Sunday, December 20, 2009

The Macro Effects of a Lower Minimum Wage

What is the macroeconomic effect of a lower minimum wage?
Next to nothing.

However, I oppose the existence of the minimum wage, and consider reversing the 40% increase from $5.15 to $7.25 a good first step.

Aproximately 2% of workers in the U.S. earn the minimum wage or less. Even if they all worked full time (and they don't) and they all earned the minimum wage (and they don't,) and all of them had their wage rate cut back to the 2006 level (and they wouldn't) then reversing the increase in the minimum wage would decrease their income by .1% of GDP. If the cost savings were all passed on in the form of lower prices, that same .1% is about how much the price level would decrease.

Krugman's approach of switching the subject to an across the board cut in wage rates is absurd. If all wages dropped nearly 30%, that would be 20% of GDP, and probably the best estimate of the direct impact on the price level would be a 20% decrease. There would be large macroeconomic effects. The impact on real money balances--currency and reserves--the real national debt, shifts in the burden of private debt, and expectations about future prices, would all be the key concerns.

Is the simple quantity theory approach correct? Nominal expenditure would remain unchanged? Would a 7% decrease in the price level, including resource prices like wages, reverse the decrease in real output and return it roughly to capacity? Or would the real demand for money rise, resulting in a further decrease in nominal expenditure?

Would a 30% decrease in wages be vastly excessive? Could it actually be inadequate? Regardless, the impact of a substantial decrease in the minimum wage on these things is trivial--lost in the noise.

Evidence suggests that the demand for minimum wage labor is inelastic. That doesn't mean that decreases in wages have no impact on employment. It rather means that a 30% decrease in the minimum wage would result in a less than 30% increase in employment. Suppose there is only a 10% increase in the employment of minimum wage workers. That would be an increase in employment of maybe 276,000. That would be about 2% of those currently unemployed and would reverse about 3.5% of the loss in employment during the recession.

If the demand for unskilled labor really is so inelastic, the total income of those earning the minimum wage drops by roughly 20%. The existing workers earn 30% less and the 10% additional workers earn more, and the net effect is a 20% decrease. But because their total earnings is so small compared to total income, this a tiny fraction of one percent of GDP. The notion that this loss in income would result in a significant decrease in consumption expenditure, sales, and production is just absurd.

The most likely effect of a decrease in the minimum wage is that more unskilled workers are hired and they produce more output. Those selling the products of unskilled labor lower the prices of those products to sell the extra output.

The increase in the actual production of goods and services represents an increase in aggregate real output and aggregate real income. The increase in real income isn't received by the unskilled workers or their employers. It is received by the more than 99% of the population that aren't minimum wage workers in the form of lower prices for the products of unskilled labor.

The reason the demand for minimum wage labor is inelastic is almost certainly because the demand for their products is inelastic. The prices of those products fall, and the total amount of revenue earned by firms using minimum wage labor decreases. But that that means is that the 99% of the public who are not minimum wage workers receive more of those products while using less income. And that leaves them with more income to spend on other things.

If the demand for the products of minimum wage workers were unit elastic, then the total revenue of that sector would be unchanged. More output would be purchased with the same amount of expenditure. And that would leave the same expenditure for other products.

If the demand for the products of minimum wage workers were elastic, then total revenues in that sector would expand due to the lower prices. Less would be spent on other products.

Does a decrease in the minimum wage have no macroeconomic impact? Of course not. The increase in the output of minimum wage workers is an increase in aggregate output and real income. Money is normal good. The increase in real income increases the demand for money. The real quantity of money must increase--at tiny bit. Fortunately, the decrease in the prices od the products of minimum wage workers decreases the price level a tiny bit. And that increases the real quantity of money a tiny bit.


  1. I had an arguement with my girlfriend about this and you have proved me right. Thank you. She will be reading this.

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