# What is the economic purpose of increasing the minimum wage?

It is generally accepted among economists that minimum wage warps the equilibrium point between the supply and demand of labor by instituting a price floor and increases unemployment for unskilled laborers (while increasing the wage for the individuals who continue to work).
However, I have noticed that politicians continue to advocate an increase in the minimum wage. Politics and political maneuvering aside, is there an economic reason as to why a higher minimum wage would benefit the economy?

• You might want to check out this question while you're at it. There's some theory in most of the answers. economics.stackexchange.com/questions/47/… – jayk Dec 4 '14 at 0:32
• I don't think you can say "generally accepted among economists" since there are multiple school of economics. Keynesian, Austrian, ... Also, I think it's wrong to say " politicians continue to advocate" since the ideology changes a lot depending on the political spectrum (left/right/top/down). – the_lotus Dec 4 '14 at 18:18
• @the_lotus Thanks for your comment. I said "generally accepted among economists" because the statistic I saw claimed that 70%-80% (I can't remember the exact number; I'll try to find it) of ALL economists believed this (not just a particular school of thought). Also, since this is micro (and most schools debate macro) I thought the statistic made sense. I purposefully left political parties out of my question because I did not want to claim something and be accused of misrepresenting the different parties. Does this address your concerns? – Mathematician Dec 4 '14 at 18:53
• @Mathematician Yes. But I would look closely at that statistic if it mentions "all economists". But now we are getting outside of the scope of your question ;) – the_lotus Dec 4 '14 at 19:16
• Why are you focussing on a change in the minimum wage? Couldn't you rephrase the question to What is the purpose / potential benefits of a minimum wage? without losing any information? – FooBar Dec 4 '14 at 21:54

# Opinion of Economists

What makes you think that economists are so aligned against the minimum wage? Take a look at the IGM Forum that polls top academic economists. There is substantial disagreement about the effects and welfare implications of a minimum wage hike.

# Theory about the minimum wage

Also, it's worth pointing out that besides empirical studies (like Card and Krueger), there are in fact theoretical reasons why a minimum wage might be welfare improving---see Lee and Saez (2012). (I'm just saying they exists, not commenting on the strength of the results.) In the Handbook of Public Economics, chapter 7, "Optimal Labor Income Taxation", they say this about that paper:

Lee and Saez use the occupational model ... with endogeneous wages and prove two results. First, they show that a binding minimum wage is desirable under the strong assumption that unemployment induced by the minimum wage hits the lowest surplus workers first. ...

Second, when labor supply responses are along the extensive margin only, which is the empirically relevant case, the co-existence of a minimum wage with a positive tax rate on low-skilled work is always (second-best) Pareto inefficient.A Pareto improving policy consists of reducing the pre-tax minimum wage while keeping constant the post-tax minimum wage by increasing transfers to low-skilled workers, and financing this reform by increasing taxes on higher paid workers. Importantly, this result is true whether or not rationing induced by the minimum wage is efficient or not.This result can also rationalize policies adopted in many OECD countries in recent decades that have decreased the minimum wage while reducing the implicit tax on low skill work through a combination of reduced payroll taxes for low skill workers and in-work benefits of the EITC type for low skill workers.

• Did not know about IGM pools, great resources! – Martin Van der Linden Dec 3 '14 at 23:03
• Is there an obvious reason why "increasing taxes on higher paid workers" is nevertheless a Pareto improvement? – Steve Jessop Dec 4 '14 at 21:58
• Good question. Maybe you could open up a separate question that focuses on that issue in that particular paper. You could provide a link to here and a reference to the paper, etc. – jmbejara Dec 4 '14 at 22:02
• @jmbejara I said "generally accepted among economists" because the statistic I saw claimed that 70%-80% (I can't remember the exact number; I'll try to find it) of ALL economists believed this (not just a particular school of thought). Also, since this is micro (and most schools debate macro) I thought the statistic made sense. – Mathematician Dec 15 '14 at 21:13
• Re:IGM: while economists disagree on MW's benefits over nothing, they mostly agree it's less effective than alternatives like EITC. From a 2007 EPI survey: "...when asked which of these three best addresses the income needs of poor families, 70% said an expanded EITC, 21% said general welfare supports, and only 9% said a higher minimum wage." epionline.org/studies/r107 – Max Ghenis Aug 30 '15 at 18:29

