Minimum Wages and Economics

Tim Harford writes on the minimum wage:

The UK minimum wage took effect 16 years ago this week, on April 1 1999. As with the Equal Pay Act, economically literate commentators feared trouble, and for much the same reason: the minimum wage would destroy jobs and harm those it was intended to help. We would face the tragic situation of employers who would only wish to hire at a low wage, workers who would rather have poorly paid work than no work at all, and the government outlawing the whole affair.

And yet, the minimum wage does not seem to have destroyed many jobs — or at least, not in a way that can be discerned by slicing up the aggregate data. (One exception: there is some evidence that in care homes, where large numbers of people are paid the minimum wage, employment has been dented.)

The general trend seems a puzzling suspension of the law of supply and demand. One explanation of the puzzle is that higher wages may attract more committed workers, with higher morale, better attendance and lower turnover. On this view, the minimum wage pushed employers into doing something they might have been wise to do anyway. To the extent that it imposed net costs on employers, they were small enough to make little difference to their appetite for hiring.

An alternative response is that the data are noisy and don’t tell us much, so we should stick to basic economic reasoning. But do we give the data a fair hearing?

At its best, economics is a fruitful dialogue between theory and empirical (data) work.  All economic models are, by nature, simplifications.  One of the judgments we have to make is whether some of the simplifcations we've made are inappropriate.  Testing our models against the data helps us do that.

The first tool an economist will reach for in trying to analyze a market is supply and demand; in that context, a minimum wage is a price floor, which creates an excess supply of labor (i.e., unemployment):

(the equilibrium wage and quantity of labor are labelled with superscript e's, and the m's mark the minimum wage and corresponding amount of labor).

We like supply and demand because it is simple and works well in many context; but the labor market is one case where its simplicity can lead us astray.  As Paul Krugman recently put it:

[B]ecause workers are people, wages are not, in fact, like the price of butter, and how much workers are paid depends as much on social forces and political power as it does on simple supply and demand.

Indeed, some empirical research has demonstrated that minimum wages do not have the effects implied by the supply and demand framework.  This NYT Magazine piece by Annie Lowrey summarized David Card and Alan Krueger's classic paper on the subject and some of the subsequent dispute.