Micro, Macro, and the Minimum Wage

Meme showing man in office with coffee mug looking skeptical saying "Yeah, I'm going to have to go ahead and disagree with you there."Economists disagree. It’s so common that there are jokes about.  For example,

If all of the economists in the world were laid end-to-end they would scarcely reach a conclusion.

and

Economics is the only field in which two people can get a Nobel Prize for saying the opposite thing.

Why?  I can’t explain all of economists’ disagreements here (I don’t have enough pixels!), but I can explain some of the disagreement over questions of raising the minimum wage.  There are numerous calls for Congress to raise the minimum wage, yet Congress has remained bitterly divided on the issue. Their disagree to a large extend reflects the disagreement among economists. To non-economists, the disagreement seems to either indicate that there really isn’t any science in economics and it’s all opinion, or that some economists must be lying or deliberating obfuscating.  In truth, though, there’s another reason for the apparent disagreement: the difference between micro and macro level economic analyses.

First, let’s establish some historical perspective on the debate. I want to clarify the difference between “normative” and “positive”.  Positive arguments are statements or conclusions about what the predicted effects of a proposal will be without taking a stand on whether those effects are desirable or tolerable. (note that the word “positive” here denotes “factual or likely”, not “good”) Normative arguments are when someone argues whether a proposal should be done. Normative arguments typically are based upon a combination of predicted outcomes and a value judgement as to whether those outcomes are desirable or tolerable compared to the alternative.  For a long time in economics, economists were actually largely in agreement on the positive science, or the predicted effects, of a rise in the minimum wage.  It was generally agreed that raising the minimum wage would give larger incomes to those who continued to work at minimum wage (i.e. low skilled) jobs but that the rise would decrease the numbers of those jobs and thus raise unemployment rates among those seeking low-skilled jobs. Historically the disagreement over minimum wage hikes was over the normative aspects: was the rise in unemployment and loss of jobs worth the increased incomes to others.

The agreement over the predicted positive effects wasn’t always unanimous. There have always been some dissenters. But in the early 1990’s Card and Krueger studied a “natural experiment” by comparing fast food restaurants on two sides of a state line when one state raised the minimum wage and the other didn’t. Their results started a fierce debate that still rages over the predicted effects of rises in minimum wages.  On one side there are now many economists who side with Card & Krueger in saying that raising the minimum wage, even if raised very significantly such as to $15 per hour from less than $8, will not decrease employment and will have a very large increase incomes. On the other side, maintaining the older stance are those such as Don Boudreaux who doggedly argue that any rise in minimum wage must increase unemployment significantly.  Like most topics in economics the practicality of measuring and analyzing the empirical data is somewhat equivocal.  Although there have been numerous studies since Card and Krueger that have buttressed their results, the empirical data along always leaves enough room for some argument.  So what does the theory say?

Don Boudreaux and others of the “increases in minimum wage MUST increase unemployment” camp, would have use believe that theory is unequivocal. The essence of their argument is that low skilled labor is a commodity sold in a market. It has a demand (firms want to buy it) and a supply (low skill workers want to sell it and get paid).  The wage that gets paid is the price of this labor commodity. The most basic supply-and-demand analysis tells us that if the government forces the price up somewhat artificially by setting a price floor (i.e. a minimum wage) below which transactions cannot occur, then there will a smaller quantity of hours of labor demanded. In other words, firms will hire and pay fewer workers. There’s often an appeal to the concept that if the price (cost) of an input or resource goes up, then the firm’s profits will go down and the firm will be less inclined to produce that good or service and therefore will buy less (hire fewer workers).

How can good theory-toting economists dispute this?  Isn’t it supply-and-demand, the most basic micro economic concept as taught in the first few chapters of any principles of econ text?  It’s easy actually. The key is that this supply-and-demand theory as argued against a rise in minimum wage has three major flaws. Two flaws are the result of the theory as applied being too simple (there’s more chapters in the micro text!) and the other  flaw reflects the difference between micro and macro in economics.