From a purely theoretical perspective, one argument for a minimum wage would be that the majority of employees work for medium-large sized businesses and face significant personal cost from switching employer. The upshot, argue some, is that firms have disproportionate bargaining power when negotiating terms of employment. To get an idea of how this would work in a model, consider the following figure that depicts a monopsonistic market in which there is a single employer that is free to dictate a take-it or leave-it wage to employees.

• The $$S$$ curve is the supply of labor. You can think of $$S$$ as depicting the lowest wage, $$w$$, at which the $$L$$th unit of labor would be willing to work.
• The $$\text{MC}$$ curve depicts the marginal cost to the firm of hiring an extra worker (this is higher than $$w$$ for the same reason that the marginal revenue is lower than $$p$$ in an ordinary monopoly market).
• The $$\text{MRP}$$ curve is the revenue that an additional worker would create for the firm (it therefore measures how much, in principle, the firm would be willing to pay for an extra unit of labor).

The efficient outcome is for the firm to employ labor so long as its willingness to pay exceeds workers' reservation wage (i.e. the efficient outcome is $$L'$$, supported by wage $$w'$$).

However, just as a standard monopolist finds it profitable to deviate from the efficient price and set $$MR=MC$$, so will our monopsonist behave in a similar fashion. In particular the profit-maximizing demand for labor is found where the marginal cost of labor is equal to its marginal revenue product (point $$A$$) so that the monopsonist employs $$L$$ units of labor. The corresponding wage is found by using the supply function to determine how much must be paid to attract those $$L$$ units; the answer is a wage of $$w$$.

Thus we see that the monopsonist hires too few people ($$L'>L$$) and pays wages that are too low ($$w'>w$$) compared to the efficient allocation. Imposing a minimum wage of $$w'$$ would correct both of these distortions.

A similar (but quantitatively less dramatic) result would hold in markets with a small number of large employers (but more than one). This is a very simple 'textbook' model and I am not sure what the current empirical evidence on this line of reasoning looks like.

• Unless I'm misunderstanding what the curves represent, in the absence of monosonist powers, a firm would seek to find the intersection of MC and MRP, so the market solution would be (w,L). If at a given level of production adding another worker would cost a firm \$12/hour while generating \$8/hour of marginal revenue, I see no reason the company would want to hire that person even if the worker's wage was only \$10/hour. A monosonist could benefit by offering a wage less than w, but that's not what your graph shows. – supercat Dec 4 '14 at 14:25 • Further, different businesses are going to face very different marginal-cost and marginal-revenue-production curves, and would thus have very different (w,L) solutions in the absence of monopsonist powers. I see no reason to believe that the amount by which firms can use monopsonist powers to depress wages would exceed the differences between different firms' "non-monosponist market" wage levels. As such, I don't see how a minimum wage could have much effect without causing market distortions which are worse than those it's supposed to fix. – supercat Dec 4 '14 at 14:35 • @supercat You are misreading the diagram. Think of the MC curve as being like an MR curve for a monopolist: it include both the "real" economic cost of hiring additional labor (given by the$S$curve) and the additional implicit cost to a monopsonist that comes from the fact that to hire a marginal unit of labor the monopsonist also has to pay a higher wage to all inframarginal units. In a competitive labor market this second effect disappears ($w$is taken as given) and$MC$coincides with$S$. I completely agree with your second point; hence the disclaimer about the textbook model. – Ubiquitous Dec 4 '14 at 15:10 • +1: I think monopsony might have been an argument made by Card and Krueger at some point. There's an EJMR discussion about it here. econjobrumors.com/topic/… – jmbejara Dec 4 '14 at 15:57 • @Ubiquitous: Thanks for the explanation; the "S" curve represents what I thought the MC curve represented, which represents the sum of all costs associated with the employee (not just wages, but also taxes, equipment, training, benefits, etc.) Even with the definition of MR as you stated, however, I would posit that whether or not there's a monosony an employer would still seek the intersection of MC and MRP. Assuming (for simplicity) that "wage" represents an all-inclusive per-worker cost, a company given a choice of spending \$10/worker hour and getting 1,000 workers... – supercat Dec 4 '14 at 16:36

