Minimum wages: The economist as a psychologist

Both Ludwig von Mises and F.A. Hayek are known for arguing that there is no such thing as a good economist who is only an economist. For these two thinkers, a good economist-as-scientist also needs to know history, philosophy of science, ethics, and physics. Mises and Hayek are thinking of what an economist-as-scientist should be familiar with and have some minimum knowledge beyond his discipline.

I would add that the economist as public educator, that is, when the economist talks as an economist to non-economists, also needs some awareness of psychology. I may not be using the term “psychology” in the most proper way, but I mean the awareness to understand what the interlocutor feels and needs and then figure out how to communicate economic insights in a way that will not be automatically (emotionally or psychologically) rejected; how to make someone accept an economics outcome they do not want to be true. How to break the bad news with empathy? This is a challenge I try to get my students to understand as one day they, too, will be economists out of the classroom in the real world.

A few days ago I found myself unexpectedly in the “psychologist” position. Only seconds after meeting for the first time two persons dropped the question: “So, what do you think about increasing the minimum wages, should we do it?” I knew nothing about these two individuals, and the only thing they knew about me was that I’m an economics professor. The answer to such a question is an Econ 101 problem: if you increase the minimum wage (above the equilibrium price) some lucky workers will get a wage increase at the expense of other ones loosing their jobs.

The first question I asked myself was “what do these two nice ladies actually want, the analytical/scientific answer, or do they want instead the ‘professor’ to confirm their bias?” This might be a delicate discussion since they may well have a loved one in the minimum wage market.

The first thing to get out of the way is that my answer as an economist is not ideologically driven or does not respond to secret political agendas. How can that be made clear? One way is to show the economics profession’s consensus on the subject from an impersonal position. I explained to them that any economics textbook from any author from any country in the world used in any university would say the same thing: “If you put the price of labor above its equilibrium (a minimum wage), it will produce a disequilibrium (unemployment). You cannot fix the price outside equilibrium and at the same time remain in equilibrium.” Yes, as Ben Powell reminds us, even Paul Krugman agrees on this. By mentioning a worldwide consensus there is no room for ideological or political agendas. It is important to mention that economics is not always about politics. The economic analysis of minimum wages has nothing to do with being a Democrat or a Republican; the political position of each party may differ, but those are not economic analyses, those are political strategies.

The next step was to deal with the issue that if such a consensus exists, why are there mentions of studies showing no harmful effects of increases in minimum wages. This is no mystery either. A well known reason of why an increase in minimum wages does not increase unemployment is because in fact there is no such increase. The politician may say he is increasing the minimum wage, but he does not say that the minimum wage is being located just above the equilibrium level and therefore he is not doing much. Another reason is to look at the effect of a minimum wage increase in a small location where low skilled workers can get another job in the next town without the need to move and therefore they will not show up as unemployed. This is another case of an ineffective increase in minimum wages. Or maybe the minimum wage increases but a benefit goes down. The total compensation to the employee does not change, its composition does.

But can the economist show his claim? Is there more clear evidence that the effects of increasing minimum wages does do harm than the complicated cases where there are no harmful effects? Again, I went geographically large. First, I compared the U.S. with Europe, which has higher minimum wages with respect to the U.S. In Europe you find higher unemployment rates, higher unemployment in the youth population, and also higher long-term unemployment. Second, I brought the case of the U.S. Fair Labor Standard Act of 1938, which fixed the minimum wage at 25 cents per hour. This law included Puerto Rico where the many workers were earning between 3 to 4 cents. Bankruptcies and unemployment skyrocketed. It was in fact unions who asked Congress to make an exception for Puerto Rico, which took two years to consider. For two years people in Puerto Rico were forced to work in the black market or fail to make a minimum income. Want more cases? See here. “See,” the psychologist says, “minimum wages are very dangerous; you can seriously harm yourself. Is that a bet you really want to make?”

Two issues remain to be explained after dealing with these three problems, (1) objection to minimum wage increases is not (necessary) an ideological or political position, (2) studies that deny the effect are doubtful for easy reasons to understand, and (3) if you look at a sample broad enough the economist’s prediction is right there.

