. This is since empirical studies proving adverse effects of the minimum wage can be exposed as much to the same methodological criticism against studies arguing in favour of the minimum wage.

The empirical method in itself can neither prove nor disprove any proposition. Hans-Hermann Hoppe notes in Economic Science and the Austrian Method, “Should experience confirm a hypothetical causal explanation, this would not prove that the hypothesis was true… (and) a falsification would never prove once and for all that a relationship between some given phenomena did not exist, just as a confirmation would never definitively prove that it did exist.” More importantly, “If an experience falsified a hypothesis, this would not be decisive either. For if it was observed that A was not followed by B, it would still be possible that the hypothetically related phenomena were causally linked. It could be that some other circumstance or variable, heretofore neglected and uncontrolled, had simply prevented the hypothesized relationship from actually being observed.”

This is the fundamental reason why—despite years of empirical scrutiny—economists continue to disagree on an issue as basic as minimum wage. The empirical method, in fact, may be ill-suited to application in the social sciences like economics whose nature is fundamentally different from the physical sciences. As Murray Rothbard explains in In Defense of Extreme Apriorism, “In the sciences of human action... it is impossible to test conclusions. There is no laboratory where facts can be isolated and controlled; the ‘facts’ of human history are complex ones, resultants of many causes. These causes can only be isolated by theory, theory that is necessarily a priori to these historical (including statistical) facts.”

Theory, faulty or fancy

Of the many theories attempting to substantiate empirical findings in favour of minimum wage, most have trumpeted the ability of the minimum wage to correct market failures while others have downplayed the significance of higher unemployment. Here are some.

Minimum wage can improve productivity: It is argued that the minimum wage will cause labour to be more productive, thus justifying higher wages. But, as the textbook case goes, if higher wages could really lead to greater productivity, producers would have paid higher wages at first go. Then, of course, markets are almost never perfectly efficient. In the real world market imperfections exist, which may prevent businesses from maximizing worker productivity through higher wages. But the real question is who possesses better incentive to correct such inefficiency: businesses that can directly profit from them, or government bureaucrats.

Producers will simply raise their prices: This might work if higher prices have no effect on consumer demand, which is unlikely unless the minimum wage corrects the failure of businesses to charge the highest price the consumer may bear. In the real world, consumers are likely to find substitutes or cut down on their demand for the product when prices rise—leading to fewer jobs. A few pennies extra may not matter to all producers and consumers, but it may affect the decisions of the marginal ones. This may be an empirical question, but possessing the knowledge required to tailor policies to such a detailed extent is often an impossible task.

Inflation-indexing will solve problems: This is the solution some like Arindrajit Dube have proposed, the logic being that wages of low-paying jobs have not kept up with economy-wide productivity improvements. Upping the minimum wage, then, would simply match wages to productivity without costing jobs. Sadly, this reasoning shows little understanding of relative prices. A general improvement in productivity is no reason to expect an identical rise in the market value of all kinds of labour, especially if the relative scarcity of low-skilled labour changes vis-à-vis other factors of production. The market is often in a constant state of flux, and government bureaucrats are the least likely to comprehend it given the little incentive they possess.

Minimum wage would raise demand: Some say a higher minimum wage, especially during times of general economic distress, will improve demand for the products of labour—thus justifying higher wages. This belief is fallacious for the simple reason that it assumes entrepreneurs to possess magical expectations that allow perfect adjustment to future demand; while, in fact, entrepreneurial decisions are largely based on current economic data. Raising the minimum wage in a climate of economic distress characterized by falling demand would simply cause more jobs to vanish.

It’s about the income-jobs trade-off: Finally, there are minimum wage supporters who have wasted no time recognizing the negative effect of the minimum wage on unemployment. However, they argue, it is the trade-off between higher unemployment among certain groups and higher wages among others that really matters. The minimum wage, then, takes the shape of a mere redistribution scheme. Some believe it would benefit low-skilled workers below the poverty line, while only affecting workers belonging to higher income brackets. But there is little logic to this proposition, as in the case of a labour surplus scenario, it is not living standards that determine who lands a job but other forms of influence. For instance, it is often unionized workers that benefit at the cost of others, although they do not necessarily belong to the lowest rung of society. It is also possible that employers paying higher wages may, when faced with labour surplus, screen based on additional criteria that the least-skilled workers may not pass.

Just in case minimum wage supporters run out of ideas to justify their policies, it is possible to cook up more imaginary cases where the minimum wage would have no effect on unemployment. This could happen, for instance, when businessmen make entrepreneurial mistakes that lead them to overpaying workers. Or when both labour and complementary factors are specific to a line of production, in which case remuneration is purely a matter of clever bargaining—provided the total remuneration demanded is below the discounted price of the product. The same holds true whenever the marginal value of any number of factors is determined, at the margin, in a particular line of production. In such cases, the minimum wage might help. But even then, the question would remain the same: can the government possess the knowledge required to do better than the market?

American economist Thomas Sowell once said, “There are three questions that would destroy most of the arguments on the left. The first is: ‘Compared to what?’ The second is: ‘At what cost?’ And the third is: ‘What hard evidence do you have?’ Now there are very few ideas on the left that can pass all three of those” This succinct case against government intervention holds great relevance when it comes to the question of the minimum wage.

Natural Order runs every Monday, with a libertarian take on the world of economics and finance.

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