1/13/14 – Does Raising the Minimum Wage Really Reduce Employment?

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Jan 13, 2014 9:12:00 AM

and tagged Commentary, Employment

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A couple of weeks ago, we had a fairly spirited debate in an Asset Management department meeting over the economic consequences of raising the minimum wage. Just for fun, and because I like to argue, I strongly took the pro side, contending that the positive consequences would outweigh the negative. This is not a particularly common (or popular) stance in the economics and investing community, but it turns out that you can make a good case for it.

In our meeting, the primary argument against an increase was that jobs would be destroyed, as employers lay off employees they can no longer afford. That may be the case, but what doesn’t often get said is that this isn’t the only, or even necessarily the economically optimal, solution. To compensate for higher costs, companies can also raise prices—or be forced to accept lower profits.

The reason for this is that many jobs are not optional, especially at the lower pay levels. An accountant, for example, can be outsourced; a fry cook cannot. For McDonalds to operate (to pick on the poster company for low-wage jobs), someone has to make the fries. Raising that person’s wage may cost the company money, but someone still has to make the fries.

“In theory, there is no difference between theory and practice. In practice, there is.” — Yogi Berra

Economic theory is very clear that a higher wage level should destroy jobs, but there has been surprisingly little empirical research on this, perhaps because the theory is so clear cut. What research there is has largely focused on aggregate employment figures, where, arguably, multiple factors could be manipulating the results. One study that focused on the micro-level effects, at the level of individual firms, is available here.

The authors took advantage of a natural experiment created in 1992, when New Jersey raised the minimum wage but the neighboring state of Pennsylvania did not, to compare what happened with employment in fast food restaurants. They also used comparisons within the New Jersey market between high- and low-wage locations to further test the results.

Cutting to the chase, in New Jersey as compared with Pennsylvania, an increase in the minimum wage resulted in increased employment overall, along with higher prices for fast food. That is, the higher costs were passed along to the consumer, but the increase in aggregate purchasing power from the higher incomes of minimum-wage workers actually more than compensated, in the aggregate, for the costs of the higher fast food prices, resulting in more demand and overall increased employment.

This specific, empirical study lends added weight to the aggregate-level studies with similar results. How, though, can this be?

The standard economics case is based on several assumptions that could turn out to be incorrect. It assumes a frictionless, perfectly competitive market, which is not the case. It assumes homogeneous labor resources—that is, people—which is not the case. It assumes full ability of companies to scale labor up or down, which is not the case.

Looking at the real world, floors have to be mopped, which takes a worker. If the employer has to pay more, it might be able to attract and retain a better worker, but it still needs that worker. That worker’s higher income will support other jobs, while the employer’s ability to charge higher prices—created by the level playing field of the minimum wage, which all competitors must pay as well—will protect profit levels. This is a possible explanation for the results seen in New Jersey.

The argument isn’t over, however. As of today, fast food requires human workers. Manufacturing once did as well. But, in many cases, they have been replaced by automation, or robots, because it is cheaper—a transition that’s happening in China today. Fast food and other service industries haven’t yet made that transition, but when robots become cheap and capable enough, workers will have to compete not against a minimum wage but against the cost of mechanized help.

That transition isn’t as far away as is commonly thought. Fast food robots are on the market today. It is only a matter of time until they become cost competitive with current wages. And when they become cheaper, the wage-driven job loss predicted by economic theory will really come into play.

The current minimum wage debate is more balanced than it would seem, at least from an economic perspective. That balance is eroding with the advance of technology, however, and we may be revisiting this discussion from the other side sooner than many people now expect.

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