First, when an economist objects to an increase in minimum wages it does not mean we do not want wages to go up. We are just saying that a minimum wage increase is not the right way to do it. I wish it were so easy, but the laws of demand and supply inform otherwise. I guess most economists would advocate for minimum wages if their negative effects were not real. Second, explain Milton Friedman’s lesson that a policy is valued by its results, not by its intentions. The economist objects because of the unintended effects of fixing the price of labor outside equilibrium, not because we wouldn’t like to see real wages increasing.

On Minimum Wages, Health Code Violations and Proper Assessment

A few days ago, Tyler Curtis at the Freeman (the Foundation for Economic Education’s flagship publication) posted a short piece on the minimum wage and health code violations in restaurants. Curtis based on a paper (unavailable in full) by Srikant Devaraj who asserted that increases in minimum wages in Seattle had led to increases in health code violations by restaurants (heavily affected by the increases).

Devaraj used a standard difference-in-difference econometric approach. The problem underlined by some was the choice of benchmark for the method : New York City. New York City and Seattle are two very different cities with different health codes. It is hard to make this claim stick even if the uncontrolled results (before statistical tests) show an increase in health code violations. Nonetheless, I have been able to find one other study that shows – based on Californian data – that there was a very small deterioration in health code violations (especially by the top restaurants) following increases.

Now, I am not convinced by the econometric design of both, but I am axiomatically convinced. This is where I think economists have made the error of relying too much on empirical methods. While, as an economic historian, I always favor more data, I also am trained to be skeptical about data does not say.

In the case of the minimum wage, the debate has raged between economists over the employment effects (i.e. the demand for labor). But this is a fraction of everything involved with the production of goods in industries affected by minimum wages. For an employer, a cost is a cost regardless of the form it takes. If an employer is forced to pay somebody above what they produce in value, then something has to give. For a 5% increase in the minimum wage, it is doubtful that an employer with three employees will be willing to sack one third of his workforce (and roughly one third of his output). So, he can cut costs differently. He may ask employees to buy their uniforms, he may refuse to provide them with free lunches, he may also even decide to cut on quality of his service – as is the case with the two studies outlined above.

The problem is that no study of the minimum wage has attempted to measure all these effects at once!  There is no study that looks simultaneously at hours worked, people employed, type of people employed (substitution effects), prices for consumers, quality and marginal benefits (uniforms, free lunch, insurance, etc.) on both the short and long-terms levels and trends (they also rarely adjust the minimum wages for regional purchasing power parities and the under-reporting of tips)

The health code violations papers show how many channels employers can use to adapt – channels which some fail to account for when they proclaim that we can raise the minimum wage without adverse consequences. Maybe its time that we, as economists, try to be more cautious when we make claims about the minimum wage’s minimal effects.

Minimum wage and length of poverty spells

I had a pre-programmed blog post on the issue of the minimum wage and poverty which was preempted by Mark Koyama (a blogger here at Notes on Liberty). The tweet is below and it has forced me to adjust the post.

Mark is absolutely right! Let me explain why with my own spin on it.

First of all, the demand curve slopes downwards – always. However, the method of adjusting to price changes (wages are a price and the minimum wage is a price control) is not an empirical constant.  I am unlikely to fire workers for a 1% in the inflation-adjusted minimum wage. Firing workers implies transaction costs that are dependent of context (for example, if I am friend with my employee, this is a transaction cost in the form of a lost friendship), firm size (I won’t fire my only employee which represents 50% of my output for a 1% hike in MW) laws (firing and hiring regulations), institutions (social institutions, reputation, norms), my clientele (how elastic is their demand) and technological alternatives. For a 1% increase, I am likely to reduce work hours or cut marginal benefits (no free soup for you). For a 10% increase, I am more likely to consider the option of firing a worker or I may shift to a new technological set that reduces my demand for labor.  It may happen rapidly or take some time, but there will eventually be an adjustment.