The title "What is the purpose of increasing the minimum wage?" and the question "is there an economic reason as to why a higher minimum wage would benefit the economy?" while overlapping, are not necessarily identical.

To answer the latter, minimum wage earners have the highest velocity money in the economy. By this, I mean that when I was working, the next incremental \$1000 was saved or paid debt, but not spent. Our budget was from the lower 60-70% of our income, and we weren't spending to keep up with anyone. But the minimum wage earner is likely living check to check, and has a list of needs that the next \$1, \$10, etc, is going to be spent on. The \$1/hr raise is \$2000/yr that goes right into the economy as spending. There is also the consideration that some number of minimum wage workers are also on government assistance programs for food, housing, etc. If the minimum wage were raised, the assistance will drop, perhaps not dollar for dollar, but in aggregate, some fraction of that increase employers will spend results in lesser demand on the taxpayer. The New York Times has published research concluding that employment is somewhat inelastic at the margin, that a minimum wage increase doesn't immediately result in fewer jobs. Of course there are limits to this, but those numbers are outside the range of proposed changes to the minimum wage. "Why not just raise the wage to \$50/hr and we can all make \$100K" is a red herring. For a sane view of the issue, focus needs to be on the numbers that are real, in the US, the \$10 level from the current \7.50. The aggregate extra income to the workers will far exceed the lost wage of those who lose their jobs and there are those who suggest that this money will actually create more jobs as it will quickly create more activity to the businesses catering to these families. Edit - This was written when there was a distinction between the question title and what was asked in the body text. My answer still mentions the difference, no longer there. Also, per comment request, I linked to the article, but links break. If the link breaks for this Times' article I'll link to a copy of it that I've archived. • Do you maybe have a link the the NYTimes article that you mention in your post? – jmbejara Dec 6 '14 at 19:57 • @jmbejara - thanks, yes, done. I added the key image from the Times article, as well as a link to the article itself. – JTP - Apologise to Monica Dec 6 '14 at 21:21 • you should change the title for him/her... – hello_there_andy Dec 11 '14 at 19:14 • With no comment contradicting or disagreeing with my answer, I remain curious why a member downvoted. Not likely to get a response, just saying. – JTP - Apologise to Monica Dec 12 '14 at 16:43 There are two mechanisms at work. First, a minimum wage will (to the extent that it affects workers) increase disposable income for a subpopulation who have a high marginal propensity to consume (increase demand). This is a somewhat old Keynesian argument: Then facing higher demand, firms will employ more, s.t. in general equilibrium the effect of a wage raise would lead to higher employment, higher production and higher consumption, a welfare improvement. Second, a minimum wage will (to the extent that it affects firms) increase labor costs. Firms potentially respond to this substituting away from that labor, which reduces employment, which has the opposite effects of above. The overall general equilibrium (GE) effects are hard to measure, we can't just randomize minimum wages for some countries. Empirical studies are somewhat ambiguous , but most state that in GE, the measure is welfare decreasing. This does not mean that Economists as a profession are mostly aligned against it (see jmbejara's post). Recently there has been a lot of interest on the use of minimum wage in the literature on optimal taxation. These recent developments tend to indicate that if a government aims at redistribution, minimum wage can often be a useful tool under imperfect information. The core intuition is that, under some assumptions, a minimum wage can be used as a tagging device to relief incentive compatibility constraints in the taxation problem. I have some (very) rough lecture notes on the topic. (One of the models reviewed is Lee and Saez 2012 mentioned in @jmbejara's answer.) See also a more recent paper by Blumkin and Danziger on the use of minimum wage to target "deserving poor" : Deserving Poor and the Desirability of a Minimum Wage. One point to mention is when you increase the purchasing power of the poorest they will use it on spending and thus boost the local economy (shops, repairs, plumbers etc). Wealthy people have more options and may invest it abroad or just save it. The social democratic model of the nordic countries with high governmental investment in social security and benefits financed by a high taxation-level gives a safety net for uneployment and disability. The selfish rich may not agree, but in all it makes them the best countries in the world to live in. • These are for the most part unsubstantiated claims. For example, it's very unclear if a minimum wage hike would boost the economy as you describe. Could you provide references? – jmbejara Dec 4 '14 at 1:33 • This answer has an implicit base in Economics. The way I understand it, it implies that the propensity to consume out of income, and to locally consume at that, is larger for the lower incomes, than the higher ones. In essence it argues that a minimum wage increase functions mainly as a redistribution of income between socio-economic classes. It does need some quantitative references to back the claim. – Alecos Papadopoulos Dec 4 '14 at 2:45 • You should emphasize that the poorest have a higher marginal propensity to consume, a necessary (but not sufficient) condition for your argument to work. – FooBar Dec 4 '14 at 21:35 • Related paper: nber.org/papers/w20073. They build a model in which the poorest have a higher marginal propensity to consume; papers deals with some of these implications. – cc7768 Sep 29 '15 at 2:44 Another argument is that, in the long run, it promotes productivity, technology and I+D. Without a minimum wage your economy will tend to turn into a new Bangladesh. It will attract low tech industries that will have very little incentive to invest time and money into making workers more productive. If each worker month cost you 1000 you will think how to maximize the potential of your workers.

