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I would posit that the minimum wage is determined more on a political than an economic basis. The fact is that there are more wage earners than business owners and, generally speaking, the wage earners prefer an increase while the business owners prefer a minimum wage decrease (perhaps even to 0). There are more wage earners to vote than business owners, and this makes it politically expedient, on the balance, to vote for a minimum wage increase.

First, is this true?

Second, if you find it to be true, why doesn't the minimum wage increase substantially more than it has over the years (focusing on the US)? What is the counter balancing force that causes minimum wages to seek equilibrium at some something between "poverty" and "living wage" level (again, in the US)? Or is even that assumption false?

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How is the minimum wage determined?

Yes and no. It is a political choice, but with economic reasoning. In the end, that's the case for every economic rule, maybe with the exception of monetary rules, as we try to preserve independence for central bankers (but it isn't completely true for the US FEDs).

When setting the new minimum wage, you compare minimum wages with other states, and with your own (earlier) state, to get a feeling what's possible and what is not. In the end, the minimum wage is a trade-off between raising earnings for some parts of the population, and decreasing employment chance for others.

How does the minimum wage affect employment?

The degree of trade-off (if you will, the transition rate between the two) is unclear. In the data, we tend to see no employment effect of minimum wages, but an increase in earnings (Dube et al (2010): (Ungated version). In fact, we see a large number of estimates around 0:

Estimated Minimum-Wage Effects Onto Unemployment

Many economists suspect (based on a strong prior that there should be an employment effect) that this is due to poor data (Matt Rognlie's comment), or long-term effects of minimum-wages (adjustment costs in technology) that we are not capable of measuring/estimating precisely (Sorkin (2015) (IDEAS)).

Why doesn't the minimum wage affect employment?

The counter-effect to some part is the political process. People are not stupid, they will accept raises in the minimum wage to some degree, but not if you go bananas. Also, there are natural counter-forces in the economy:

  • minimum wages are nominal
  • minimum wages are lower bounds

To that end, if you increase the minimum wage, eventually inflation will wash off the real impact. Also, raises in the minimum wage tend to become substitutes for (non-forced) increases in the wage level.

Have a look at the following graph, which depicts the relative impact of minimum wages. The author plots the maximum of minimum wages at a time period, deflated by average hourly wage in the private sector among production and non-supervisory employees (no managers). It really looks as if any spike (raise in the minimum wages) gets deflated quite quickly, doesn't it?

Relative Minimum Wages

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While business owners are generally united in their stance against minimum wage increases, wage earners do not always prefer a wage increase. Minimum wage puts pressure on the least productive workers and puts them at a threat of being fired. For example, if a worker produces 10 dollars of revenue for the business owner, but costs him 7.50 dollars an hour, then everything works fine for both of them. If the minimum wage is increased to 11 dollars an hour, then the business owner will simply fire the worker. That is not something the worker would prefer. On the political front, businesses are usually outspoken about their intentions to lay off people in case of the minimum wage hikes. Political parties are also aware of a possible spike in unemployment resulting from minimum wage hikes. If the economy is heavily reliant on low-skilled cheap workforce, an excessive minimum wage hike would be disastrous for its growth.

Also, developed and highly competitive economies, like the US, have a good portion of voting age population working for a monthly salary, which is usually way above the minimum wage. These salary-earners are consumers of goods and services produced by wage-earners, so they are generally against increases to minimum wage.

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    $\begingroup$ Interesting analysis. Is the ultimate outcome of your reasoning that these factors tend to keep the minimum wage increases a larger number of small increases, and it's more about the nation collectively agreeing to keep the minimum wage level in a rough equilibrium between where it would float to anyway economically (probably to a bit lower level then that we set) and collective political and social factors that by themselves might push it a bit higher? $\endgroup$ – LightCC Nov 21 '15 at 19:18
  • $\begingroup$ Yes, but there are also economic reasons to raise minimum wage. It can be actually helpful for economic growth. Increasing minimum wage can force low-skilled unproductive workers to either work harder and increase their productivity or get them fired and potentially re-hired where they can be more productive. But that is very risky and requires a lot of conditions to be true, like there have to be flexible labor laws in place, plenty of opportunities for workers to train/retrain/get education, the economy has to be on growth track, etc. $\endgroup$ – Arthur Tarasov Nov 22 '15 at 3:45
  • $\begingroup$ I liked your analysis. So the voter support for an increase in the minimum wage would be given by the relatively small group of people who are affected by the higher minimum wage but are not fired. I think two things are worth mentioning, however: first, the people earning slightly above 11 dollars may prefer a higher minimum wage to insure themselves against future losses in productivity. Second, in a general equilibrium setting the revenue also changes (in either direction) when the minimum wage changes. this makes it hard to track who would actually be fired. $\endgroup$ – HRSE Dec 22 '15 at 3:37
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It's interesting comparing how limited minimum wage increases are compared to how often we see price ceilings for housing (rent control). For the minimum wage, there is arguably a shortage of labor demand, and for rent control, there is a shortage in housing supply that results.

Thing is though, for the modest minimum wage increases we have seen, we haven't seen much of a fall in unemployment in the United States. I take the neoclassical argument for explaining this: Firms can push wages below the equilibrium because they know the worker is more averse to quitting that the typical large firm is averse to losing one worker. The search costs of finding a new job may very well prevent a worker from finding a better paying job. The minimum wage could be a correctional tool for that (albeit a very awkward one). Generally, a minimum wage of around 40-50% of the median wage in a country will not have significant negative effects on employment.

Politicians can shape popular opinion on many different fronts, not just minimum wage. So if they were to decide moving the minimum wage were harmful, they might be willing not to raise it and just gain their public mandate somehow else, especially if a political position is seen as someone who is entrusted with political decisions rather than being trusted to represent the aggregate of their constitutents (senate vs. house of representatives).

As for housing control though, we do see clear housing shortages whenever rent control happens. It gets passed through a lot more because you can see homelessness when it happens. You can take pictures of that sort of thing. Not so much with minimum wage, at least that's what I figure.

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  • $\begingroup$ Thanks for the response. While I tend to follow and agree with the reasoning, do you have any references for the claims given - e.g. minimum 40-50% of the median wage will not have a negative effect on employment, etc. $\endgroup$ – LightCC Nov 21 '15 at 19:14
  • $\begingroup$ The Economist did a report on it. I think this is the link: economist.com/news/leaders/… $\endgroup$ – Kitsune Cavalry Nov 21 '15 at 21:42
  • $\begingroup$ Ah, whoever gave the downvote, I'd love to have some feedback on my answer! $\endgroup$ – Kitsune Cavalry Dec 22 '15 at 21:47

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