Who Pays for the Minimum Wage?

Lessons in thinking at the margin

Since the proposed $15 per hour federal minimum wage is all the rage, I thought that I would get in on the fun and write a special Monday-edition of Economic Forces to follow-up on Brian’s post. In particular, I want to re-orient the conversation around who pays for the higher minimum wage.

Let’s start with basic incentives. All else equal, a worker wants to earn the highest wage possible. A firm wants to pay the lowest wage possible. This is true regardless of whether the wage is determined through supply and demand or through some decentralized bargaining process. The idea that workers want higher wages and firms want lower wages is also independent of the market power of the workers or the firms.

It seems important to start with this basic observation because there seems to be an emerging view that the minimum wage results in a simple redistribution from the firm to the worker with little other consequence. This makes the “who pays” question easy to answer. It is the firm. But why would this be the case? If a firm is content by paying its workers $10 per hour, and minimum wage is increase to $15 per hour, shouldn’t we assume that firms will try to make some sort of adjustment? Of course we should.

Let’s start with competitive markets. People, even economists, say the darndest things about competitive markets. For example, people misunderstand the zero profits condition in competitive markets. The core assumption for competitive markets is that firms are price-takers. They don’t have control over the price of the good they sell because they’re constrained by competition. It does not require an assumption that all firms are identical. When firms differ in terms of their cost structure, the zero profits condition just implies that the marginal firm earns zero profits.

The reason that this point is important is that it suggests that, even in competitive markets, firms will respond in different ways to an increase in the minimum wage. For some firms, the higher wage might be a threat to the continued viability of the firm. Marginal firms might reduce employment by shutting down, while other firms will try to take steps to avoid the increased cost.

As Brian correctly pointed out, if we are thinking about the competitive market, we should probably be thinking about hours worked rather than employment. The competitive model suggests that hours worked decline and the marginal product of labor increases. There are a number of ways that this could be accomplished.

First, firms could limit their hours of operation. Firms that can produce the same volume or reduce their volume of output by a lower percentage than they reduce their hours of labor might choose this strategy. In doing so, the firm increases its output per unit of time. This forces workers to produce more per hour than they otherwise would.

Second, consider retail establishments. At a sufficiently low wage, firms will be willing to hire enough workers to cover things like lunch breaks. For example, a retailer might overlap the shifts of cashiers to make sure that the store has a sufficient number of cashiers to minimize the length of checkout lines during the workers’ lunch breaks. For higher wages, the retail might prefer to offer the cashiers shorter, consecutive shifts or to simply allow the checkout lines to be longer during lunch breaks. Alternatively, the retailer could force non-cashiers to operate cash register during busy times while expecting them to continue to accomplish their other tasks.

In each of these examples, there is no reason to believe that employment must change at all. Nevertheless, we should not consider the policy costless. Some of the costs associated with the higher minimum wage are not paid by the firm. In each example, workers are more productive, but they are more productive because they have less downtime and/or must put forth more effort and might have a more stressful work environment. Of course some workers might be happy to put forth more effort and have more stress in exchange for higher wages. Nonetheless, greater effort and stress is not costless.

Customers also bear a cost of these changes in each example. Shorter business hours make the firm harder to reach or lead to longer waiting times or checkout lines. Retailers that eliminate cashiers or make other workers operate a cash register in addition to their normal duties will end up with longer checkout lines. This increases the total cost of shopping to the customers.

Of course, some reductions in hours worked might manifest themselves in reduced employment over the longer term. Retailers might install self-checkouts. Restaurants might replace servers with a counter service. As a result, the identity of those who pay the costs associated with a higher minimum wage might evolve over time.

This is just the standard competitive model though. Proponents of a higher minimum wage argue that the competitive market isn’t useful. We need to focus on models in which firms have market power. But is there a reason to believe that firms with market power will behave differently than competitive firms?

We are often told that the employment effects are small because firms have monopsony power in the labor market. However, if firms have market power, this raises an interesting question: why don’t these firms with market power actually pass through this higher labor cost with higher prices? In fact, that seems to be exactly what these firms do. Peter Harasztosi and Attila Lindner examine the effects of a significant increase in the minimum wage in Hungary. They find that increases in the minimum wage result in higher output prices. Interestingly, they find that prices rise by a greater percentage in the non-tradable-goods sector than in the tradable-goods sector. Why? Because the tradable goods market faces competition from foreign producers and therefore competition limits these firms’ ability to raise their prices. So, market power actually seems to lead to greater pass-through of the costs of the minimum wage to consumers through higher prices. They estimate that as much as 75 percent of the increase in the minimum wage is paid for by higher output prices. This is not exactly the redistribution from firms to workers that is often claimed.

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It is clear from the public discussion of the minimum wage that there are some people, including economists, who think that the reason to support raising the minimum wage is that doing so helps low-wage workers. Indeed, the minimum wage seems to be a pretty popular policy, at least in some circles. Why the minimum wage is popular in comparison to other policies aimed at helping low-wage workers has always been a puzzle to me. I even wrote a paper about it (just for fun, not for publication — how psychotic!). My argument is that people perceive the minimum wage as a substitute for a bargaining tool available only to higher-skilled workers. Perhaps, this is correct. However, even in my model, the cost of the minimum wage is that it increases unemployment.

What this post has hopefully pointed out is that a lot of the costs associated with the minimum wage are likely “unseen” in the sense that it is not always obvious that these costs are due to the minimum wage. The costs are often passed through to consumers through things like longer wait times and higher prices. Over the longer term, the costs might be paid more directly by workers as firms switch to more capital-intensive production and re-organize their methods of production. Of course, advocates of a higher minimum wage might argue that the benefits of higher wages for low-wage workers is worth the higher costs for consumers. Nonetheless, these consumer costs are real costs that are often left out of the standard cost-benefit analysis.