Tuesday, April 29, 2014

Removing money from the minimum wage debate

Many people think that economics has a lot to do with money. But in reality economics is so much more than money. There are certainly areas within economics that focus on money; monetary policy, money and banking, the role of the Federal Reserve system, etc. There is also an overlap between economics and finance when it comes to things like the stock market and investments.

But many fields within economics do not focus on money. In fact, money often obscures what is really going on. To demonstrate how money can cloud an issue, I am going to give an example in the context of a minimum wage.

Suppose Henry owns a small diner. To keep things simple let's assume that this diner only serves hamburgers. Henry has 4 workers; Tom, Hank, Fred and Carl. Each worker produces 9 hamburgers per hour. This is a world without money, so each worker is paid in hamburgers.

(One of the benefits of having a universal medium of exchange such as money is that it solves the coincidence of wants problem. In order for Tom, Hank, Fred or Carl to consume something other than a hamburger they have to find someone who has what they want and is willing to take some amount of hamburgers in exchange for that good or service. Money, as opposed to barter, makes it easier for people to find willing trade partners.)

Since each of the workers is being paid in hamburgers I will further simplify the example and assume that there is only one other good in this economy, apples. The exchange rate is 1 hamburger equals 3 apples, or 1H = 3A. Out of the 9 hamburgers that each one of the workers produces, they get to keep 7 as their pay. The other 2 hamburgers go to Henry. This is the return on his capital. Henry provides the grill, the knives, the counter space, the restaurant itself, and all of the things other than workers that go into making hamburgers. So Henry pays each worker 7 hamburgers, he keeps 2 hamburgers from each of the 4 workers, and thus he earns 8 hamburgers per hour.

Now suppose the government doesn't think that 7 hamburgers per hour is a fair amount of burgers for the workers and they increase the amount to 8 hamburgers per hour. Henry now only keeps 1 hamburger from each worker instead of 2 and his earnings are now 4 hamburgers per hour instead of 8. All of the workers are now getting 8 hamburgers per hour.

Note that there is no more output than before. There are still only 36 hamburger being created per hour. The minimum wage just moved hamburgers from Henry to the workers. Before the minimum wage Henry could trade his 8 hamburgers for 24 apples. After the minimum wage he only has enough hamburgers to get 12 apples. Henry could try to increase his apple consumption by raising the price of his burgers. That is, he could unilaterally increase the price of a hamburger from 3 apples to 5 apples. If he did that then he would be able to get 20 apples after the minimum wage increase. This is still not as many apples as he was getting before but it is closer.

Note however that the apple producer, let's call him Johnny, now has to pay more for a hamburger than he did before. Johnny is worse off if Henry raises the price of a hamburger from 3 apples to 5 apples in response to the minimum wage increase. Because Johnny will be worse off, he might not agree to Henry raising the price and avoid buying hamburgers from Henry. If that is the case Henry might just have to accept that he can only get 12 apples after the minimum wage instead of 24. With no price increase the workers: Tom, Hank, Fred, and Carl, are better off, Henry is worse off, and Johnny is not affected. If Henry is able to pass on some of the cost to Johnny by raising his price, then both Johnny and Henry are worse off but the workers are still better off than before the minimum wage. There is no way to make everyone better off with a minimum wage though, since the minimum wage only moves hamburgers around between Henry and the 4 workers. It does not make the 4 workers more productive.

Suppose instead of setting the minimum wage at 8 hamburgers per hour, congress increases it to 9. Since the workers only produce 9 hamburgers per hour, Henry either has to accept 0 hamburgers for himself, shut down, or find workers who are more productive and can produce more than 9 hamburgers per hour. This is another important point; a minimum wage often changes the type of worker that is employed. Henry will have to find more productive workers in order to stay in business and so the 4 workers he currently has will be out of a job since they only produce 9 hamburgers per hour. No other hamburger diner will hire them since they cannot produce more than the amount an employer is required to pay them. Any employer who tries to hire them will get no return on his capital. The least skilled workers are the people who suffer the job losses when a minimum wage is imposed.

Removing money allows us to see what is really going on . People only care about money because they can trade it for the stuff they really want: hamburgers, apples, cars, books, etc. No one values money for money's sake. When people talk about increasing the minimum wage and only think about dollars, it muddles what is really going on. People are paid based on what they produce, and in the long run it is impossible for any business to pay somebody more than what they produce. Minimum wages do not create any more stuff, they simply shuffle production around. Also, it is the least productive worker that is harmed the most when a minimum wage is imposed.

Societies only get richer when they create more output. A minimum wage does not further that goal and anyone who tells you otherwise is either ignorant or lying.

Friday, April 18, 2014

Campaign contributions and free speech

My most recent article about the McCutcheon case and free speech.

