Wednesday, May 27, 2015

A higher minimum wage in one area may harm low-skill workers in other areas

The Los Angeles' city council recently passed a anti low-skill worker bill minimum wage increase that will increase the city's minimum wage from $9/hour to $15/hour. This ill-advised, and I would argue cruel, increase in the minimum wage will banish the least productive workers of LA - teens, the undereducated, the elderly - from the labor market. For LA teenagers in particular it will now be more difficult to find their first job. In light of LA's actions, Don Boudreaux at Cafe Hayek asks all minimum wage supporters a very appropriate question: if the minimum wage was enforced by fining and arresting employees who voluntarily work for less than the government mandated wage rather than the employers who pay them, would you still support it? He states that:

"If a minimum-wage policy is both economically justified and morally acceptable, you should have no problem with this manner of enforcement."

I agree with him. And when the question is phrased in the way he poses it a minimum wage sounds even worse.

And if punishing LA's low-skill workers by preventing them from negotiating their own wage with employers isn't bad enough, there is reason to believe that a higher minimum wage in places like LA, Seattle, and San Francisco will also eventually affect the employment opportunities of low-skill workers in other areas of the country.

Profit maximizing firms are always on the lookout for ways to reduce costs holding quality constant (or in the best case scenario to reduce costs and increase quality). Since there are many different ways to produce the same good, if one of the factors of production, say labor, increases, firms will have an incentive to use less of that factor and more of something else in their production process. For example, if the price of low-skill workers increases relative to the cost of a machine that can do the same job firms will have an incentive to switch to the machine. It is easier to demonstrate this using some simple math.

To set the stage for this post, lets think about a real life example; touch screen ordering. McDonald's is currently installing some touch screens for patrons to order their meals and at Clemson University one of the food courts also has a touch screen ordering system for the grill portion of the restaurant. The choice facing a restaurant is touch screen or cashier. If a restaurant is currently using a cashier and paying them a wage, they will only switch to the touch screen if the cost of switching and the future discounted costs of operating and maintaining the touch screen device are less than the future discounted costs of using workers and paying them a wage. We can write this as

D + K + I + RK  < WL

Where D represents the development costs of creating and perfecting the device, K represents the costs of working out the kinks/the trial run/adjustment costs, I represents the installation costs, and RK represents the net present value of the operating and maintenance costs. On the other side of the inequality WL represents the net present value of the labor costs. (In math terms RK and WL are: RK = [ (rk) / (1+i)^n from n=0 to N ] where r is the rental rare of a unit of capital, k is the number of units of capital, and i is the interest rate and WL = [ (wl) / (1+i)^n from n=0 to N ] where w is the wage and l is the amount of labor hours. But if this looks messy and confusing to you don't worry about it as it's not crucial for the example.)

The owner of a restaurant will only switch to a touch screen device rather than a cashier if the left side of the above inequality is less than the right side, since in that case the owner's costs will be lower and they will earn a larger profit.

If the cashier is earning the minimum wage or something close to it and the minimum wage is increased, say from $9 to $15, the right side of the above inequality will increase while the left side will stay the same (the w part of WL is going up).  If the increase in the wage is enough to make the right side larger than the left side the firm will switch from a cashier to a touch screen. Suppose that an increase from $9 to $15 does induce a switch to touch screen devices in LA McDonald's restaurants. Can this impact McDonald's restaurants in areas where the minimum wage doesn't increase? In theory yes.

Once some McDonald's restaurants make the switch, the costs for other McDonald's to switch will be lower. The reason for this is that the McDonald's who switch later will not have to pay the D or K costs: the development or kinks/trial run/adjustment costs. Once the technology is developed and perfected the late-adopting McDonald's can just copy what has already been done. So after the McDonald's restaurants in high wage areas install and perfect touch screen devices for ordering, the other McDonald's face the decision of

I + RK < WL

This means that it may make sense to adopt the technology once it has been developed and perfected even if the wage in the lower wage areas does not change. In this scenario the left side decreases as D and K go to 0 while the right side stays the same. In fact, one could argue that the RK will decline for late-adopting restaurants as well as the maintenance costs decline over time as more technicians are trained and the reliability and performance of the software and hardware increase over time.

What this means is that higher minimum wages in areas like Seattle, LA, and San Francisco can lead to a decline in low-skill employment opportunities in places like Greenville, SC and Dayton, OH as the technology employed to offset the higher labor costs in the former cities spread to the latter.

Also, firm owners and operators live in the real world. They see other cities and local governments raising their minimum wage and they start to think that it could happen in their area too. This also gives them an incentive to switch since in expectation labor costs are going up. If more cities make the same bad policy choice as LA and Seattle firm owners around the country may start to think that resistance is futile and that it is best just to adapt in advance of a minimum wage increase by preemptively switching to more capital.

