February 6, 2014
By Oren M. Levin-Waldman
In his State of the Union Address the President called for an increase in the minimum wage, and already those on the right are yelling about how harmful that will be for the economy in this period of slow growth. Shying away from the topic of income inequality, the President talked about opportunity ladders and how the minimum wage might be one of those for the working poor.
What he neglected to mention was the larger benefits of the minimum wage for the middle class. Perhaps our politicians can be forgiven for their confusion on the matter because at times it appears as though the economists are equally confused.
Their confusion would appear to a be a function of the distinction typically made between micro-economics on the one hand, and macro-economics on the other. The competitive market model is clearly a micro-model: when workers lower their wage demands, employers will hire more workers. The idea that workers whose wages are increasing will be able to demand more goods and services in the aggregate because they have greater purchasing power is a macro-model. When the two collide, the result in many ways resembles the tragedy of the commons.
The tragedy of the commons is the theory by Garret Hardin that when individuals act on their own and rationally according to their self-interests the shared resource of the community will be depleted. By depleting the common resource the group’s long-term interests will be undermined. The theory was based on William Forster Lloyd’s 1833 pamphlet about land tenure in Europe. If everybody brought their cattle to the common grazing area, which it would be in their self-interest to do because it was free, the end result would be the destruction of the common grazing area. As a result, they would no longer have anyplace to bring their cattle to. Individual rationality would then result in collective irrationality.
We can see the same thing happening with the minimum wage. In micro-theory at the level of the firm it makes perfect sense to pay workers as little as possible. In this vein, it is logical that employers will respond to workers lowering their wage demands by demanding more of their labor services. But if all workers were to pay their workers as little as possible, there would be no demand for firms’ goods and services because workers wouldn’t have the wherewithal to purchase them.
What typically happens, however, is economist often take the micro-model and attempt to couch it in macro-terms: if all workers lower their wage demands, more employers will hire them and the result will be the absence of unemployment, or so that is the case in a purely competitive market. What about the fact that workers who have now agreed to accept lower wages will have less purchasing power, which will result in a shrinkage of aggregate demand? The model simply assumes that prices will readjust themselves downward so as not to have that shrinkage in demand.
The problem with this assumption is that there is a limit to how low prices can fall because most employers have reduced costs. Moreover, the fundamental assumption of the competitive market model that the cause of unemployment is wage rigidity — the refusal of workers to accept lower wages, which is only hardened by a minimum wage that creates a floor — is just flat out wrong. Unemployment is caused by the absence of demand for goods and services. As workers forced to accept lower wages demand less, the result will unemployment as other businesses are forced to lay people off. A worker could theoretically accept a wage of zero and still be unemployed if the would-be employer has no need for him or her because nobody is demanding that employer’s goods. This is why monetary policy is ultimately limited, especially in a severe recession. It assumes that if interest rates are low enough employers will simply create jobs without considering that in the absence of demand employers have no real need to create them.
This tragedy of the commons appears to have had two results. First it has allowed two opposing sides on the political debate over the minimum wage to cloak their respective positions in economic terms. Those who oppose the minimum wage can always point to the micro-model to justify their position. They can easily rationalize the payment of substandard wages by pointing to the disemployment effects predicted by the model. Their outspoken concern for those who will lose their jobs surely sounds nicer than coming out and saying that they don’t want to sacrifice anything to pay their workers more. Those who favor the minimum wage point to the macro-model to make their case that an increase means that those who receive it will have more money to spend, and that the increased demand will ultimately ripple through the economy.
The problem, however, is that they do not usually make this argument. Rather they talk about how minimum wage workers cannot live on the minimum wage, which has the effect of relegating the issue to an anti-poverty argument. The larger argument of the macroeconomic effects is only offered as an afterthought. If the focus is only on a small segment of the labor market that earns the minimum wage we are ultimately left with the tragedy of the commons, whereby each side speaks past each other.
The macroeconomic argument needs to be couched in terms of how the minimum wage through its likely ripple effects throughout the wage distribution will benefit the middle class. When presented as a middle class issue, the more macro-model can come out of hiding. Moreover, to talk about it in macroeconomic terms is to return the minimum wage to where it was originally supposed to be when the Fair Labor Standards Act was enacted in 1938, which was, along with collective bargaining, to create labor market institutions that would stabilize labor-management relations. By inflating wages in a depression where wages were already depressed, the minimum wage would assist recovery efforts by offering workers enhanced purchasing power. The minimum wage was initially conceived of as a labor-management or human resources issue, and it can be restored to its rightful place if we emphasize its middle class value.