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Price Floors and Minimum Wages

March 15, 2011

[This is an excerpt from Lesson 17 – Price Controls, of Lessons for the Young Economist, by Robert P. Murphy. PDF file of the complete book can be downloaded at Mises.org.]

Price Floors

A price floor is a legal minimum, in which the government does not allow the price of a good or service to fall below the “floor.” Buyers caught paying less than the floor price face fines or other forms of punishment. The public justification for price floors is that certain sellers deserve a higher price for their goods or services than what they would receive in a pure market economy.

In modern Western countries labor is the primary recipient of price floors.[1] In particular the government imposes a minimum wage making it illegal for an employer to pay a worker less than a certain amount per hour. Because this is the most popular and recognizable example of a price floor, we will concentrate on it for the rest of this lesson.[2] The analysis generally applies to other goods or services.

As with price ceilings, price floors have many unintended consequences, which should make the proponents of the minimum wage reconsider whether they are really helping unskilled workers. The consequences include:

Immediate Surplus (or Glut)

The market-clearing price (wage) for unskilled labor equates the quantity demanded by employers, with the quantity supplied by unskilled workers. If the government sets a floor above the market-clearing level, then it will induce a surplus of unskilled labor. There will be a supply glut, meaning more workers are trying to find jobs at the going wage than employers want to hire. This situation is more popularly known as unemployment. The following diagram illustrates the effects of a minimum wage law.

Market for Low-Skill Labor Services

Market for Low-Skill Labor Services

In the diagram, the equilibrium wage is $5 per hour. At this wage, employers want to hire 100,000 workers, and 100,000 people apply for these types of low-skill jobs. When the government comes in and artificially raises the wage rate to $8 an hour, the quantity of workers seeking jobs rises to 120,000, while the quantity demanded falls to 80,000. Thus there is a shortage of 40,000 workers. These 40,000 unskilled people are willing to work at the going wage of $8 an hour, but no matter how many applications they fill out, they simply cannot get a job.

Even at this stage, it is not obvious that the minimum wage law is helping unskilled workers. It’s true, the 80,000 who retain their jobs now make $3 more per hour, but there are 20,000 people who would have been happy to work at $5 an hour and yet now can’t get a job at all. In addition, there are 20,000 other workers who are frustrated by the inability to find a job at $8 an hour, but they wouldn’t be working in any case since $5 an hour would be unacceptable to them.

It is crucial to realize that the minimum wage law does not compel an employer to hire a low-skilled applicant. It simply makes it illegal to hire the applicant for less than the minimum wage. Far from penalizing the rejection of a job application, the minimum wage law actually makes it more burdensome for an employer to give someone a job.

Ruling out cases of philanthropy or other non-commercial contexts, an employer hires a worker because he expects the worker to bring in enough extra revenues to justify the paycheck. (If the employer didn’t think the employee would do so, he’d be losing money on the deal and would have no incentive to hire.) By artificially raising the bar of the minimum paycheck, the government effectively makes it impossible for people with productivities below a certain level to get a job.

Keep in mind that some unskilled workers simply do not produce $8 worth of extra output for every hour they are on the job. If someone’s labor only produces, say, $7 of output per hour, then an $8 minimum wage would force an employer to lose $1 for every hour this person works. If the employer wants to maximize his profits, it would be smarter not to hire this person at all.

Lower Demand in the Long Run

If the government enacts a minimum wage law that takes employers by surprise, they will respond immediately by cutting back on the number of employees.[3] In the longer run (so long as they expect the minimum wage to remain in force) the employers will alter their businesses in ways that will reduce their demand for labor.[4] For example, the employers can install more equipment and better tools to allow each (retained) worker to perform more duties. This raises his or her productivity on the margin; a given worker can produce more output per hour if his workplace has more machinery.

For example, a modern fast food restaurant can be staffed by a handful of people and still serve hundreds of meals in a single shift, whereas the same feat would have required many more workers at a fast food restaurant in the 1950s. Part of the difference is the tremendous advances in automation in the last 60 years. A well-trained worker can load the soda dispenser with an empty cup and press a button, while using a specialized scoop to dump fries into a carton resting in a specially designed holder, as she listens to a drive-through order on her headset and then punches it onto a keyboard with buttons denoting each value meal. If the customer needs change, the worker might not even have to count it out, as the register automatically shoots out the appropriate combination of quarters, dimes, nickels, and pennies.

Thus rather than having to retain (say) 8 workers at $8 an hour with the old setup, the restaurant owner can spend many thousands of dollars installing the latest equipment and floor design. This investment allows him to achieve the same output but with only 5 workers, thus saving $24 an hour. Over the course of hundreds of shifts, the investment in redesigning the restaurant pays for itself.[5] But after the renovations the restaurant is permanently less dependent on human beings to get the job done.

