How can price theory help us navigate the minimum wage debate?

Always look for the margins where people can adjust

Did you hear the good news?! Workers everywhere are about to be saved through Biden’s $15 minimum wage.

Welp, today, I want to talk a bit about the minimum wage.

Economists seem to be the only people who aren’t so sure. Not all economists though. There has been an increasingly popular view within economics that standard economic arguments against the minimum wage are wrong and the data tells us that the minimum wage does not actually cost jobs.

Some of the latest studies, although by no means all, suggest the minimum wage is not as harmful as economists commonly warn. Papers in top journals, passing all muster of empirical rigor that economics demands find no effect of minimum wage on employment. Anyone who dismisses this literature out of hand is foolish.

In this post, I won’t summarize the latest research on the minimum wage, let alone come to an answer on the policy point. I’m no expert on this topic. There are a lot of great pieces out there, summarizing tons of papers. I recommend everyone start with Jeffrey Clemens's piece. Each has its strengths and weaknesses.

In this newsletter, my task is more humble. I simply want to lay out some theory that you can keep in mind when thinking about how seriously to take the leap from an empirical paper to the policy recommendation of a $15 minimum wage.

Econ’s Simplest Model

First, let’s take the simple Econ 101 model of supply and demand literally. What does it say?

The standard model says a price floor reduces the equilibrium quantity in the market studied. Remember how we have defined the labor market. What are our units?

The market is for “an hour of labor.” The unit for the quantity is “an hour.” (Actually, as Alchian taught us, it’s hours/unit of time, but that’s a separate point we don’t need to get into.) The basic model says that the minimum wage reduces the “hours of labor.”

Notice the market is not “a job.” The units are not the number of jobs. The basic model says nothing about what happens to the number of jobs.

This is important because some of the papers on minimum wage mainly focus on employment, not hours. I’m not saying their study is wrong; I just want to point out how it relates to the standard model economists think about. There is a subtle difference to keep in mind.

(Correction: I previously wrote that the recent QJE paper by Cengiz, Dube, Lindner, and Zipperer only studied employment. I was wrong. They include hours in the Appendix. I apologize to readers and the authors for missing that.)

In fact, I think the most straightforward interpretation predicts that employment would be constant. Take a market with a fixed wage, w*. If we assume each worker has a diminishing marginal product and they become less productive as they work more and more, then in a competitive market, a firm will offer each worker a job for the number of hours such that, for the marginal hour, the worker is producing w* worth of output. Now slightly increase w* and the firm will offer each worker slightly fewer hours. If there are fixed costs to hiring or firing workers, we would predict that number of employed workers would remain constant, but it was hours that adjust.

Richer, Competitive Markets

One thing that price theory stresses, beyond Walrasian competitive models or supply and demand is that all markets are connected through prices, but not only prices. People also adjust on quantity, as the previous example shows. Moreover, there are many margins that people can change their behavior with the changing circumstances. People aren't chessmen you move on a board at your whim. There are innumerable subtleties that our models will always miss.

There is always another margin where people can adjust and substitute on.

For a silly example, imagine a minimum wage on left-handed people. If left-handed and right-handed people are otherwise identical, we would simply see the firm swap out its left-handed workers for right-handed workers. If we naively went and counted the hours worked, we would find that the firm hired the same amount of hours before and after the policy. The firm had multiple margins on which it could respond. Luckily for the firm, the workers were perfect substitutes, so the ability to find a perfect substitute means they weren’t hurt by the legislation.

It’s worth observing that the “multiple margins” argument also means the minimum wage isn’t as bad as the simple model says, besides being a transfer from left-handed to right-handed workers.

The example is desired to show how the policy won’t achieve its goals; it doesn’t apply to everyone. The more important point is that the policy, no matter how complicated, cannot apply to every margin, so will not work as effectively as the model suggests.

Again, it helps to think through an extreme example. Take a waitress. Now suppose the job contract/offer is not just a wage but a wage plus another perk, like a reduced price on the food at the restaurant. If the wage is forced up, the competitive firm will respond by lowering the other perk. The policy cannot address all the margins of adjustment, even if it can in the model.

