Wednesday, January 17, 2007

Follow the Sandwiches

For the past few days Steven M. Warshawsky from American Thinker engaged in a minimum wage debate with Cafe Hayek's Don Boudreaux and Russ Roberts. Since Mr. Warshawsky seems to have stopped posting on Cafe Hayek (though one has to admire how long he kept commenting to people who disagreed with him), I thought I'd quickly show why the minimum wage has a negative net impact on the economy.

Warshawsky doesn't think anyone can pull this off. In his post about the minimum wage, he said:
However, it is not obvious a priori that total welfare will go down as a result of a federal minimum wage increase from $5.15 to $7.25 per hour.
In other words, one cannot intuitively demonstrate that raising the minimum wage will make society worse off. But actually this is quite easy.

Consider fourteen people at McDonald's working for $5.15 an hour, each making Big Macs (it's a busy McDonald's). In total, it costs McDonald's $72.10 to employ them all. Now suppose the minimum wage rises to $7.25 and management responds by firing four Big Mac makers. In this new restaurant, there are ten people pouring the secret sauce, with total costs of about the same as before: $72.50 (do me a favor and ignore the forty-cent discrepency; it is not needed to understand the point I'm making).

At a glance, Warshawsky is completely correct. Four people get fired but ten people benefit. How can one tell if society is better off from this? It's a wash--money is merely transfered from some people to others. In the big picture, the world is the same.

But now take another look. In the $5.15 world, McDonald's made fourteen Big Macs. In the $7.25 world, it makes only ten. The movement of money is ambigious, but the number of Big Macs is not. Society is strictly poorer.

Now one could claim that people earning more would be more productive--we'd get eleven or twelve sandwichs, not ten. But that's still not as much as fourteen. What if in the $7.25 world, the ten workers made fifteen? Then society has gained, but in this world, a minimum wage hike is not needed; McDonald's would have every reason to raise wages on its own. This is what Henry Ford did on his assembly line when he raised the hourly rate: the increase in worker productively more than made up the extra expense. By definition, firms which raise wages because of the law would not raise them because doing so betters productivity.

This example can be applied to all sorts of scenarios. Maybe the company didn't fire any workers and the money came from the CEOs. That means they couldn't spend those dollars on more investment in the company or a trip to Paris or a donation to cancer research. Maybe the prices rise. That means consumers spend less on many other things: a notebook here, cell phone minutes there. From person to person it is merely a transfer, but net production decreases. Society as a whole is made worse off.

Q.E.D.

12 comments:

Jason Br. said...

The four fired workers do not vanish. They move into household production, a.k.a. the underground economy. Unless you can prove that they produce less there -- and since they are no longer producing Big Macs, you cannot do so because it is not apples to apples -- you can't show what you are claiming to show.

Anonymous said...

Hi, thanks for commenting on the debate. I think your example is OK, but it is based on a hypothetical situation that would change if you simply changed the assumptions, e.g., how many workers would lose their jobs after the increase in the min wage. This is my point. I haven't seen any analyses that make an effort to calculate the actual effects of a proposed min wage increase, based on what we know about the demand elasticity for low-wage labor in different occupations and similar "objective" factors.

Steven M. Warshawsky

Jason Br. said...

The entirety of economics is hypothetical -- it is always based on some ceteris paribus assumptions. The analyses you ask for must make the same sorts of assumptions, just different ones -- they would assume, for instance, that the elasticity for low-wage labor, once measured for a historical period, can be assumed to hold constant in the future. In the end, when you account for several such parameters and the confidence intervals surrounding their best-guess future values, you'll end up with a range of possible outcomes. I'd wager quite a bit of cash that the range would include both net-positive and net-negative scenarios -- and that we would STILL find plenty with which to seriously quibble about how the study was performed.

So... considering (1) that these analyses are extremely expensive and time-consuming to undertake; (2) that the only entity with an encompassing interest is the government; (3) that the people who have the power to fund such studies already know what they want to do on the issue and they have the power to do it, so they are unlikely to want to fund the study, which is possibly why you haven't seen such studies... Why should you or I be wasting our lives at agitating to get such studies done?

Also, *all* these analyses (including David's) ignore political effects. For instance, a minimum wage increase may lead to greater political opposition to immigration and free trade, as law-abiding businessmen (the only kind with a voice in government) face greater competitive pressure from the underground economy and from overseas, which in turn could lead to negative "economic" effects such as a tariff on sugar, increasing the consumption of weird replacement sweeteners...oh, wait, we already have that...

David said...

Jason: Good question. Where do the four workers go? I don't know, but I bet they won't be contributing anything worth more four Big Macs. It's the same situacion as before. If they are producing more (even if its extra satisfaction from watching Scrubs all day), then we don't need the minimum wage to go up to get this. They will do this on their own. If they are producing less, then we are poorer.

Jason Br. said...

