The Implications Of A Minimum Wage

Thursday, June 18, 2020

Editor’s Note: This is an edited excerpt from a longer essay by Mr. Ohanian, titled ‘The Effect of Economic Freedom on Labor Market Efficiency and Performance,' published by the Hoover Institution as part of a new initiative, "Socialism and Free-Market Capitalism: The Human Prosperity Project."

The efficient operation of the US labor market in absorbing new workers has been the exception more than the rule when compared to other developed countries. Today, several major economies with far fewer young workers than the United States, such as France, Italy, and Spain, currently have youth unemployment rates of at least 20 percent, even 10 years after the global financial crisis. This compares to a youth unemployment rate of about eight percent in the United States.

The Heritage Foundation and the Organisation for Economic Co-operation and Development systematically rank countries on labor market freedom and flexibility. Both these rankings have been conducted for many years and they are widely cited and used in making comparisons across countries and analyzing labor market outcomes.

The Heritage Foundation ranks the United States as having the most labor market freedom among all countries. The ranking is based on six factors: (1) The minimum wage relative to average value added per worker, (2) the cost of hiring new workers, (3) the cost of adjusting worker hours, (4) the cost of dismissing redundant employees, (5) the length of term of mandated notice of dismissal, and (6) the extent and size of mandatory severance pay. Each of these factors in the Heritage Foundation index has important economic implications for the efficient and free operation of the labor market.

[Editor’s note: The rest of the excerpt focuses on the question of a minimum wage.]

The minimum wage relative to average worker productivity gauges how many workers may be negatively affected by the minimum wage because their employment cost exceeds the value of their production. Specifically, if the minimum wage is higher than a worker’s productivity, then the worker will not be hired because the hiring organization will take a loss on that worker. Instead, it will focus hiring efforts on workers whose productivity exceeds the minimum wage.

In a free labor market, inexperienced workers would have many more opportunities because employers would not be restricted to paying them a wage exceeding the value of their production. Instead, workers would be paid according to their productivity. While inexperienced workers may be paid relatively low wages, their pay would rise as their skills increased with experience and job training.

Those who may be priced out of the market due to a high minimum wage include workers who have not yet acquired sufficient skills to realistically compete for higher wage jobs, such as young workers, immigrants, and workers who have been out of the labor force for a considerable period of time, such as parents who left the labor force to raise children and workers recovering from long-term disabilities.

At one time, there was nearly universal agreement among economists and policy makers that high minimum wages depressed employment, particularly for young people who were still in the process of accumulating skills and experience.

The economic logic behind this once-standard view is simple. Fixing the price of any good or service above its market price will result in lower demand. In the labor market, this means that any worker who does not deliver enough value to offset an artificially high minimum wage will be unemployed.

Youth unemployment statistics highlight the impact of minimum wages. In mid-2012, more than two years after the end of the last recession, teenage unemployment (ages sixteen to nineteen) was 25 percent, compared to a 6.7 percent unemployment rate for prime age workers (ages 25 to 54). Even today, with the strongest job market in the last fifty years, teenage unemployment is 12.6 percent, compared to a prime age worker unemployment rate of 2.9 percent.

Despite the simple economic logic described above, and the observed large difference in unemployment rates by age, some commentators today hold the view that raising the minimum wage will have little, if any, effect on unemployment and instead will substantially raise the standard of living among nearly all low-wage workers.

Perhaps the major factor driving this change in opinion was research by David Card and Alan Krueger. In an influential paper, Card and Krueger (in 1994) compared changes in employment in fast-food restaurants between New Jersey, which increased its hourly wage from $4.25 to $5.05 in 1992, and Pennsylvania, which kept its minimum wage at $4.25. They surveyed about four hundred fast-food restaurants near the New Jersey-Eastern Pennsylvania border by phone and asked restaurant managers about employment levels before and after the New Jersey minimum wage change.

