On Minimum Wages

The minimum wage was devised so as to assist the low-skilled and low-paid members of the workforce by guarantying that there is floor below which the market wage cannot fall. Although it's a well-intentioned policy, it has perverse effects and in fact, it does more damage than good to the people it aims at helping. However, when trying to illustrate the problems of such policies, one is often vilified and socially disparaged. Yet, I will still try to explain 3 issues that arise due to the imposition of minimum wages.

Let us start by considering the general labour market of Figure 1. In such a market the firms demand labour and the workers supply the labour. The demand curve slopes downward since the higher the wage the less workers the firms want to hire on average. Similarly, the higher the wage the more the workers are willing to work.

Figure 1: A general labour market

Suppose that at wage "W*" the number of workers the firm wants to hire equals the number workers that are willing to work and thus the market clears. In this equilibrium, we have "L*" workers hired with each receiving "W*", and most importantly, there is NO unemployment because "L*" workers are willing to work and exactly "L*" workers are working.

If, however, the wage rate "W*" is deemed to be too low,  the government may wish to increase it by imposing a minimum wage. This means that the wage rate must be placed ABOVE the equilibrium wage, otherwise such a policy is pointless. For example, the government may impose a minimum wage of "Wmin". However, at this rate "LS" workers want to work whereas the firms want employ only "LD".  Consequently, only "LD" workers are employed and the rest "Ls - LD"  are considered unemployed since they are willing and able to work but cannot find employment (the economic definition of unemployment).
Surely, the minimum wage benefits those "LD" workers who continue to be employed as they now receive higher wages. However, how about those "L*- LD" workers who lost their job? Will the workers that are still employed concur to transfer part of their wage to reimburse them? Although, total earnings for the workforce as whole could increase due to the minimum wage (if the percentage drop in employment is less in absolute terms than the percentage increase in the wage), the fact remains that now we have unemployed workers.

One may suggest, that the firm should not layoff its workers. However, suppose you are a firm owner and you have determined that a particular job is worth $400 to you and you currently have 1 employee. What would you do if a minimum wage was imposed which raised the wage rate to $500? In fact you have a couple of options; (i) you wait until your employee's contract expires and then you fire him or her (or fire him or her immediately), or, (ii) you continue to pay him or her $400 but now this payment will be "under the table". The first option results to unemployment and the second to underground economy. Both pretty terrible options.

Yet the emergence of unemployment is not the only unfortunate consequence of minimum wages. I find that Milton Friedman was correct to point out that employment is a dynamic game. A worker may start at a low-paying job in order to receive some training and skills which will help him or her in his or her future career path. That is, a low-paying job can help people who where unable to attend a university or a college to put their foot in the door and receive some training which could prove extremely valuable. As a matter of fact, Walmart's store managers are mostly workers who were initially hired for the lowest paid jobs at the company. By raising minimum wage less workers will be able to put their foot in the door. 

In concluding, the policy of minimum wages is counterproductive as it has numerous unintended consequences three of which where stated above; (1) unemployment, (2) underground economy and (3) deprivation of opportunity for training. Moreover, a solid and extremely valid case can be made that one must not meddle with market prices since they provide valuable information about the market.

Figure 2: Subsidizing employment

But, let's ignore this issue for the moment and suppose that we all agree that the wage must be increased to "Wmin". Instead of imposing a minimum wage which will result to unemployment, the government could instead subsidize employment by paying a sum of money to the firms for each worker they employ. This would shift the demand curve outwards in order to cross the supply curve at wage "Wmin" with "Ls" workers employed as seen in the figure on the left. Hence, under the subsidization scheme both wages and employment increase, whereas with the minimum wage only wages increase with employment falling. 

So, if you were the government, which policy would you choose?