One of the few bright spots in the U.S. economy has been in the lower paying service sector industry. Now, the push by Democrats for a minimum wage hike is a direct target at job creation in the service sector industry.
Please remember that this is not a subjective interpretation based on a political bias, but instead on sound economic analysis. In this article I will show you, from a mathematical and microeconomics perspective, what happens when minimum wages are artificially set higher by the government.
Labor Supply and Demand
Labor is charted on a supply and demand chart just like other market forces.
The wages paid are on the vertical axis, while the quantity of workers demanded is on the horizontal axis. Demand slopes downward (D), while supply slopes upward (S).
In a perfectly competitive labor market, equilibrium is established where the supply and demand curves meet.
Now look at what happens when the minimum wage is artificially set higher by the government.
Minimum Wage Hikes
When wages are artificially set higher by the government in the form of minimum wage hikes, workers wages go up, but the quantity of workers demanded (D) goes down. In other words, a minimum wage hike raises the unemployment rate and puts more people out of work.
The supply (S) of workers goes up as the labor participation rate rises from people going back into the workforce in a desire to get that higher minimum wage job.
Notice the box that is created from the rise in the minimum wage. This is a big problem as it represents an inefficiency in the free marketplace. This inefficiency manifests in the economy as a shortage of available jobs.
In other words, when the minimum wage is raised, a business will raise the price of its products, and reduce its total number of workers, in order to offset the increased labor costs.
Wages Can Only Rise On An Increase In Demand
The only way to increase worker wages AND the total number of jobs at the same time is if a business has more consumer demand for its products and services. This will shift the demand curve outward:
As consumer demand for a firm’s products and services increase, it shifts the demand curve outward so that wages will go up, while the demand for workers goes up, and a new market equilibrium is established.
Unions Impact On Wages and Jobs
The only way to increase worker wages and the total number of jobs at the same time, is if demand for a businesses products/services goes up. Some Democrats assert that the other way for wages to go up, beyond setting an increase in the minimum wage, is by employees becoming part of a union. That is not entirely true.
If a union exerts monopoly power in a market, say for grocers, wages will rise to W** in the chart below:
Once again though, notice what happens to the quantity of labor, it falls to Q**. In other words, while the wages of those working go up, the number of people with jobs goes down. The difference between the supply of labor S (those wanting jobs), and the employer demand for that labor D (jobs available), is once again a labor shortage:
The Law of Diminishing Returns
Raising the minimum wage is also a problem because of the law of diminishing returns. Basically this means that if the government raised the minimum wage from say $9 an hour to $15, if the worker produced more value, the company that had to pay the higher wage would not have a problem because the workers increased value would offset the increased cost. But that’s not what happens. A worker can only produce so much value in a particular job and so there is the law of diminishing marginal productivity.
The marginal revenue product, or MRP, is the increase in total revenue, resulting from the increase in labor revenue for that employee.
The marginal resource cost, or MRC, is the increase in total cost, resulting from the increase in labor cost for that employee. In a perfectly competitive market, MRC equals the wage rate.
A business, in order to maximize profits, will hire additional employees so long as each employee hired adds more to the firm’s total revenues than it does to total costs. In other words, there is the profit maximizing rule which states that it will be profitable for a firm to hire additional employees up to the point at which that additional employee’s MRP is equal to its MRC.
If the number of workers currently employed by a firm is such that the MRC of the last worker is less than the MRP, the firm can profit by hiring more workers. However, if the number of workers already hired is such that the MRC of the last worker exceeds the MRP, the firm is employing workers who are not paying their way, and it can thereby increase its profits by laying off some workers.
Here is an illustration of the profit maximizing rule. Suppose that the government sets the wage rate at $13.95. How many workers will the firm hire?
The firm will hire one worker because the first worker adds $14 to total revenue, and slightly less, $13.95 to total cost:
In other words, the MRP exceeds the MRC for the first worker, so it is profitable to hire that worker.
Now consider if the government had not raised the minimum wage to $13.95 but instead allowed the firm to continue to pay $9.95 an hour. How many workers will the firm hire?
The firm will hire three workers.
I see a lot of people making the mistake of thinking that a minimum wage hike of only a few dollars per hour is no big deal in terms of job layoffs. As you can see from the law of diminishing returns, mathematically that is not the case. In terms of the hypothetical business above, a difference of just $4 per hour amounted to a difference of 1 available job versus 3 available jobs or a whopping 200% increase in available jobs due to the lower hourly wage.
Even a small increase in the minimum wage will have a huge negative impact on the total available jobs.
Because we are on the subject of labor and wages, I thought I would briefly discuss the impact that immigration has on wages.
Immigration Lowers Wages
Increased immigration puts a downward pressure on wages. Immigration shifts the supply curve outward and results in lower wages:
In other words, increased immigration leads to lower wages and an increase in the number of lower paying jobs.