David R. Henderson  

Why Minimum Wages Can Take Time to Destroy Jobs

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Jonathan Meer and Jeremy West have found that increases in the minimum wage destroy jobs, not so much by destroying current jobs as by reducing the growth rate of new jobs.

That makes sense if employers' investments in capital are even partially irreversible, that is, if some costs of capital investment are sunk, as seems plausible.

Here's a simple numerical example to illustrate the point.

Imagine that an employer is contemplating investing $100K in the price and installation of a piece of machinery that he expects to last 5 years. Assume for simplicity that once it is bought and installed, the salvage value is zero. (Numbers greater than zero work also, but complicate the analysis, with no additional insight.)

Assume that the current minimum wage is $7 an hour and that the employer contemplates hiring a worker for a standard work year of 2,000 hours. At that wage rate, he can find a suitable worker. Assume that there are no other components of the pay package and that there are no other costs of production. Assume that the employer expects to be able to sell the annual output from the machine/worker combination for $37,000. Assume, for simplicity, a zero real interest rate. (That, by the way, is often a bad assumption but in recent years, it is not far off.)

If the employer expects no increases in wages over the next 5 years, will he make the investment? Yes.

The reason is that his costs over the 5 years are $100K for equipment and $70K for labor, for a total of $170K. His revenues are $185K. Net profit: $15K.

But now imagine that after 2 years of operating profitably, the employer faces a minimum wage of $10 an hour.

Had he known this in advance, he would have known that his cost of labor over the 5 years would have been $14K plus $14K plus $20K plus $20K plus $20K, or $88K. So his total costs would have been $188K. Compare that to the $185K of revenue and the employer would not have invested.

But the employer has invested. The equipment cost is sunk. Will the employer continue? Yes he will. The reason: he now compares $20K of annual labor cost to $37K of annual revenue and finds that it is worthwhile to continue.

So he will not lay off the labor.

However, other potential employer/investors facing the same numbers will not make the investment. So whatever growth rate of jobs there would have been will not come about. The growth rate will be lower.


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COMMENTS (14 to date)
john hare writes:

It has amazed me that this point is so little discussed. Esp in regard to offshoring jobs. The aging of many factories illustrates this all too well.

jon writes:

Does something kind of similar happen with free trade agreements? For example, let's say the laborers in Mexico are willing to work for significantly less than those in Michigan. So a rational CEO would obviously move south. But he has the costs of moving south and setting up a new plant to consider. So we don't actually see the harm until much later.

Jason writes:

@jon, What do you mean "harm" ?

ThomasH writes:

Somehow this (the slight change in the NAIRU, which I'd like to see quantified) does not seem to explain why people who are skeptical about the minimum wage do not go on to support higher EITC as an alternative way to raise incomes of low-wage earning people.

Even in (Democratic Socialist) Sweden the laws of supply and demand function;

Customers simply use their cellphones to unlock the door with a swipe of the finger and scan their purchases. All they need to do is to register for the service and download an app. They get charged for their purchases in a monthly invoice.
The shop has basics like milk, bread, sugar, canned food, diapers and other products that you expect to find in a small convenience store. It doesn't have tobacco or medical drugs because of the risk of theft. Alcohol cannot be sold in convenience stores in Sweden.
"My ambition is to spread this idea to other villages and small towns," said Ilijason. "It is incredible that no one has thought of his before."
He hopes the savings of having no staff will help bring back small stores to the countryside.

LD Bottorff writes:

Your analysis omits the reduction in non-minimum wage jobs. If fewer new facilities or businesses are built, there will be less demand for the engineers, construction workers, and IT workers that set up new enterprises. This results in lower employment for both low skill workers and high skill workers. Sorry I can't remember the study, but I thought one pro-minimum wage economist did a cross-border study and found higher unemployment in the county that raised the minimum wage, but he dismissed it because the unemployment increase was not in the minimum wage workers.

Swami writes:

This topic is destructive to the professionalism of economists in general.

