Bryan Caplan  

Is Welfare a Band-Aid for Nominal Wage Rigidity?

Marshall's scissors and the La... What's a Doctor to Do?...
The minimum wage and welfare (broadly defined to include unemployment benefits and such) curiously interact.  As I've previously explained:
The minimum wage deprives the unfortunate workers shown in red of their ability to support themselves.  Given this involuntary unemployment, the case for welfare is suddenly easier to make.  What happens if the government in its mercy puts the unemployed on the dole? 

The answer may surprise you.  The supply of labor falls to S', of course, because free money makes workers less eager to work.  But unless welfare is ample enough to push the market-clearing wage above the legal minimum wage, welfare has no effect on the wage or quantity of hours worked!  Why not?  Because thanks to the minimum wage, jobs are rationed.  There's still a line of eager applicants even if the marginal payoff for work declines. 

With a binding minimum wage, the only clear-cut effect of welfare is to transform involuntary unemployment into voluntary unemployment.  That's why the red line shrinks: Some - though not all - of the workers who craved a job at the minimum wage now shrug, "Eh, now that I've got free money, why interview?"

Figure 3: Low-Skilled Labor Market With Minimum Wage and Welfare

That's the simple analysis.  Suppose, however, that if involuntary unemployment gets high enough, policy-makers cut the minimum wage.  In this scenario, raising welfare makes the minimum wage less likely to fall.  As a result, the social cost of welfare is higher than it looks on the surface.  Yes, in the short-run, welfare merely "converts" involuntary unemployment to voluntary unemployment.  In the long-run, though, welfare increases overall unemployment by making the collateral damage of the minimum wage more politically palatable.

The same principles applies if employers can gradually circumvent the minimum wage by requiring employees to work faster or harder.  (Just picture labor demand rising because workers produce more per hour, and labor supply falling because workers suffer more per hour).  The higher the rate of involuntary unemployment - the fraction of workers who want a job given current market conditions - the more appealing this circumvention becomes.  When welfare converts involuntary unemployment to voluntary unemployment, it "sedates" the market's normal urge to undo the damage of the minimum wage.

Convinced?  Now let's generalize to a much broader problem.  Like most economists, I embrace standard New Keynesian models that blame mass unemployment on nominal wage rigidity.  Workers' and managers' deep distaste for hourly pay cuts functions like an economy-wide morass of job-specific minimum wage laws.  How does welfare interact with this nominal wage rigidity?

Once again, the short-run interaction is harmless.  Workers who genuinely can't find a job because they've been priced out of the market receive some government money to help them make ends meet.  Welfare converts desperate involuntary unemployment into merely unhappy voluntary unemployment.

In the long-run, though, welfare makes unemployment more likely to persist.  When lots of unemployed workers are eager to work under current conditions, employers have the upper hand.  This doesn't mean they can safely ignore workers' distaste for nominal wage cuts.  But it does embolden employers to search for ways to cut compensation without incurring workers' wrath.  When welfare makes unemployment more bearable, then, employers search less aggressively for ways to cut pay.  As a result, full employment takes longer to return.

The upshot: Welfare is not a harmless band-aid for nominal wage rigidity.  It's more like scratching a mosquito bite.  In the short-run, welfare makes unemployed workers feel better.  In the long-run, though, welfare makes workers more likely to stay unemployed.  The reason isn't that welfare makes unemployment "fun."  The reason, instead, is that welfare retards job creation by reinforcing nominal wage rigidity.

Economists have recently been debating the effect of denying unemployment checks to the long-term unemployed.  Market-oriented economists tend to think that as soon as the checks stop coming, the unemployed get off their couches and find jobs.  Old-style Keynesians tend to think the welfare cut-off will merely impoverish the unemployed - not get them back to work. 

I say both sides are wrong.  Holding wages constant, cutting unemployment benefits does nothing to make employers want to hire more people.  But cutting unemployment benefits does corrode nominal rigidity, leading - by a slow and painful path - to higher employment.  When the government cuts unemployment benefits, don't expect a sudden return to full employment.  Instead, expect a gradual increase in job hunting, which in turn sluggishly drags wages back down to full-employment levels.

Many readers will conclude that the government should forget the long-run and keep sending unemployment checks.  I beg to differ.  Hazlitt was right: "Today is already the tomorrow which the bad economist yesterday urged us to ignore."  If unemployment benefits had not been extended to 99 weeks in 2009, the labor market could easily already be back to normal.

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COMMENTS (7 to date)
Randy writes:

Thoughts on Welfare/Minimum wage;

1. People shouldn't be forced to work. Does that seem like an odd starting point? Well, then consider how many working age members of society do not do any real work. There are politicians who spend their time making and enforcing rules that people who actually work must comply with. There are managers who spend their time getting those who actually work to do as much work as possible. There are capital "owners" who spend their time moving "their" capital to the managers who promise the best return from the people who do real work. We have "educators" who spend their time justifying to the people who do real work why it is right and just that they must do real work so that all the people who pretend to work can maintain their privileges. So... we have a system that handsomely rewards those who do all the right things politically, and consigns the rest to life in the "labor market" - and if they don't like it, well... they can just realize that this is all they should expect in this best of all possible worlds...

