The Minimum Wage's Dirty Little Secret

David Laband is Professor of Economics at Auburn University in Auburn, Alabama.

The current administration and their pals in the Congress only too obviously think that boosting the minimum wage by 90 cents per hour over the next two years is good politics (if bad economics). They are demonstrably wrong. This battle plan for “helping” lower-income Americans in the class warfare that dominates a partisan retro-1960s mindset is in reality a blueprint for failure and worse. The inevitable results of an increase in the minimum wage will be to further disadvantage the least-skilled, lowest-paid workers in America and increase employment and earnings among the most-skilled, well-paid workers.

Let’s start with the obvious: an increase in the minimum wage is not going to directly help many of the least-skilled workers. Only 4 percent of hourly workers in America currently earn minimum wage. These individuals bring few, if any, skills to the workplace; they acquire job skills via on-the-job training provided by their employers. In the face of a 21 percent increase in their unit labor cost, some employers of unskilled labor will react by unhiring these individuals. No doubt, the individuals who do not get fired will appreciate the political effort as their nominal wages will increase. However, the unfortunate ones who end up in the ranks of the unemployed may feel differently.

While this disemployment effect among unskilled labor of increases in the minimum wage is widely recognized among economists, what is not so apparent is that the employability of these workers has been diminished, by virtue of reduced opportunities to develop job skills. It is harder to get a second job based on skills developed on one’s first job, if one doesn’t get a first job. This surely will result in an increased duration of unemployment among unskilled workers.

The redistributive effects among unskilled workers of an increase in the minimum wage are, in the aggregate, trivial in comparison to the redistributive effects among more-skilled workers and providers of capital. Consider the reaction of an individual who has been working for several months or years and who has developed job skills that an employer finds valuable enough to justify paying him $5.15 per hour. After the proposed increases are fully in place, this individual will be paid the same as someone with no job skills. From his perspective, there appears to have been no differential reward to acquiring his job skills. Upset about this, he petitions his employer (or his union petitions the employer) to raise his wages. In so doing, of course, another round of wage increase requests by workers earning $6.00 per hour will be touched off, and so on. In a nutshell, an increase in the minimum wage incites a ratcheting up of wages that affects millions of workers earning more than minimum wage.

There are three principal effects of this general increase in wage compensation:

1. Employers will tend to reduce non-wage compensation in an effort to minimize their overall production costs. That is, employer-provided benefits are a casualty of increases in the minimum wage.

2. As labor costs (generally) rise, producers will hire less labor and more capital. There is no worse time for labor generally (and unskilled labor specifically) to contemplate an increase in the minimum wage than when technological advances are reducing the cost of capital. The high cost of middle-management labor combined with rapid reductions in the cost of computer-processed information was the driving force behind the corporate restructuring of the late 1980s and early 1990s that put hundreds of thousands of white-collar workers in the unemployment lines.

3. Although it may appear that ratcheted-up wages benefit lower-wage employees, the appearance is deceptive. In the long run, less-skilled workers are disproportionately harmed by artificially induced increases in wages. An example illustrates the argument.

Suppose the minimum wage rises from $4.25 per hour to $5.15 per hour (a slightly more than 21 percent increase). Assume that the increase does not trigger offsetting cuts in employer-provided benefits and that wages “ratchet-up” the labor force in an amount exactly equal to the increase in the minimum wage. That is, workers who used to earn $9.00 per hour before the increased minimum wage earn $9.90 per hour after the minimum wage has officially been raised; those who earned $18.00 per hour before earn $18.90 after, and so on.

From the standpoint of employers, a 90-cent per hour increase in wages represents a proportionately larger increase in labor costs of unskilled or low-skilled workers than of high-skilled workers. The increase from $9.00 per hour to $9.90 represents a 10 percent increase in labor costs; the increase from $18.00 per hour to $18.90 per hour reflects a 5 percent increase in labor costs. If the productivity of labor has not changed at all (and none of the discussion of the benefits of raising the minimum wage even touches on the subject of productivity), employers have every incentive to substitute more productive, higher-wage labor for less productive, lower-wage labor.

Both the substitution of lower-cost capital for higher-cost labor and the substitution of higher-skilled labor for lower-skilled labor seriously mitigate any purported benefits of a hike in the minimum wage. With respect to the substitution of capital for labor, there is both a direct effect on labor markets and a resulting indirect effect. As firms increasingly use machines in their production processes, the production and management of the new technology require an increasingly skilled labor force. This drives employers on the margin to favor highly educated and skilled workers over less well-educated, less-skilled workers, since the former are more productive than the latter.

Separately, the differential (proportionate) cost impact of a hike in the minimum wage causes employers to favor highly-educated and skilled workers over less well-educated, less-skilled workers; the former are less costly than the latter. Both tendencies add fuel to the job-market emphasis on highly-educated, highly-skilled labor, to the detriment of the uneducated, unskilled component of the labor market (i.e., the very component liberal politicians and theorists profess so much compassion for, so much so that they claim this compassion defines the difference between them and their conservative counterparts).

Put bluntly, the politically sponsored increases in the minimum wage are partly responsible for the much-ballyhooed increasing income inequality in America, which politicians then claim demands corrective action. This is a case of medicine causing a disease that politicians then seek to cure with more of the same medicine. A better course of treatment would be to fire the doctors.