In any case, the minimum wage will imply some losses with a deadweight loss. Only the method by which it materializes is debatable.  By definition, some people will be hurt and generally and even if supply is super-elastic (doubtful), some suppliers (workers)  will be ejected from the market (or the quantity of labor they can supply will be ulitmately reduced). Since the minimum wage generally tends to fall on unskilled workers, this must be correlated with workers close to the poverty line.

Ideally, we’d need a measure of the minimum wage to be compared with the “at-risk” population over a long period of time in order to encapsulate all the effects of the minimum wage. The perfect measure is the “length of poverty spell” variable which has been emerging progressively from the BLS. The problem is that it is not broken down by state. Fortunately, Canada has that variable (well, a low-income variable which is a relatie poverty measure) for provinces. Inside the Survey of Labor and Income Dynamics (affectionally known as the SLID), this longitudinal variable has a span of eight years. Basically, we can know if a person has been below the low-income threshold for up to eight years. Let’s take that extreme measure and plot it against the minimum wage divided by the average wage.

As one can see from the scatter plot below, there is a more or less clear relationship between the minimum wage as a share of the average wage and the length of poverty spells. What is more impressive is that this graph is not a regression. More precisely, the provinces with the highest minimum wages (like my own province of Quebec and the province of Nova Scotia) also have the most extensive social welfare nets. Alberta,  a province with the lowest minimum wage ratio and one of the least “generous” social welfare net in Canada, is at the very bottom of the pack in terms of the persistence of poverty.

minimumwagepoverty

I think this graph acts in very modest (but clear) support to Mark’s point (which is also the point of Burkhauser, Sabia, MaCurdy and many others)

On quasi-rents and the minimum wage

Ryan Murphy of Southern Methodist University has a new article published in Economics Bulletin regarding the minimum wage and “quasi-rents”.  The argument made by Ryan has the advantage of theoretically fleshing out a point made by many skeptics of the new literature. Generally, the argument has been that in the short-term, the minimum wage may have minimal effects, but in the long-term, firms will adjust.

I tended, until Ryan’s article, to be more or less skeptic of the value of this counter-argument. My point has always been that the new literature (like the Dube-Lester-Reich paper) tends to act as a partial equilibrium story (focusing only on one sector only or one indicator). My view has always been very “Coasian” in the sense that there are transaction costs to adapting to any new minimum wage rate.

The height of the hike and what industries are primarily affected will determine the method of adjustments. Firms can cut on benefits, substitute between forms of labor (the minimum wage increases the supply of older workers which remplace younger inexperienced workers), hours or training. They can also, depending on the elasticity of demand for their products, increase prices or cut quality. They can also cut employment. All of these are channels of adjustment and they will be used differently depending on the context. They are all different expressions of the fact that the demand curve slopes downward. But each expression has costs to be used that are to be weighted against their benefits – which are highly circumstantial. For example, if I have a firm of two employees, I will not sacrifice half my workforce by firing a worker (thus sacrificing 50% of my output) for a 5% hike in the minimum wage. Not only would this be an over-reaction, but there are transaction costs for me to fire that worker : separation fees, emotional pain, learning what the employee was doing etc. Reducing his hours would be a safer adjustment.

Until there is a study that measures all of these adjustments channels at once, I am skeptical.

So where does Ryan’s story come in? Well, none of my arguments had a long-term component. They were largely void of any time dimension. While I am aware of research like those of Meer and WestClemens and Wither and Clemens regarding job growth patterns following minimum wage hikes, I always discounted that argument. I was always reluctant to engage in long-term reasoning because I felt it was conceding a point that ought not to be conceded even if that counter-point is valid.  I only used it to top up the rest of my argument. But Ryan introduced to me the concept of quasi-rents, of which I had vaguely heard during my undergraduate microeconomics class.

