Monday, March 2, 2015

A higher minimum wage does not make society better off or create jobs

I had a discussion today with a friend about the minimum wage and it gave me an idea for a thought experiment. Many pundits insist that a higher minimum wage will create jobs (see here for one example). The argument goes as follows (taken from the article linked to above):

"What critics of a higher minimum wage ignore is that, by putting more money into the pockets of the working poor — a group that necessarily spends nearly all its income on such locally provided basics as rent, food, transport and child care — an adequate minimum wage increases a community’s level of sales and thereby creates more jobs."

But can the minimum wage really create more jobs overall? The answer to this questions is most certainly no and a simple example will explain why.

Suppose there are two parts of a town; the owners of businesses live in one part and the workers live in another. These owners and workers produce widgets and everyone demands 1 widget per day. Owners are wealthier than workers. There are the same number of workers as owners.

In each area of town there is a pizza parlor that is owned by the government and uses no workers (the pizza is completely made by machines and has a perfectly elastic supply). Workers only go to their pizza parlor and owners only go to their pizza parlor. The equilibrium price of pizza is $9/pizza in each area. The equilibrium quantity for owners is 100 pizzas per month, while the equilibrium quantity for workers is 80 pizzas per month. (since owners are wealthier and they each demand the same amount of widgets owners spend the rest of their money on more pizza.) The graphs below represent the markets for pizzas in each part of town.


Now let's suppose the government passes a minimum wage increase in the widget factory. For the purposes of this example I will assume that the minimum wage increase is completely absorbed by the owners i.e. the owners take less money and pay the workers more; prices of widgets do not change (this is the preferred outcome of most minimum wage supporters as well).

This increase in the minimum wage will have an income effect on the demand for pizza for both the owners and workers. Since the workers now earn more money, the demand for pizza in their part of town will increase. The demand curve will shift out as in the following diagram.

The increase in demand will increase the quantity supplied of pizzas in the worker's pizza parlor; there will be a movement along the supply curve to the right.

But where do the inputs for the new pizzas come from? The increase in the minimum wage did not change the supply curves of pizza. There was no technology increase; no new way of making pizzas was created. In order to increase the quantity supplied of pizzas in the workers part of town the raw materials for pizza (dough, cheese, pepperoni, etc.) must come from somewhere.

And that is where the owners come in. Remember they are poorer now. So the demand for pizza in their parlor decreases, as in the graph below.

When the demand for pizza decreases in the owners parlor, the quantity supplied decreases and moves to the left. This frees up resources (dough, cheese, pepperoni) to be used for other things. In this case the pizza inputs that are no longer being used in the owner's parlor can be used in the worker's parlor.

This example illustrates a key point: society can not be made better off overall by moving money from one group of people to another. Wealth is created by more production, by figuring out ways to make more stuff using less resources. The minimum wage does not affect the supply curves of the products that workers demand. Yes they have more money, but all that does is increase their demand for certain goods while it decreases the demand of other goods that were bought by the people that used to have the money. 

A higher minimum wage does not increase output so it cannot make society better off overall. Increases in the minimum wage simply shift money around, resulting in higher demand for some goods and lower demand for others, just like in this pizza example. The net effect is 0, since the pizza resources freed up by the decrease in demand on the owner's side were the same pizza resources used to increase the quantity supplied on the worker's side. In a more complex economy the increases and decreases in demand will be spread out over more products and it will be hard for any one person to see exactly where the changes are taking place, but the result will still hold. Workers are an input, just like pepperoni, and if more workers are going to be used in one market following a demand increase then less workers must be used somewhere else following a demand decrease.

So the next time someone tells you that the minimum wage will increase jobs by increasing demand, ask them where the new workers are coming from. Just like pepperoni, workers can't appear out of thin air.

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