Any empirical paper will necessarily be limited in the margins it measures and it will tend to focus on money since that is what the best data is on. But life is about more than money people! I am shocked that the minimum wage proponents would be so materialistic to assume that only money matters to the workers.

I am a professor, not because of the wage, but because of the whole package of being a professor. That structure of the whole job and contract is determined by competition, not just the wage. Under competition, McCloskey writes in The Applied Theory of Price

“the whole pay, in happiness as well as money, of the marginal worker, just indifferent between the two jobs, must be equal in the two. If the pay is not equal, the worker must be compensated by other differentials between the jobs—differentials in working conditions, say, or in the reliability of employment.”

(Have I said how good McCloskey’s textbook is? It’s really good, especially the chapter linked.)

Ideally, for empirical work, we would have not just wages, but other fringe benefits, because one possible response of firms would also be to change the job. In the perfect world for research, we could also determine the value to workers and the cost to firms of things that don’t fall under benefits like the “enjoyability of a manager.” Workers who are paid less may be compensated with less oversight. Again, if the wage is forced up, the firm may respond by closer monitoring on the worker, which is costly to the firm and worker. Multiple margins.

My multiple margins point is closely related to the distinction between short-run vs. long-run elasticities. In order to get well-identified estimates, most papers need to look at a short time frame surrounding the minimum wage increase, which is an estimate of the short-run effects. Over time, more margins to adjust open up. Production inputs that were fixed for a year even can become variable over a longer time horizon. Any estimate of the effect of the policy is not just biased, but always biased downward because moving to a new equilibrium takes time.

My multiple margins point is not meant to be a moving target for people who believe the standard model is flawed. Of course, any paper can’t measure everything. I, the skeptic of the minimum wage, can’t just poke holes after every study that comes out and claim victory. Any dumb theorist can poke holes in the applicability of any data analysis. Well done studies that find no effect of the minimum wage should move our priors, just not as completely as some people want to claim.

Monopsonistic Markets

So far I have dealt with competitive markets. Any enlightened economist knows that the labor market is monopsonistic! Workers are not paid what they are worth because firms have market power over them, pushing wages below the value of what the worker is paid. That’s what all the evidence points to, we are told.

I will be the first to admit. If a demander of labor has market power, there are certain minimum wages that can improve welfare. But even monopsony doesn’t guarantee a minimum wage increases welfare. Remember, the firm can respond by changing hours, just as a competitive firm would. Simply yelling “monopsony!” doesn’t avoid that complication. The problem is, again, a job is not simply a wage, but also hours worked.

Most economic discussions are based around “efficiency.” If you simply want to redistribute to workers, a minimum wage may be the effective way to do that. Regulation is a way to benefit one side at the expense of the other, as my last post discussed.

If your goal is to redistribute to low wage workers, the minimum wage may be the optimal policy with competitive markets, as shown by David Lee and Emmanual Saez, contrary to common claims about using EITC for low-wage workers.

This result actually flips when labor markets aren’t competitive, which is what most economics-centric proponents of the minimum wage believe. With labor market frictions, meaning the firms have some market power, taxes can optimally redistribute to low-wage workers, so you don’t need a minimum wage, as Rafael Guthmann and Keyvan Eslami, two exceptional economists that everyone should read, show.

So there are some things to keep in mind while navigating the minimum wage debate. Just remember, use price theory to guide your thinking. Oh, and never engage with the minimum wage debate online. It’s not worth the pain.

I’m sad to report that Bill Allen passed away last week. Don Boudreaux and David Henderson have reflections of Bill Allen and his work. For my intellectual formation, Allen is most important as the author of the classic price theory textbook University Economics with Armen Alchian. He also had a daily radio program for 14 years where he explained basic economics. I would have loved to have listened to those when I was discovering economics. If anyone knows where recordings are online, let me know.

With Prof. Allen’s passing and Walter Williams’s just over a month before, we have lost two giants of UCLA price theory. These weren’t the big academic names who get all of the academic citations of Armen Alchian or Harold Demsetz, but Profs. Allen and Williams taught generations of people the power of price theory in their teaching and popular writing, including your humble writers at Economic Forces. We hope we can keep the UCLA tradition alive in whatever small way we can.