Basically, here is the argument about quasi-rents: in the short-term, there are rents to be extracted from fixed factors of productions. Firms need these quasi-rents to remain in business, but only in the long-run.  However, if labor can find a way to capture the rents in the short-run, they will get higher earnings and employers will not fire people as much. As a result, there is basically a reshuffling of the consumer surplus. However, in the long-run, nothing is fixed and firm owners can adjust by shifting to different production methods. Thus, they will reduce their future hirings. In Ryan’s words:

But the on-impact negative effects of minimum wages may be hidden. In the longer run, after the quasi-rent is dissipated, the owner would have the incentive to eventually switch from more labor-intensive methods to ones that are less globally efficient (this being the conventional “demand slopes down” result). More perniciously, the threat of future increases in the minimum wage may create regime uncertainty undermining a willingness to invest in the types of technology and capital complementary to low skilled labor, thereby reducing employment for low skilled workers. That is to say, the risk of the appropriation of quasi-rents can shift investment towards capital unlikely to be appropriated via the minimum wage. Repeated and arbitrary increases in the minimum wage worsen this risk. This is consistent with the recent shift towards long run effects of increases in the minimum wage, for instance Meer and West (2016).

This is exactly what Andrew Seltzer found for the introduction of the minimum wage during the Great Depression in certain American industries. In the short-term, the capital was more or less fixed and production methods could not be abandonned easily. In the long run, firms adapted and shifted production methods. This is why Ryan’s argument is convincing. It offers a theoretical explanation for the empirical results observed by Dube, Lester and Reich or Card and Krueger. It fits well with theories of imperfect markets (damn I hate that word that is basically saying that all markets have frictions) like those of Alan Manning (see his Monopsony in Motion here).

This is the kind of work on the minimum wage that, if measured, should force considerable requestionning on the part of minimum wage hike advocates.

Minimum wage, measurements and incarceration rates

A few weeks ago, I published a blog post about how incarceration rates affect our measurement of the relative economic conditions of Blacks in America. My claim was that the statistics are hiding a reversal of the painfully achieved advances secured between 1870 and 1960. Basically, my claim was that those who (in greater numbers) found their ways to a prison cell tended to be at the bottom of the income distribution, were more susceptible to be unemployed and had lower wages. This creates a composition effect whereby the official surveys cream-skim the top of black wage, income and employment distributions.

But, could this problem also affect our measurement of the effects of minimum wage? Let me be clear before you continue ahead, I am just asking this question because I could find no satisfactory answer to (or even mention of) this issue.

In recent times, minimum wage surveys have tended to find some gains in earnings for some workers following increases in minimum wage rates. Regardless of how you look at the prison population, it increases  – albeit at a decelerating rate since the early 2000s – since the 1980s. Coincidentally, that starting point is also the point at which the famous Minimum Wage Study Commission was published (1981). That report basically cemented the point made by George Stigler (i.e. minimum wages are not desirable). That report surveyed the entire literature to summarize the amplitude of the effects. That literature encompassed articles written between the end of the Second World War and … well… 1981. If you look below at the graph, incarceration rates were more or less constant during that regime. Thus, if there were composition effects associated with surveys of wages, incomes and employment, they were more moderate than after 1981 when incarceration rates surged.

minwage

But, its also after 1981 that some papers began to find some positive effects of minimum wage increases. These studies took place under a growing composition problem in surveys of wages, incomes and employment. Take the famous Dube, Lester and Reich paper in the Review of Economics and Statistics  who used data from 1990 to 2006. During that period, the male incarceration rate surged from 297 per 100,000 to 501 per 100,000. I understand that DLR used a time fixed effect method, but would that be sufficient to at least deal with the issue of shifting labour supplied (it won’t for the data bias issues described notably by Bruce Western)

If we assume that those who are plausibly affected by minimum wages (i.e. lower income individuals) are also those more likely to end up in jail in the United States, then there is clearly a bias. As they are dropped from the labor market (or as they join the prison population), they leave only the workers least affected by the minimum wage inside the samples. That is one possibility.

