Is minimum wage increase at this time harmful to the economy?

The last time the federal minimum wage was raised to $7.25 to all covered and non-exempt workers was in 2009.  Given the current average hourly wage of $20 President Obama is proposing a moderate hourly minimum wage increase of $9 by 2015.  Since inflation rate has gone up by 7% during 2009-12, minimum hourly wage now is only $6.77 in 2009 dollars.  The current minimum wage, even in 2012 dollars, is less than the minimum wage of $10.55 in 1968 in 2012 dollars. Hence workers who earn minimum wage have not gained any ground in their purchasing power.  Even average hours worked have not changed much since the worst recession of 2007-08 to compensate for the loss of real purchasing power.

Conservatives in and out of the Congress and many economists have traditionally opposed the concept of minimum wage.  Following classical economists, such as Adam Smith, they argue that in a market economy and perfectly competitive labor markets, fixing minimum wage above the market clearing wage would create unemployment.  This happens because at a wage higher than the market clearing wage quantity supplied of labor increases but quantity demanded of labor decreases, thus creating excess supply of labor.  Hence, low wage workers, which policy makers are trying to help, would face unemployment.

It should not be a liberal and conservative issue.  Since 1970 three Republican administrations, including President George W. Bush, had minimum wage increases without any adverse long run effects on unemployment rates.  Whatever minor adverse effects minimum wage increases have had on unemployment and the economy over a period of time pales in comparison to social costs of financial crises due to financial mismanagement.

The classical view on minimum wage is deficient on many accounts. According to Natalie Sabadish and Doug Hall of the Economic Policy Institute (EPI), 13 million workers (approximately 8% of the labor force) would benefit from the minimum wage increase.  An additional 4.7 million who earn slightly above the minimum wage will also benefit from the increase.  EPI estimates that 84% of these workers are more than 20 years old and 47.3 % are full time workers, working at least 35 hours per week.  The data on yearly average hours worked shows that 35 weekly work hours is more typical for a full time worker.  Assuming 52 work weeks during a year, without vacation time, $9 minimum wage would amount to an annual income of $16,380 for a worker who works 35 hours per week.

As shown above, income with minimum wage increase to $9 is below the poverty income for a family of 4 members.  Therefore, it does not represent a significant disturbance to the labor market, even if we make an unrealistic assumption of perfect competition.   However, evidence shows that due to imperfect information and other frictions in labor markets, differential wages prevail for the same quality labor even in the same area and industry.  The empirical studies by Professors David Card and Alan Krueger even show that minimum wage resulted in increased employment.   Such an outcome is also possible when employers have monopsony power, e.g., a single employer in a mining town.  At least there is no convincing evidence that minimum wage has long term adverse effects in labor markets.

Workers are not like commodities traded in the market.  Workers have emotions and provide the best work effort when they think wages are fair and employers provide a supportive work environment.  To reduce costs associated with absenteeism, morale, turnover, lack of effort and monitoring, employers would be willing to pay a higher wage than the market clearing wage.   In 1914 Henry Ford increased wages from $2.34 to $5 per day, higher than the going wage in the Detroit labor market, and reduced working day from 9 hours to 8.  It resulted in higher productivity, lower cost, lower turnover rates and higher profits.

Economists call Henry Ford’s wage increase efficiency wage, a wage higher than the market clearing wage. Efficiency wage, which is voluntarily paid by employers in the labor market, is partly responsible for involuntary unemployment due to excess supply of labor faced by such employers.  However, efficiency wage benefits workers as well as employers, and with higher productivity and reduced costs it also increases profits and employment in the long run. Minimum wage works like efficiency wage.

A minimum wage increase would boost aggregate consumption spending and therefore economic activity, since low wage workers spend most of their income on consumption.  At the same time it would reduce expenditures on transfer payments.

It is also the right time to increase minimum wage in light of increasing share of profits in national income.  It would also contribute to the reduction of wage inequality. The high earnings inequality that we face now is stressful for any dynamic and rich democracy.

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