The conclusion:

"The amount of money someone has is largely the result of talents and traits like intelligence, perseverance, dedication, prudence and yes, some charisma and a little luck. Restricting how people can use their money is restricting how they can use their talents. People like Mr. McCutcheon should not have to choose between being a public figure like Ellen DeGeneres or supporting numerous political candidates. Mr. McCutcheon will likely never have the same effect that Ellen or Jon Stewart has on politics but he should be free to try."

Monday, April 7, 2014

Does basic economic theory really justify wealth transfers?

Many economists and students of economics justify wealth transfers, e.g. taxing rich Paul and giving his money to poor Peter, on the grounds that the marginal utility (or benefit) of another dollars is less for a wealthy person than a poorer person. That is, we can take a dollar from a wealthy person and their utility loss will be less than the utility gain by the poorer person. The diagram below illustrates this theory.

Diagram 1

The Y axis measures utility (i.e. benefit, satisfaction) and the X axis measures income. The slope of the utility profile is the marginal utility, or the additional satisfaction, gained by one more dollar of income. In this picture it is easy to see that the slope of the total utility line is steeper at $50,000 than $500,000. So if two people had this same utility profile there would be a net gain in the total utility of society if a dollar was taken from the person earning $500,000 and given to the person earning $50,000.

Seems simple right? But of course this is not the whole story. There is no reason to think that all people have the same utility profile when it comes to income. People of similar ability often choose different career paths. Some high ability people choose occupations where they work long hours and receive large incomes. Other people with similar ability choose less stressful occupations with lower incomes. In fact, it is easy to find people of similar ability in the same occupation working for the same employer who choose to exert different amounts of effort on the job. This usually results in different incomes. Think of salesman working for the same employer, bankers working in the same branch, or even professors working for the same university in the same department. Some of these people will work long hours trying to get the next raise or make the next sale, while others prefer to work less and spend more time with their friends or families. Neither choice is correct, but they are different.

In this case, the utility profiles might look something like the diagram below.

Diagram 2

In this diagram, person A is the person who really values money. Their marginal utility of another dollar of income is higher at all income levels than person B's. In this diagram, the marginal utility of another dollar for person A is greater at $500,000 than the marginal utility of another dollar for person B is at $50,000. So it is no longer a net utility gain to take a dollar from person A and give it to person B, even though person A is wealthier. If diagram 2 more accurately portrays reality than diagram 1 the utility justification for taking money from the wealthy and giving it to the less wealthy no longer applies.

My personal opinion is that diagram 2 more accurately reflects reality. The empirical observation that people with similar ability and in similar occupations exert different amounts of effort on the job implies that people have different utility profiles over income.

Some people might say that their are other factors going on though and that in reality the profiles of people are in fact quite similar. In this case it is different opportunity costs that lead to the observable differences in work effort, not necessarily differences in marginal utility holding all else constant. So let's assume that people do have the same utility profile over income. Does that mean that all income sources must have the same utility profile? What if earned income has a different utility profile than "free" income?

The argument I am making is that people value a dollar differently depending on where it comes from. If I work harder at my job or work more hours to earn another dollar, the satisfaction I get from that dollar is different than the satisfaction I would get if I found a dollar on the ground.

Nobel Prize winning economist Milton Friedman observed that people act differently when they spend money depending on whose money it is and who they are spending it on. The marginal utility, marginal cost decision that results from spending another dollar is different depending on the source of the income. I think a similar idea is true when it comes to earning income. People take pride in earning their own money; that is they get satisfaction above and beyond the value of the dollar they earn. People on average do not seem to enjoy being given money, whether through charity or by government programs, as much as they enjoy "earning their keep". Most people do not like being labeled a charity case. In this case a person's utility profile would be different based on the source of income and might look like the diagram below.
Diagram 3

In diagram 3 earned income, the black profile, has a higher marginal utility at all income levels than what I label "free" income. "Free" income is unearned income that is the result of charity, a government program, a serendipitous event, etc. If this diagram is accurate and every person has similar profiles over earned and "free" income then taking a dollar from someone who earned $50,000 and giving it to someone who already has $50,000 is not a net utility gain since the marginal utility of an earned dollar is greater than the marginal utility of a "free" dollar. This is the case even if the person who is receiving the "free" dollar has has less than $50,000 in income e.g. only $20,000 or $10,000.

I believe that diagrams 2 and 3 accurately reflect reality. That is, people have different utility profiles over income as a whole and different utility profiles over the sources of income.

In real life utility is impossible to measure with 100% accuracy. But even if it could be measured accurately I think we would find that the assumption that wealthy people have a lower marginal utility of another dollar than less wealthy people is incorrect. Taken together diagrams 2 and 3 invalidate the utility justification for taking money from the relatively wealthy and giving it to the less wealthy.