The other possibility – which is that surveys do not suffer from a large composition, but which is not mutually exclusive to that composition problem – is that the growing prison population represents a year-over-year reduction in the labor supply which offsets the effects of hikes in the minimum wage (or maybe even eliminates them entirely if the shift is big enough).

minwage2

I have tried many variations of this google scholar research and went back to my copy of the Handbook of Labor Economics and my Economics of Inequality, Poverty and Discrimination  (a book worth reading by the way) and I found very little on this point. Very few scholars have considered the possibility of this problem (which implies a shift of the labor supply curve concurrent with minimum wage hikes and a composition problem where those affected are simply not measured anymore). Yet, I feel like this is a defensible claim. In England, where some studies also show minimal effects or positive effects of the minimum wage, there has also been an increase in the prison population. In contrast, Canada – whose prison population is declining moderately (meaning that the labor supply is increasing as the minimum wage is being increased – the studies do tend to find the “conventional” result.

Am I crazy or is this a case of poor measurement? Personally, I feel that there must an answer, but please tell me I did not just stumble on this!

The minimum wage still bites

Politicians, pundits and activists jumped on a new literature that asserts that there no negative effects of substantial increases of the minimum wage on employment. Constantly, they cite this new literature as evidence that the “traditional” viewpoint is wrong. This is because they misunderstand (or misrepresent) the new literature.

What the new literature finds is that there could be no significant negative effects on employment. This is not the same as saying there are no negative effects overall. In fact, it is more proper to consider how businesses adjust to different-sized changes by using various means. Once, the minimum wage is seen in this more nuanced light, the conclusion is that it still bites pretty hard.

The New Minimum Wage Literature

Broadly speaking, the new literature states that there are minimal employment losses following increases in the minimum wage. It was initiated twenty years ago by the works of Alan Krueger and David Card who found that, in Pennsylvania and New Jersey, a change in the minimum wage had not led to losses in employment. This caused an important surprise in the academic community and numerous papers have found roughly similar conclusions.

These studies imply that the demand for labor was quite inelastic – inelastic enough to avoid large losses in employment. This is a contested conclusion. David Neumark and William Wascher are critical of the methods underlying these conclusions. Using different estimation methods, they found larger elasticities in line with the traditional viewpoint. They also pointed out Card and Krueger’s initial study had several design flaws. With arguably better data, they reversed the initial Card and Krueger conclusion.

These critics notwithstanding, let us assume that the new minimum wage literature is broadly correct. Does that mean that the minimum wage is void of adverse consequences? The answer is a resounding no.

This is because of an important nuance that has been lost on many in the broader public. In a meta-analysis of 200 scholarly articles realized by Belman and Wolfson, there are no statistically discernable effects of “moderate increases” on employment. The keyword here is “moderate” because the effects of increases in the minimum wage on employment may be non-linear. This means that while a 10% increase in the minimum wage would reduce teen employment by 1%, a 40% increase will reduce teen employment by more than 4%. A recent study by Jeremy Jackson and Aspen Gorry suggests as much: the larger the increase of the minimum wage, the larger the effects on employment.

If labor costs increase moderately, the strategy to reduce employment may be relatively inefficient. The increase of labor costs needs to reach a certain threshold before employers choose to fire workers. Below such a threshold, employers may use a wide array of mechanisms to adjust.

Adjustment channels

Employers on their respective markets face different constraints. This diversity of constraints means that there is no “unique” solution to greater labor costs. For example, if the demand for one’s products is quite inelastic, labor costs can be passed on to consumers through an increase in prices. While this may not necessarily hurt workers at the minimum wage, it impoverishes other workers who have fewer dollars left to spend elsewhere. This is still a negative outcome of the minimum wage – its just not a negative outcome on the variable of employment.

In other cases, employers might reduce employment indirectly by reducing hours of work. This is an easy solution to use for employers who cannot, for a small increase in labor costs, afford to fire a worker. Even Belman and Wolfson – who are sympathetic to the idea of increasing the minimum wage – concede that increases in the minimum wage do lead to moderate decreases in labor hours. More skeptical researcher, like Neumark and Wascher, find that the effects on hours worked is much larger. Again, the variable affected is not employment measured as the number of people holding a job. However, a reduction in the number of hours worked is a clearly a perverse outcome.