And if you think that touch screen ordering machines aren't a good example, here is a link to an article about an automated burger-making machine. The company that created it plans on starting a chain of restaurants that use the machine. Once all of the bugs are worked out how high does the minimum wage need to be before other companies license the technology or create their own by copying what has already been done?

This is just one more way that a higher minimum wage negatively impacts low-skill workers, even if the workers don't live in an area that has a relatively high minimum wage.

Wednesday, May 20, 2015

60 years of urban change

The Institute for Quality Communities at the University of Oklahoma has a neat collection of maps that allow you to view cities from all over the country both before and after highways were constructed. It is troubling to see how many people were displaced by eminent domain and the highway system. Atlanta in particular was heavily impacted by I-85.

Tuesday, May 19, 2015

Federalism and economic growth

In a recent paper by J.W. Hatfield ("Federalism, taxation, and economic growth." Journal of Urban Economics, 2015. A draft version can be found here.) the author shows that federalism and the resulting competition for capital leads to a tax policy that maximizes economic growth. From the conclusion:

"Our work shows that federalism, and the attendant competition for capital, will drive tax policy to the growth maximizing level, while a centralized government will choose tax policy that does not maximize growth....When many districts exist, competition will drive the districts to choose tax policies that maximize the private rate of return and hence the growth rate of the economy. A centralized government, by contrast, will choose to maximize its own objective function, the welfare of the median voter..."

Their model does make some important assumptions that do not exactly match reality, namely that labor is completely immobile and that all capital is mobile. Neither assumption is true, since labor i.e. workers are able to move to new locations and some capital, such as buildings and roads, are immobile once they are built. But a lot of capital is relatively more mobile than labor, which is the primary reason countries often tax capital gains at lower rates than labor income. Because there are international capital markets capitalists are able to invest their capital where it will get the highest rate of return.

What this paper does show is that municipal and state competition is an important condition for generating economic growth. Just like in the business world, competition encourages governments to produce the stuff that people want. When people are able to vote with their feet government officials must be attentive to the needs of their constituents. If people are unable to exit the jurisdiction of a bad government there is less of an incentive for the government to change course. The federal government can afford to be less attentive than the state governments, and the states less than the cities, towns, and villages, because it is harder to leave the US than it is to leave South Carolina or the city of Clemson.

Competition is also important because it fosters innovation. Economist and Nobel Prize winner F.A. Hayek noted that competition is a discovery process. He explained that we need competition to help us discover what are the best ways of doing things. Because firms have to compete with each other for customers they are continuously looking for new and better ways to provide a good or service that already exists or create a new good or service that satisfies a consumer want. Firms need to provide consumers with value, and that means giving them what they want at the lowest possible cost. Competition ensures that firms are always on the lookout for new ways to create more with less, which keeps prices low and conserves resources that can then be used on other things. Competition between governments fosters similar outcomes.

In the business world it is well known that monopolies stifle innovation, reduce output, and charge high prices. But it is less understood by the general public that a government monopoly leads to these same bad outcomes. Federalism is important and needs to protected. It helps create the conditions necessary for innovation and economic growth, both of which make us all better off.

Tuesday, May 12, 2015

The Rise of American Big Government

Here is a paper by Michael Dahlen that provides a brief history of how the US government became so large and intrusive. It is a good paper that anyone can understand and everyone should read.

Monday, May 11, 2015

Robert Reich and his faulty argument for a higher minimum wage

In a recent video Robert Reich makes the case (albeit a bad one) for a $15 minimum wage. I have addressed several of his argument's flaws in other posts (a "virtuous" cycle of demand is nonsense, the least skilled and least productive do get pushed out of the labor market, corporations already do their part) so in this post I want to highlight his misleading statement at the 1:35 mark that "many" of the workers who would be helped by a higher minimum wage are key breadwinners.

The chart above was taken from the website. This chart shows how many of each type of person would see a direct pay increase due to a higher minimum wage. Keep in mind that only 3.6 million workers, or 4.7% of the hourly paid workforce, made at or below the federal minimum wage in 2012. Because the Whitehouse's plan is to raise the wage from $7.25 to $10.10 it claims that 19 million people would be directly affected. But out of these 19 million, only 26% of the workers who would experience a direct increase have kids. 26% doesn't seem like "many" to me. 12% are in fact teenagers trying to earn pocket money, as Mr. Reich puts it, which as a group is almost as large as the married-with-kids category that Mr. Reich seems so concerned about (16%) and larger than the unmarried-with-kids group (10%). 62% of those who would be directly affected are adults over the age of 18 with no kids. So while it may be difficult to support oneself on a minimum wage job, the current situation is hardly the family-with-children crisis that Mr. Reich is making it out to be.