The first flaw in the simple supply-and-demand model application to minimum wage type jobs is that there’s really very little evidence that labor markets behave like commodity markets or that they conform to the assumptions necessary to use a supply-and-demand model.  Most jobs, including minimum wage jobs, are more like long-lasting relationships. They aren’t commodity, transaction based like a market for selling widgets or apples or even theatre tickets.  There are dramatic transaction costs involved. Put another way, it’s expensive to hire people (and to fire them and then replace them). Minimum wage jobs aren’t homogenous (they aren’t all the same) the way the theory requires.  Further, the wage paid affects the productivity of the worker, which in turn affects the value of that worker’s output to the firm. When the wage is boosted, workers work harder, stay longer on the job, quit less often, and gradually acquire more productivity and skills. Firms often find that when forced to pay the higher wage, the firm’s total costs, including hiring costs, etc, stays level or even declines.  This is the essence of Arindajit Dube’s studies.

The second flaw is in focusing on the cost of the worker’s wages as if it were the sole consideration in the firm’s decision of how much to produce. The standard theory of the firm and production, which is covered in-depth just a few chapters later in the same economics textbooks after the supply-and-demand model makes it clear:  a firm will produce whatever quantity makes it the most profit. The primary constraints on the output are the demand for the end product, the pricing of the end product, and the core technology used. In other words, if the firm can still sell the output to consumers, it will produce it and the technology (means of production) will require it to hire the necessary labor. A rise in the price of a particular input does not necessarily mean a drop in the quantity produced.

The other two flaws in the arguments against minimum wage increases require shifting to a macro perspective. Micro economics is often described as studying individuals and individual products/markets.  That’s only partially true. Actually micro is a methodology. It’s more properly called “comparative statics using partial equilibrium analysis”.  Micro theories and models explicitly focus on only one particular shifting variable (the wage in this case) and it assumes that all other variables or influences are held constant or unchanged. (Economists call this the ceteris paribus assumption).  In contrast, macro theories are often described as focusing on large aggregate phenomena such gross national product or the inflation rate or the national unemployment rate.  But again, there’s actually a methodological difference. Macro theories require a general systems approach accounting for multiple effects and ripples of many variables that are interrelated.  Let’s look at minimum wage increases as an example of these differences in methodology between macro and micro.

In micro, there’s really only the price (i.e. the wage itself), the quantity of jobs offered, and the quantity of workers available, all of it in the low skill arena.  That’s it. So the micro analysis sees that when the minimum wage is boosted, the firm pays more per worker and each employed worker gets more. End of story.  The only micro question is how it all affects the quantities of jobs.

Macro, however, recognizes that nothing happens in isolation in the economy. There’s a circular flow. Workers are also simultaneously customers. So when the minimum wage goes up, yes, the workers get paid more and firm pays out more money. But what do those workers do with the additional money income? They buy things. Who do they buy them from? Firms that sell and produce products. So the firms not only pay out more money to workers, the firms also get to collect more money by selling more to the increased consumer demand.  But, you say, Acme’s newly enriched minimum wage workers don’t buy that much stuff from Acme. Doesn’t matter. The workers spend it somewhere. And that firm uses the additional money and additional demand to buy more inputs and pay more profits. And those firms and workers then experience income increases and so on and so on as the money circulates throughout the economy. Eventually even Acme sees an increase in sales and revenue collected which in turn helps pay for the wage boosts.  Macro looks at the whole system.

In recent years, many cities and some states have taken it on themselves to raise the minimum wage, often to a so-called “living wage”.  The empirical results have pretty clearly supported the macro analysis. Rises in minimum wages tend to not depress employment and actually tend to stimulate the local economy.  This is the macro analysis.

Sometimes economists just disagree and sometimes they let their ideological and political biases color their professional arguments. Some of that happens in the debates on minimum wage increases.  However, much of apparent disagreement arises from the choice of whether to view the issue through a micro lens or a macro lens.

To read more about the economic analysis of minimum wage increases see these earlier posts:

 

 

Links on Minimum Wage

A few minimum wage links to use in my guest lecture/discussion with Professor Reglin’s classes tomorrow:

 

Inflation Erodes Real Value of Minimum Wage

Although the minimum wage in 1968 was $1.25, prices were a lot lower then. In terms of today’s purchasing power using today’s 2010 dollars, the real value of the minimum wage in 1968 was $9.86.  Since the minimum wage (Federal) was increased in 2009 to $7.25, that means that the minimum wage is still 25% lower than in 1968.  Graph of the changes over time and source data at ReMapping Debate. and at TableauSoftware.com.