What would happen if the minimum wage laws were repealed? Would businesses pay their employees a penny an hour?

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Question: 

What would happen if the minimum wage laws were repealed? Would businesses pay their employees a penny an hour?

If raising the minimum wage to $10.10 would be good for the economy, wouldn't raising it to $20 be better? If not, at what point are the good economic effects of a minimum wage outweighed by the bad?

Answer: 

If minimum wage laws were repealed, the vast majority of U.S. workers would not have their wages impacted. Through supply and demand, competitive market forces drive up the wage rates of most workers to levels considerably above the current federal minimum rate of $7.25 an hour (or the somewhat higher minimums imposed by many states). Given their options, most workers are not willing to supply their labor for $7.25 an hour, let alone for a penny an hour. Still, some nonworkers would be happy to work for some amount between a penny and $7.25 an hour if given the opportunity. The question is whether such opportunities should be restricted by law.

While there is room for reasonable debate, historically most economists (regardless of political persuasion) believe that well-intended minimum wage laws tend to be counterproductive to improving the wellbeing of low-wage workers – especially compared with alternative policies like expanding the Earned Income Tax Credit. If a firm perceives that certain employees are not productive enough to warrant the higher mandated wage, these employees may find themselves out of a job – or not hired in the first place.

From the public’s perspective, minimum wage laws are usually seen as a vehicle for redistributing some of a company’s profits back to its workers at the low end of the wage distribution. In this context, the question is whether society is better served when an extra dollar of profit goes to a company’s executives (or shareholders) or instead is redirected to its low-wage workers. Given how difficult it is to live on $7.25 an hour – and how easy it is to live on an executive’s pay – it might seem only right to insist that employers pay at least a “living wage” (or “fair wage”) such that hard-working employees can make ends meet.

But this perspective implicitly assumes that the minimum wage job will still be available (and at the same number of hours), after the minimum wage is increased – businesses will absorb at least most of the costs in the form of lower profits. From a practical perspective, however, the difficulty is that minimum wage mandates are not coupled with mandates on how many workers will be hired in prosperous times or let go during downturns. Raising the price of low-skill labor tends to make firms less interested in hiring low-skill labor. Generally speaking, the higher the minimum wage, the greater the incentive for companies to substitute away from low-skill labor to relatively cheaper inputs including automated technology.

As with most policies, there are winners and losers. Workers who retain their jobs will get a raise as the policy intends. Even small raises are very welcome for low-income workers. Boosting the minimum wage can also mean slightly higher wages further up the wage distribution (a so-called “ripple effect” in the internal wage structure) to maintain employee morale. Moreover, this extra income to low-wage workers is likely to be immediately spent, so it can even lead to a mild short-run stimulative effect on the economy. But for the unlucky workers, it can instead mean losing their jobs because they are viewed as not producing enough revenue to justify their higher mandated wage. For these former employees, the effective “minimum wage” turns out to be zero, not their old $7.25 rate, nor the proposed $10.10 they were expecting to receive. Among other unintended consequences, higher input prices of labor may also translate into higher prices of goods and services which disproportionately harms the poor.

With some notable exceptions (see, e.g., Card and Krueger, American Economic Review, 1994 and AER comment by Neumark and Wascher, 2000), the vast majority of economic studies in the last 75 years conclude that minimum wage laws, while boosting some workers’ wages, have at least some dampening effect on employment. A recent (February 2014) report by the nonpartisan Congressional Budget Office (CBO) highlights this tradeoff. On the plus side, the CBO estimates that raising the minimum wage to $10.10 an hour would lift 900,000 families out of poverty and increase the incomes of 16.5 million low-wage workers. On the negative side, they estimate that the proposed wage hike would reduce total employment by about 500,000 workers over the next two years (with considerable uncertainty about these numbers).

Some additional points are worth keeping in mind. First, most minimum wage jobs in the U.S. are entry-level positions. These jobs, while low paying, can be critically important in helping young or otherwise less-skilled workers learn new skills on the job, establish professional track records, and eventually move up the ladder. A reduction in the availability of entry-level jobs makes it more difficult for disadvantaged workers to gain traction in the labor force. Some will instead end up receiving income support through government transfer programs despite preferring to work.

More generally, one should be skeptical about the effectiveness of minimum wage laws in ameliorating poverty. There is only a loose relationship between working in a minimum wage job and living in (or near) poverty. Based on data from the Bureau of Labor Statistics, about half of all workers paid the minimum wage are teenagers or young adults under the age of 25, most of whom live in households with incomes far above the poverty line. To be sure, older workers earning the minimum wage are more likely to be struggling financially. Still, many are not poor. For example, many minimum wage workers are secondary earners in relatively high-income households.

If the objective is to reduce poverty, minimum wage laws (even if effective) are thought to be less “target efficient” than policies designed to directly subsidize the income of poor households – e.g., through tax credits, such as expanding the Earned Income Tax Credit, or in-kind transfers such as food assistance or subsidized health insurance. From the public’s perspective, such programs cost money while a hike in the minimum wage appears to be free. Measuring true costs, of course, is more complicated than measuring the number of dollars spent on a program; mandatory wage increases are not free.

Economic theory does not rule out the possibility that minimum wage laws can increase employment in some cases. In particular, firms with some monopsony power may be induced to hire more workers if the minimum wage is set slightly above the market wage. The arguments become technical, but the basic idea is that a firm that is contemplating hiring one more worker at a price above the market rate no longer has to worry about needing to also give raises to all its existing workers of comparable productivity (since existing workers are already also being paid this higher minimum wage). Yet, as Stigler pointed out in 1946, the monopsony model has limited relevance to a national minimum wage. To induce more employment, the minimum wage has to be set within a narrow range that is difficult to determine and varies from firm to firm.

Intuitively, most everyone understands that raising the minimum wage to $20 or $30 an hour would have devastating effects on the employment prospects of less skilled workers: unemployment rates would skyrocket within such groups, so we see no serious proposals for increases of such magnitudes. Raising the minimum wage to only $10.10 would have much milder effects that might be difficult to detect in the aggregate – though such effects would still be noticed by employees who received raises or lost their jobs.

The key point is that minimum wage laws do not actually require employers to pay someone at least the minimum wage. It only requires the person to be paid that amount if the person is still employed. Regardless of one’s philosophy of a fair distribution of income, many economists fear that minimum wage laws tend to stifle employment opportunities for low-skill workers, youth, workers with disabilities, and minorities – the very groups the policies are intended to protect.