Recently, there has been a lot of discussion about the issue of minimum wage due to the circulating proposals to raise it in the US and the new econometric studies purporting to demonstrate that raising the minimum wage slightly does not affect employment.
What got me thinking about this issue was the realization that the standard supply and demand for labor story in which workers are paid their marginal product does not quite survive realistic scrutiny. After all, if a company gets profit (sometimes fairly substantial like more than 25% for McDonald’s in 2013), it by definition means that at least some of the factors of production used by it are not paid their marginal product.
Substantial profits exist because the economy is never even close to an equilibrium. New products and ways of producing old ones are constantly being created some of which later turn out to be not worth the effort. These new products often do not just add themselves to the choice space of consumers, they often make other products obsolete or change the valuations of other products. At the same time, the reallocation of resources is not perfect and timeless. In such conditions it is not possible to talk about absolute efficiency of resource allocation, only about its efficiency with respect to the production opportunities known within a certain period. In other words, a resource will be used dynamically efficiently if at the moment there is no known way of reallocating it to a more productive venture.
This leads us to the issue of relative labor market monopsony, i.e. the ability of a firm to pay workers less than the contribution they make to the firm’s product. In an economy where firms receive profits this situation is probably not an exception but the rule. Does it, however mean that instituting a minimum wage in such an economy would be a good idea?
Let us assume that the government introducing a minimum wage is even capable of doing it in such a way that it does not make it unprofitable (not profitable enough) for certain firms to keep or hire some workers (i.e. a no direct increase in unemployment scenario) which is in itself a huge assumption to make. Still, I’d argue that such a policy would bring substantial economic damage because it would impede reallocation of labor to more productive uses.
Recall that in a dynamic market economy resource prices and profit rates tend to reflect the relative market values of goods that firms produce and the relative productivity of those resources. The change of wages in such an order usually happens if an entrepreneur sees correctly that it is possible to offer an employee a better wage (or a better combination of wage and working conditions) and achieve with it the same or higher profit rate and acts on this realization (or even lower profit rate even it is the best alternative the entrepreneur sees for using his money). But in order to be able to succeed in this activity, entrepreneurs need access to prices that reflect the current relative success of other entrepreneurs in satisfying consumer needs with the existing resources.
However, if the government forces entrepreneurs to pay some of their employees more than their relative entrepreneurial success warrants, it distorts the economic calculation based on arbitrage between resource and consumer good prices.
The affected entrepreneurs can respond to an increase in minimum wage in two main ways: they may just comply and get their profits reduce or they may adjust in one way or another, for instance by making the working conditions less attractive.
We have already assumed away the reduction in employment. Let us assume away also other forms of adjustment and assume that the affected entrepreneurs will just accept the reduction of their profit rates. The impact of this development will be twofold. First, the attention of other entrepreneurs will be relatively diverted away from the particular industry. They will not see that its profit rate without government distortion is actually higher and may warrant entry into it. This will probably hamper innovation in this industry and actually reduce competition in the correct, rivalrous sense of the word. Secondly, the wages of some employees will tend to be higher than is warranted by the current ability of entrepreneurs to create value with their help. It is not difficult to imagine that some innovations could be profitable if entrepreneurs could pay those workers a bit more than the non-distorted wage but less than the minimum wage.
So to sum up, a first approximation analysis based on market process logic seems to suggest that a minimum wage will hamper economic growth even if it does not result in decreases in employment. Of course, much more can be said if one goes deeper into various issues and interconnections.