Update: another argument is that the wage is set by negociating power of workers and employeers. You may set some basic rules or you may let the parts to set it by themselves. That means lots of negociation, strikes, unions, meetings, etc. A lot of energy is spent by both sides trying to negociate. Strikes reduce productivity. Some workers that can stop the system have greater power (air controllers, train drivers). This may spoil the culture of companies.

• -1: Please provide references for the implicit assumptions and assertions in the text. Intuitively, the US has quite low minimum wage standards compared to West Europe, and yet has not transformed to Bangladesh. Lack of minimum wages does not seem to be a sufficient condition. – FooBar Dec 4 '14 at 21:29
• Really? Europe minimum wage is high only on UK, France, Belgium and Holland. But surely it is not a 100% condition, for example , if the equilibrium wage is high you do not need to rise it artificially. Anyway, it is a reason, but it is hard to measure its effect. en.wikipedia.org/wiki/… – borjab Dec 5 '14 at 10:06
• And US minimum wage historically had higher purchasing power. For example, now, people can't work their way to the university. Y randalolson.com/2014/03/22/… – borjab Dec 5 '14 at 10:10

The reason politicians favor increasing the minimum wage is that it makes people think they care for the poor, while the predictable side-effects increase the number of out-of-work people who will then be reliant upon the government (and, by implication, a politician whom they think "cares" for them).

In reality, the effect of a price floor on any type of good or service is simple and predictable: it removes from the market goods or services of that type whose value would be insufficient to justify even the minimum price. When low-value goods or services are removed from the market, this will often increase the relative demand for those goods or services which remain in the market, but eliminate the demand for those which don't.

If a business has a choice between hiring someone who would demand \$7/hour and could do something in eight hours, or someone who would demand \$10/hour but could do the job in seven, it would likely hire the less productive worker. Even though the former worker wasn't as productive as the latter, a willingness to work for lower pay would allow that worker to compete in the marketplace. Denying the former worker the ability to compete on price may allow the latter worker to demand more pay, but will also leave the former worker without any means of offering employers any reason to hire him.