If we want to help working parents with children there are other, better ways to do that. One way is to increase the earned income tax credit (EITC). The EITC only applies to the working poor and does not create the same barrier to employment that the artificially high minimum wage does. It would be better if the people who wanted a job could get one at some wage and then programs like the EITC chipped in to raise their total income. Then the lowest skilled people could gain skills and move up the income ladder over time rather than being priced out of the labor market right from the start.

Tuesday, May 5, 2015

How subsidies for higher education contribute to the higher cost of tuition

The rising cost of college is routinely noted by politicians, college administrators, reporters, college kids and parents. Politicians often insist that the solution for rising costs is more government aid. Many of them insist that increasing the amount of Pell Grants and subsidizing student loans are necessary in order to make college affordable for most people. But basic economic theory shows us that while subsidies can increase the amount of education that people consume and lower the cost to the people who get the subsidies, the subsidies also raise the true cost and can create a feedback effect that involves granting increasingly larger subsidies.

Research by economists Claudia Goldin and Stephanie Riegg Cellini looked at the cost of for-profit colleges that are eligible for federal financial aid and the cost of for-profit colleges not eligible for aid.

"They found that for-profits that get federal subsidies charge, on average, 78 percent more than for-profit institutions that are not eligible for aid. The price difference is almost identical to the value of the subsidy. “It’s hard not to infer that federal student aid system is kind of allowing that to happen,” Professor Cellini told me."

So how does a subsidy contribute to higher tuition? Lets analyze this starting with the diagram below.

Ignore the MB + subsidy line right now. Without a subsidy, a person will consumer education up to the point at which their marginal benefit of another unit of education is equal to their marginal cost. In the diagram above that is at the price of P1 and the amount E1. If we want this person to consume more education, we can give them a subsidy. In this case the subsidy is the amount Ps - Pc. The effect of the subsidy is that it shifts the marginal benefit curve up by the amount of the subsidy (MB + subsidy line). Now the person will consume E2, they will pay a price of Pc, but the cost of supplying E2 is Ps. The difference of Ps - Pc is the portion of the cost that is paid for by the subsidy. So the subsidy increases the amount of education that this person consumes by lowering the cost to them, even though the marginal cost of supplying the education has gone up from P1 to Ps.

If a lot of people are awarded a subsidy and start consuming more education, say by going to college rather than getting a job after high school, the total demand for college can shift to the right like in the diagram below.

The original demand for college, prior to the subsidy, was D1. Tuition cost was T1 and quantity Q1 was supplied. After the subsidy, as more people attend college, demand shifts to the right to D2. The new tuition cost is T2 and Q2 is supplied. So the subsidy can raise the cost of tuition by increasing the demand for college. How does this new higher tuition price impact the recipients of the subsidy?

I know there is a lot going on in this diagram but bear with me. Prior to the demand shift and immediately after the subsidy our college attendee was paying Pc and consuming E2. After a lot of other people start doing this as well the demand curve for college shifts to the right and tuition goes up. This impacts the individual college attendee as it increases the cost of more education. This is depicted in the diagram as a shift in the marginal cost curve from MC1 to MC2. When the costs curve shifts up the subsidy is no longer large enough to help the attendee consume E2. In fact, as drawn the subsidy recipient only consumes E1 again (where the MB + old subsidy line intersects the MC2 line). The price is P2 but they only pay P1 as the subsidy makes up the difference.

If E2 is a college degree and that is the goal of providing the subsidy, then with the new higher cost curve (MC2) the subsidy has to be increased to get a person to consume E2 again. The new subsidy amount is Ps2 - Pc. The larger subsidy increases the marginal benefit curve from MB + old subsidy to MB + new subsidy. The person will consume E2 again and they will pay Pc with the difference being covered by the subsidy (Ps2 - Pc).

This is a stylized example but it helps explain how subsidies contribute to the rising cost of college. The initial subsidy led to an increase in demand for education, which raised the cost, which meant a larger subsidy was required. If the new, larger subsidy induces some additional students who were not affected by the original, smaller subsidy to purchase more education then the process will start all over again. The new students will increase the demand for college, which will increase tuition, which will then need to be covered by a larger subsidy etc.

This video from Learn Liberty talks about the effect of subsidies and other reasons for why college costs keep rising.

So the next time you hear a politician say that we need larger subsidies to offset the cost of college, remember that those subsidies are partly to blame for the rising costs.