They reported that the New Jersey restaurants had expanded employment by nearly three full-time equivalent workers relative to Pennsylvania restaurants. This result was extremely surprising, as it defies the most basic economic argument that artificially raising wages of low-skilled labor depresses the demand for that labor.

However, there are problems with Card and Krueger’s analysis, including data collection and their research design. In terms of data collection, Card and Krueger relied on telephone surveys with the restaurants. Subsequent research based on better data collection showed very different results.

In a series of papers and a book, David Neumark and William Wascher review many minimum wage studies, including that of Card and Krueger . In contrast to the latter, Neumark and Wascher redo the New Jersey and Pennsylvania fast-food restaurant study by using administrative payroll data from fast-food restaurants rather than telephone interviews. Payroll data is more reliable than the telephone interview responses obtained by Card and Krueger because restaurants have a legal obligation to report taxable income and costs.

In contrast to the Card and Krueger study, Neumark and Wascher found that the higher minimum wage in New Jersey had reduced New Jersey employment by about 4 percent relative to Pennsylvania, in which the minimum wage was not changed. This finding is in line with standard economic logic and with the majority of previous empirical estimates of the impact of a minimum wage.

Neumark’s most recent review (in 2019) of many short-run minimum wage studies concludes as follows: “The preponderance of evidence indicates that minimum wages reduce employment of the least‐skilled workers. Earlier estimates suggested an ‘elasticity’ of about −0.1 to −0.2. Many estimates are still in this range … More definitively, though, it is indisputable that there is a body of evidence pointing to job losses from higher minimum wages. Characterizations of the literature as providing no evidence of job loss are simply inaccurate.”

More recently, economists have begun to study the long-run effects of minimum wages on employment. This is important, as the short-run responses to a higher minimum wage, which are the focus of much of the literature, may be very different from long-run responses. This is because it takes time for employers to make adjustments in response to minimum wage changes, including installation of new capital investments and adoption of new technologies, both of which can substitute for workers.

Research by Isaac Sorkin shows that the difference between the short-run and long-run effects of minimum wage legislation can be enormous. Sorkin measures the responsiveness of employment to a wage change using the economic concept of demand elasticity, which is the percentage change in labor demand in response to a given percentage change in the wage.

He shows that the contemporaneous elasticity of labor demand can be virtually zero upon impact of a minimum wage change, in which he estimates that a 10 percent change in the wage generates an immediate .02 percent drop in employment. However, he finds that this sensitivity rises to -.252, meaning that a 10 percent change in the wage generates a 2.5 percent drop in employment after six years, which is roughly one hundred times larger than the immediate effect.

This large difference reflects the fact that as labor costs rise, businesses economize on labor by substituting capital and new technologies for workers and also by offshoring some tasks to lower-cost providers of labor services. This large difference between short- and long-run effects is incredibly important but rarely is documented by empirical studies.

Minimum wage research has important implications for current policy discussions. In particular, there are a number of proposals to raise the federal minimum wage from its current level of $7.25 per hour to $15 per hour.

At its current level, the minimum wage affects very few workers, just 0.28 percent of the labor force. According to the Labor Department, almost half of minimum wage workers are workers younger than twenty-five, who account for only about 20 percent of the overall labor force.

However, if the minimum wage were raised to $15 per hour, then it would affect over 40 percent of American workers. Alan Krueger, one of the authors of the New Jersey–Pennsylvania study cited above and a former economic adviser to President Obama, warned of job loss if the minimum wage were raised to $15 per hour.

An important risk of a $15 federal minimum wage is that low earners in relatively poor states would be particularly hard hit. For example, the average hourly wage in Mississippi is under $15 per hour.

There are policies that will improve the efficiency of the labor market while promoting compensation growth for those who may be adversely affected by the minimum wage. These policies include expanding the earned income tax credit, increasing the scope and scale of enterprise zones which incentivize businesses to locate in poor neighborhoods, improving our K-12 education system, and expanding preschool programs.

Lee Ohanian is a Senior Fellow at the Hoover Institution at Stanford University and a Professor of Economics at UCLA.