2. So... a relatively high minimum wage absolutely makes sense - even a living wage. Under the current rules of property, the owners are entitled to claim 100% of the profits, while the workers who actually create the value from day to day are allowed only the wages they "agree" to. That is out balance, and a minimum wage is a step toward achieving a better balance. Can it work? Not likely in the current political system. Nonetheless, it represents a reality that many would like to repress.

3. Welfare programs that enhance the position of those who do real work also make sense, for the same reason that the minimum wage makes sense.

4. Welfare programs that enhance the position of those who won't work, or to those who pretend to work, makes no sense at all. Those who work should be allowed to choose who they will or will not support. Those who won't work have no claim, and those who pretend to work are already claiming more than they deserve. And if those who pretend to work wish to care for those who won't work, then they should pay for it themselves - they can afford it.

Jeff writes:

"Today is already the tomorrow which the bad economist yesterday urged us to ignore."

Excellent line. Ought to be quoted more often.

mulp writes:

What about the case when the minimum wage is so low that without welfare, half the workers become some combination of

    unable to fill the car with gas
    unable to make car payments or pay for car repairs
    unable to pay the rent
    unable to pay for food
    unable to pay the water bill
    unable to pay the electric bill
    unable to pay for heating oil

  • NPR reported on food stamps this week, providing the dual benefits they provide: the food the poor, many workers, and the profits from food sales to tens of thousands of retailers. The Feds handle the payments but is by policy not allowed to report which retailers get how much food stamp money. The States administer the handing out the cards and setting benefits, so a few States list the worker-employer statistics. WalMart has 15% of its workers on food stamps, but that is in a State where 15% of all workers get food stamps.

If the entities were small businesses, and operating expenses, rent, water, electric, etc, exceeded revenue, the answer is bankruptcy and liquidation with all assets sold to pay as many of the bills as possible.

In the case of a person, how is the person liquidated? Euthanasia and sale of body parts?

Or is the labor market supply reduced by workers dying from hunger, exposure, illness until the labor pool is reduced enough to drive wages high enough to pay enough to live on? But as the worker poor die off, demand for goods and services will fall, reducing the need for labor, so the equilibrium would require perhaps twice the number of deaths as the number of unemployment in a recession like today. That is the model for reducing the number of businesses in a down economy, so is that the solution for low labor demand?

Worker writes:

Less welfare also makes people accept less pleasant jobs, e.g., first-step jobs, not just dream jobs, or ones that are further away, have lower status, harder work, etc.

vikingvista writes:
Under the current rules of property, the owners are entitled to claim 100% of the profits

Or 100% of the losses, while the employees get their wages first, and either way. And "under the current rules of property", the employees "are entitled to claim 100% of" those wages.

A great many people voluntarily and understandably choose the security of wages over the uncertainty of the entrepreneurship or investing upon which those wages are utterly dependent.

Floccina writes:

Mulp you do understand that people can live on less than minimum wage

Arthur_500 writes:

I too listened with disgust to the article on Marketplace regarding food stamps. Minimum wages are a volatile issue that is much based on incorrect assumption of living off the minimum wage.

80% of minimum wage earners are individuals who are not living off the wage - for example kids living at home with mom and dad. This is an entry level job and pay is commensurate with the employee skills and market conditions.

For those who live off the welfare system I go back to a study done in my state over 20 years ago when it was determined that to get off welfare the individual needed $15 per hour to get the same benefit. However, the individuals were mostly not $15 employees. Therefore, welfare inhibits individuals from learning the skills necessary to earn a reasonable living wage by subsidizing poor life choices and not giving incentive to change.

Some believe that the economy does well with welfare, food stamps etc because business gets sales. Balderdash! People need to eat. People will find necessary food. Either they will get employment in order to purchase it or they will get it through other means such as charitable organizations. Either way the foodstuffs will be sold. Will it include chips and Soda to have with TV? Probably not but then maybe they need incentive to earn more to get those goodies.

What about businesses that pay low wages? What does the market bear? If I can't afford to live off minimum wage then I need another job. I can work hard at another minimum wage job or graduate to a better paying job. However, if the market will not allow the employer to obtain adequate employees for minimum wages then they pay a higher wage. Many places you see McDonald's paying higher than min wage because the market will not provide adequate staffing at that level.

BTW I speak from some experience. Years ago my wife departed and I lost a job becoming an unemployed single parent. As a male I was not allowed Welfare and needed to get a job. (Were I a woman I would have been able to be a stay-at-home mother) The next day I started a new job at minimum wage. I rode a bicycle to work and got daycare assistance for a short time. In the meantime I continued to look for work. If you have skills and put in the necessary effort you can do better for yourself. If you have no skills and no work ethic welfare is not going to help you become a productive member of society.

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