If politicians really wanted to help the working poor, they would work to minimize the amount of money an employer must spend on someone's labor to leave the worker noticeably better off than he would be with no job. If there were some job some not-particularly-good workers could do that could provide $5/hour worth of value to an employer even after deducting the costs of e.g. transporting the person to/from work, providing child care if needed, etc., then significant economic good would come from allowing such people to be hired, and allow them to add their wages to whatever welfare benefits they could receive from doing nothing. Such a policy, however, would reduce politicians' power over the lower classes, however, and is thus unlikely to ever see the light of day. • -1: This doesn't answer the question. As mentioned on other answers, the OP is (1) not looking for political reasoning and (2) is asking for economic reasons for "an economic reason as to why a higher minimum wage would benefit the economy"---not the other way around. – jmbejara Dec 4 '14 at 15:41 • @jmbejara: My second paragraph specifies the economic effect: it removes certain potential workers from the economy. Removing such workers from the economy will eliminate any economic output those workers could have produced, but could improve the economic situation of some of the workers who remain. Since different people have different definitions of what it means to "improve the economy", some people might regard the net effects as beneficial while others regard them as detrimental. – supercat Dec 4 '14 at 16:20 • -1: Not answering the question. Besides @jmbejara s point, the OP asks whether there is any argument for a minimum wage. What you provide is an argument against it, and a (not backed up) claim whether minimum wages are a welfare improvement. – FooBar Dec 4 '14 at 21:49 Most respondents have not much addressed the issue of purpose, but have focused more on outcomes. Me too. If a nursing home raises the pay of its carers from the minimum wage by a significant amount, then it may gain benefits that include: reduced costs for recruitment and training; better care; better continuity of care; staff goodwill; enhanced reputation; increased demand. The higher the minimum wage goes, the less scope a nursing home has to follow such a plan. • -1: You highlight one direct mechanism in which a minimum wage affects economic outcomes negatively. The OP asked for a direct mechanism in which a minimum wage affects economic outcomes positively. – FooBar Dec 5 '14 at 22:56 • Of course you are right, FooBar. If we take nursing home to be a metaphor for country... – John MacNeill Dec 6 '14 at 7:24 The immediate effect of increasing the minimum wage is obviously more disposable income for minimum wage workers, increased expense for employers, possibly higher prices, and an increase in the amount of taxes collected. But this leads to a chain of economic events that will resolve in a possibly new equilibrium that may or may not be any more beneficial. Higher wages enables higher paid workers to choose a different bundle of goods that they consume. If some of the new purchasing options are outside the area that they work, the money may be lost from the community or microeconomy. The money may not return until the economy adjusts and inflation reestablishes a new equilibrium price level at which point the basket of goods to choose from may become local again. Also, consider that minimum wage workers may have debt and so additional money earned might not go toward purchasing anything new or local; and may also flow away from local circulation. Firms requiring certain numbers of employees won't necessarily go out of business but will have to lessen other costs in other ways. This could lower the quality of goods & services and affect people's consumption from the firm given their preferences. Within the local economy, given wage earners' new indifference curves, some firms may lose additional business to other firms while dealing with additional wage costs. Firms may raise prices to compensate, reestablishing the wage vs price equilibrium, BUT if the rate of money flow out of the local economy increases, local residents including the firms and wage earners may find themselves with higher prices but less money in their own local economy to afford those higher prices. Income taxes and payroll tax collections would increase. Depending on the government's discretion, the tax revenue may either be effectively or ineffectively applied. This could make the government look good or not so good. • -1: A long and unscientific rant without references to justify the many assumptions and assertions explicit and implicit. – FooBar Dec 4 '14 at 21:25 • @jmbejara: Taxing the higher paid for redistribution to the lower paid is Pareto inefficient. Assuming that higher paid is higher skilled and