Another effect is that employers might reduce expenses associated with their workers. Even Card and Krueger, in their book on the minimum wage, recognize that employers may opt to cut on things like discounted uniforms and free meals. An employer facing a 5% increase in the minimum wage will see his labor costs increase, but firing an employee means less production and lower revenues. Thus, firing may not be an option for such a small increase. However, cutting on the expenses associated with that worker is an easy option to use. This means fewer marginal benefits and on-job training. Employers adjust by altering the method of compensation.  For example, economist Mindy Marks estimated that a 1$ increase of the minimum reduced by 6.2% the probability that a worker would be offered health insurance.  Again, employers adjust and the effects are not seen on employment. Nonetheless, these are undisputedly negative effects.

The effect may also be observed on the type of employment. Employers may decide to substitute some workers by other types of workers. Economist David Neumark pointed that, subsumed in the statistical aggregate of “labor force” is a shift in its shift. In his article, written for the Employment Policies Institute, he stated that “less skilled teens are displaced from the job market, while more highly skilled teens are lured in by higher wages (even at the expense of cutbacks in their educational attainment)”. Another example could be that a higher minimum wage induces retired workers to return to the labor force. Employers, at the sight of a greater supply of experienced workers, prefer to hire these individuals and fire less-skilled workers. In such case, “total employment” does not change, but the composition of employment is heavily changed. The negative effects are clear though: less-skilled workers are not allowed to acquire new skills through experience.

Conclusion

None of these adjustment mechanisms in response to “moderate increases in the minimum wage” are desirable. Yet, all of these channels would allow us to conclude that there are no effects on employment. To misconstrue the ability of employers to select multiple channels of adjustments other than reducing employment as the proof that the minimum wage has no negative effects is perverse in the utmost. The statement that “moderate increases in the minimum wage has no statistically significant effects on employment” is merely a positive scientific statement with no normative implications whatsoever. If anything, the multiple adjustment mechanisms suggest that the minimum wage still hurts and that is both a positive and normative statement.

From the Comments: the Unemployment Rate

Dr. Gibson has won the much-cherished gold star I had offered in a previous comment. My question had to do with the green dot in this graph, and Dr. Gibson explained it to perfection. He writes:

The widely followed U3 unemployment rate, as shown in the figure, is the number of unemployed divided by the labor force. The labor force excludes discouraged workers. The labor force participation rate is the labor force size (employed & unemployed) divided by the population. The green dot shows what the U3 rate would be if that ratio had stayed the same since Jan. 2009.

The U6 statistic counts discouraged workers as unemployed. That rate is currently around 15%.

See also: Unemployment: What It Is

From the article Dr. Gibson directs us towards comes some other important information:

Government policies contribute to unemployment above and beyond natural unemployment. The most notorious of these policies are minimum wage laws. These laws make it illegal, effectively, for low-skilled workers to accept employment. Anyone who cannot generate $8 worth of production per hour cannot expect to be paid more than $8. Such unfortunate people might be productive at $6 per hour but are forbidden to accept employment at this rate and are instead condemned to joblessness and all its attendant miseries. This burden falls most heavily on black teenagers, whose unemployment rate (based on those seeking work and excluding those who are in school) is well over 40 percent. The benefits accrue mainly to slightly higher-skilled workers, who have climbed onto the metaphorical ladder leading to better jobs and who are shielded from competition from those excluded by minimum-wage laws […]

Labor unions, as voluntary associations bargaining freely with employers, are unobjectionable. They did a lot of good in the past when working conditions in many places were pretty bad. But now they are granted special privileges by law—basically the privilege to engage in violent or coercive activities. The result is often wage agreements that are above market-clearing levels. Those left out are of course unemployed.

While labor unions can boost their members’ compensation at the expense of non-union workers, higher wages generally and higher living standards are due mainly to increased productivity, which in turn depends on high levels of capital investment. People are more willing to save and invest when they have confidence in the future, and that confidence comes from respect for property rights.

For more on minimum wage laws, see Bad Idea of the Year.