Non-wage Competition

The “problem” that minimum wage laws seek to fix is that the demand for labor is not high enough so that every willing worker can find a job paying a generous wage. By enacting a minimum wage, the government doesn’t alter this underlying reality. Workers still need to compete with each other for every job opening, it’s just that the minimum wage takes away one method of bargaining. Ironically this feature of minimum wage laws hurts precisely those groups that are the most vulnerable and in need of employment.

For example, a 20-year-old immigrant who doesn’t speak the native tongue and has no work experience could not possibly compete for a job opening in a factory against middle class suburban college students (home for the summer) who belong to the same gym as the factory owner’s family, if the two applicants had to receive the same wage. But if the immigrant is allowed to underbid the wage demands of the native college students, he can get the job. The employer might take a chance and hire the immigrant with broken English at, say, $4 an hour, to see if he’s a hard worker and can be quickly trained. But if the government requires that all new hires receive $8 an hour from Day One, the immigrant can never get off the ground and establish a (legal) job history, which could allow him to move up the rungs of the wage ladder.

Minimum wage laws take away the ability of low-skilled workers to compete for jobs by lowering their wage demands. Employers will therefore fill the (smaller) pool of job openings according to other criteria. To get a job you “need to know someone,” be related to someone already in the company, and so forth. The workers who will fail on these criteria are largely the ones that the proponents of the minimum wage think they are helping.

Drop in Workplace Quality

By forcing employers to pay more per hour, and by ensuring a long line of willing workers ready to replace anyone who quits, minimum wage laws reduce the incentive for employers to make jobs attractive in other dimensions. For example, the employer might reduce break times, stop providing free food in the lunch room, and set the thermostat higher in the summer and lower in the winter. The employer might be slower to replace overhead fluorescent bulbs, and (in an office environment) might spend less money on office furniture. Perhaps the bathrooms will be stocked with very cheap toilet paper and clinical-smelling hand soap.

Perversely, the minimum wage law takes away potential arrangements that would make employers and workers happier. Suppose 3,000 people make $8 an hour working at a very hot factory that is cooled only by fans. The owner of the factory surveys the workers and they unanimously agree that they would much rather earn $7.50 an hour, if the employer would install central air conditioning. For her part, the owner of the factory reckons that with 1,000 people working on any given shift, the proposed pay cut would save her $500 per hour in labor costs. She does some research and believes she can install central air and pay the higher utility bills for about $450 an hour, all things considered.

Clearly this sounds like a win-win proposal. The workers take a slight pay cut, it’s true, but they would rather have a smaller paycheck without dripping in sweat 8 hours a day. The owner on the other hand would have to shell out thousands of dollars upfront to install the new unit, but over time the lower wage payments would more than compensate for this initial outlay (and the higher utility bills). But if the minimum wage is set at $8 per hour, this sensible proposal will not occur, because it is illegal. Thus the workers toil miserably away in their sweat-soaked clothes, and the factory owner earns $50 less per hour of operations. Although this final example is a bit contrived, it illustrates a major flaw with minimum wage laws: A job is attractive for many reasons, the paycheck being just one. By arbitrarily setting a floor below the wage, the government might perversely cause the other job attributes to decline so that even those workers who keep their jobs end up being hurt—let alone those workers who can’t get a job at all.

Footnotes:

[1] Farmers are also beneficiaries of price supports, in which the government assures a guaranteed minimum price for certain agricultural products. However, typically the government establishes this floor by using tax dollars to artificially boost the demand for the privileged items. Rather than punishing people who pay less than $10 per bushel of wheat, the government steps in and buys up wheat (and stores it in silos) whenever the market price would otherwise fall below $10. The analysis of this type of “price floor” is much different from the situation we are analyzing in the text.

[2] Our analysis of a wage floor explicitly enforced by the government largely applies to the case where a union threatens violence or property destruction in order to raise the wages of its members above the market-clearing level. Many economists view this as a form of government intervention, because governments typically do not punish unions for criminal intimidation the way they would punish other attempts (by employers during labor negotiations for example) to disturb voluntary transactions. However in the text we will restrict the discussion to the purer intervention that comes directly from the government.

[3] Or at least, they will desire to do so, just as soon as contractual obligations allow. In practice there might be other constraints, such as the loss of employee morale if the boss lets 10% of the staff go in response to a minimum wage hike. Nonetheless, other things equal a minimum wage increase will reduce the profitmaximizing number of (low-skilled) employees for a given business.

[4] To say that the demand (not just the quantity demanded) falls in the long run means two things: First, at the constant minimum wage, the number of workers who can find jobs will fall. Second, even if the government eventually removed the minimum wage, the equilibrium number of workers hired (at that point) would initially be lower than the original number of workers before the imposition of the minimum wage.

[5] Note that at the original wage of $5 per hour, the renovation would only save the owner $15 an hour in reduced labor costs. Depending on the expense of renovation (properly accounting for interest and the depreciation of the new equipment), the minimum wage law could be the difference between designing a restaurant to be run by 8 employees versus 5.

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