lower paid is lower skilled is an assumptive recrimination that justifies the disparity but is not necessarily true. If true, then taking money from better paid to subsidize lower paid punitively forfeits money that, individually, could be used with better discretion to employ lower paid. Rather than doling thinly spread welfare as aid for overpriced housing or gratification, added demand for labor would spur demand for training. Gov't can't micromanage. – SavedByZero Dec 5 '14 at 3:15 • @Martin Van der Linden, supercat, FooBar: In line with jmbejara's excerpt, an increase in minimum wage is simulated by tax relief for the poor. However, the tax relief is insufficient for them to better themselves significantly. People can be poor due to lack of training, lack of knowledge about existing options, misfortune, and/or lack of capital beyond required living costs. Simulating a slightly higher wage or slightly lower price level solves nothing and is patronizing. Feed a person a fish OR teach a person how to fish and feed them for life. – SavedByZero Dec 5 '14 at 3:37 • @Foobar; The 'rant' addresses what you paraphrase. If indeed, the wage raise better enables a subpopulation of workers with a large propensity to consume from other businesses that serve them, then their credit line will increase and their neighborhoods will gentrify. Other economic shocks can change booms to busts against which higher minimum wages cannot insure. Defaults will ensue. If increased minimum wages lead to layoffs, employers may still hire better skill for the money for which more may compete prior to a general increase in the price level (a short run benefit to employers.) – SavedByZero Dec 5 '14 at 4:07 • @user58446; To add to your economic observation, not all businesses have employees. But either way, when sellers see that there is more money to be had from buyers that are getting paid more money, sellers will raise prices and/or come up with additional surplus capturing schemes. Sellers are also buyers of other sellers. When sellers see that other sellers are opportunistically raising their prices, then sellers, in finding their Nash equilibrium, will be reluctant to lower their prices thereby creating inflation which negates the real value of the minimum wage used to originally fuel it. – SavedByZero Dec 5 '14 at 4:39 I am not an economist but I have had a very firm opinion about this since I first considered it as a young worker who has witnessed the increase of minimum wage and the increase in inflation over a 15-year period: The fundamental problem with this is that if a significant amount of a population require a minimum wage increase, the economy will adjust in order neutralize this increased buying power after a very short time. For example: Once it is determined by 'an industry' - computers, food, transportation, etc. that a significant amount of the population is now receiving more money (albeit 50 cents an hour), then surely their prices will soon reflect this increased buying power of the poor and the effect of the wage increase will then be effectectively neutralized. Can you blame the manufacturer? After all, they are now having to pay some of their workers more and are seeing a loss because of it. Some call this type of thing 'inflation'. This increase will continue indefintely, much like a worm which stretches out their head farther than he can normally reach, the rest of the body will soon follow. Only the worm actuallly gets somehere, I do not believe the same is true for society or the economy. To further this point: how far do you think we can keep increaing the minimum wage? Indefinitely? Without unchecked inflation, soon we would find ourselves in a position where a loaf of bread costs one million dollars... but the minimum wage is 2 million so we can still buy our loaf of bread for a half-hour's worth of work. Of course, there was a short period before the bread manufucters increased their bread prices from$900,000 to 1 million, so for a short time those receiving minimum wage saw an increase in their buying power, but it was fake/forced/temporary. They didn't do anything to truly increase their buying power: their skills were the same, their lives were the same, and so naturally the rest of the economy will adjust to keep everything else just the same.

In conclusion and to answer your actual question: I believe inreasing the minimum wage is nothing more than a facade used by a political party or politician to increase their reputation amongst those who would benefit the most, the recipients of the wage increase, and garner votes from those who do not realize how futile the politician's attempts are in the long term at making peoples' lives any better. It's a shortcut, which omits any of the hard work that is really required to accomplish anything in the real world. Like most shortcuts, their effects are usually "short-term".