As a businessperson, I assure you that large increases in the minimum wage will lead to some unpredictable combination of the following:
1). Reductions in hours worked per employee (which doesn't necessarily have anything to do with employment levels, as employers prefer LARGER pools of part timers AEE and the minimum wage increases the EMPLOYERS' bargaining power.)
2). Slow shifts toward higher skilled workers and away from lower skilled workers (again not necessarily leading to higher overall unemployment)
3). Gradual replacement of labor with technology (which may actually stimulate technological innovation, thus long term promoting productivity)
4). Other ripple effects on business costs as employers shave corners where they still can to maintain margins(the savings may be in reduced landscaping budget at a fast food place)
5). Higher prices or lower quality
6). Lower margins and thus fewer businesses and jobs long term.
7). Fewer employees shorter term
8). Lower benefits or less training or tougher oversight of existing employees

The point isn't that there is any short term significant effect on employment levels. That is simply one possible outcome as businesses respond short and long term. But note what does change ... The market becomes less efficient, and the least skilled workers are not likely to be the beneficiaries of these changes short or long term. Indeed they are likely on the bad end of most changes.

Any economist arguing simply for or against short term employment levels of smaller changes to the minimum wage is missing the big picture. It is an example of people arguing over oversimplified models and ignoring reality.

This entire debate is kind of sad.

David R. Henderson writes:

@Swami,
I can see you’re not a frequent reader of my articles and posts on the minimum wage. That’s kind of sad.

David R. Henderson writes:

@Swami,
By the way, your insult led to my reaction above.
On the meat of the issue, though, you make very good points and they’re the kind that I have made in the past and that Don Boudreaux at cafehayek has made also, and much more extensively than I have.
If you want to change people’s minds, you might want to reconsider your insulting style. It’s not good when you insult those who disagree with you, and it’s not good when you insult those who agree with you.

Don Boudreaux writes:

David: I do not read Swami's comment as insulting. I took him or her to be reinforcing the argument you make in the post and that, as you point out in your comment, I (and you and others) make elsewhere. Now perhaps I misread him or her; perhaps he or she regards it as sad that you and I often engage in the minimum-wage debate. But I don't think he or she need be read in this way.

I agree with what I take to be his point that it is indeed sad that economists must still have such a debate. It's as if geologists, long settled on the reality that the earth is billions of years old, are still debating whether or not one particular slice of the earth is also that old rather than being only 6,000 years old.

john hare writes:

@Swami,
I disagree with your point #1. As an employer I prefer fewer workers with higher degrees of self direction. Large numbers of part timers is management intensive, less productive, and more error prone.

I can make money off of a $20.00 an hour employee. It's difficult to impossible with an $8.00 an hour one. And you don't get $20.00 an hour people by overpaying low end people. Minimum wage reduces my bargaining power with potential trainees.

On your point #8. Tougher oversight is a losing game. The sheer effort it takes to force someone to do their job is often more work that doing it yourself.

Otherwise I tend to agree with your points.

David R. Henderson writes:

@Don Boudreaux,
Thanks. I might have erred. Did I, Swami?

Rajeev writes:

Hi
This is very interesting.
I do see why firms would move towards capital-intensive production.
However, even if each new firm chooses more capital-intensive production, does it follow that the economy as a whole will consume less labour?

Warm Regards
Rajeev

Rajeev writes:

This article from 2014 suggests that this was already known to Economists back in the 1950s and '60s: https://www.jacobinmag.com/2014/05/pikettys-fair-weather-friends/
To quote the relevant bits:

Today, empirical studies of manufacturing industries are unanimous in finding that per-worker productivity is constant... The point should be underlined: if workers’ productivity stays constant rather than diminishing as more are employed in a firm, then it would be irrational for a firm to lay off some workers just because, say, a strike or a minimum wage law hiked up their wage. The employer would get the worst of both worlds: a lower profit margin on every unit of output produced (because of the higher wage) and fewer units produced (because of the laid-off workers).

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