Couldn't we make an argument with similar logic as follows: If politicians are producing more (even if it's extra satisfaction from passing the minimum wage), they will do this on their own? Or, conversely: if it were worth it for people to resist the politicians passing the minimum wage, they would do it?

Anonymous said...

Because I can't resist a good debate, let me just add the thought that ALL public policy choices require weighing the costs and the benefits (as best they can be defined and measured), including the political realities of any given situation. I get impatient with the libertarians and free market types, not because I disagree with their basic worldview, but because they think that these questions can be "decided" by uttering a few glib economic "truisms." But such an approach neither is effective politically in the short run, nor promotes the cause of economic freedom in the long run.

Steven M. Warshawsky

Jason Br. said...

Steven, I'm not certain to whom you are talking, but I happen to have little patience for straw-man arguments. I'm not a libertarian, just an economist, and I'm pointing out a couple methodological facts: the study you (and I) would like to see won't be performed because it can't be performed. All you're going to get is what you have now: ideologues or bureaucrats of various stripes (no one else will bother to do the research) torturing the data and claiming that (1) theory or (2) past performance will predict future results, and that we should care about (1) Pareto efficiency or (2) GDP maximization or (3) political expediency or (4) whatever. In the end, the data will have to be interpreted, and the interpretation will be made using theoretical tools (these are possibly the mysterious "truisms" you deride). But to paraphrase Rummy: You go into politics with the data and analysis tools you have, not the data and tools you wish you had.

Anonymous said...

Just making a general observation, not a specific criticism of any particular post. Although I am not as skeptical as Jason about the ability generate/obtain more useful data to use in our policy analyses. The people I was debating this issue with on Cafe Hayek, for the most part, think only in "theoretical" terms and make no effort to provide any objective support for their positions.

Steven M. Warshawsky

jenna said...

Errr...that's all very nice in a classroom sort of analysis but...McDonald's is going to make those remaining 10 workers make as many Big Macs as they need to make in order to meet the demand on the other side of the counter. Threaten them with losing their jobs, too, and they'll make all 14 Big Macs and dare not complain. If they make less, and demand is met, then McDonald's was overproducing to begin with. You don't need to raise rages to raise productivity - there are less kind ways to do it.

Furthermore, let's assume that all 14 workers keep their jobs. Companies will often campaign against min. wage raises with a bunch of hullaballoo about it taking away from investment or philanthropy. McDonald's, and most companies that employ lots of min. wage workers do not engage in much philanthropy. Usually the more 'upscale' companies (not talking about wealth, but image) do that.

Investment? Profit? You do realize that McDonald's, and many other companies affected by the min. wage, get their money not from the sale of burgers but from the rent money collected on properties leased to franchisees? The franchisee finds ways to not go out of business, wage increase or not, and McDonald's collects rent as usual. Very little dent in their profit either way.

So really, that money is going to come out of a CEO's salary. So less money is pumped into the economy by the CEO jet-setting around...but that same money is pumped into the economy by the people whose wages just increased, because they're buying food for their kids. Whether the CEO spends or invests it, or whether the poor folks at the bottom spend it, it's going to go back into the economy.

The fact that most min. wage workers are there because they can't find anything else, and yet can't afford to live on $5 an hour, is another point, but not a hardcore economic one.

Jason Br. said...

"The franchisee finds ways to not go out of business, wage increase or not, and McDonald's collects rent as usual. Very little dent in their profit either way.

"So really, that money is going to come out of a CEO's salary."

Jenna, do you not see the contradiction in the above? No dent in profit, nothing comes out of the CEO's salary (assuming for the moment that the CEO is something of a residual claimant -- sorry for the "classroom" term).

In your example, the workers were enjoying a rent in terms of slack -- they weren't working as hard before the firings as afterward, and therefore relative to how hard they were working before, they have suffered a quality-of-life loss. Their gain in increased wages has been countered by their loss in rent from slack, so they are quite possibly no better off after the wage increase.

David said...

Sorry; I've been away all weekend at a colloquium.

Jason: This is why politicians have to use force. Now you could say that this is still optimizing on the employers part (they are obeying the law) but that's also defending the mafia on the same grounds. The government created a scenario in such a way where other actors have to make a crappy choice.

Steven M. Warshawsky: It's not my goal to discuss what's politically feasible. My goal here is to show people the economics of the minimum wage. Ideally, I'll change people's minds which then influences what's politically feasible but I don't care about considering to compromise the hard economics for the benefit of politicians. I don't expect my blog to be the tipping point, but I'll be damned if I don't try (I also gain satisfaction from explaining the economics).

Jenna: Clearly if McD's could encourage them to go faster, they would with the law. People can only go so fast and the company knows it--that's why they automate when they can. And even if they can physically go faster that doesn't mean they won't complain. People aren't slaves; they quit McD's jobs all the time.

Of course McD's gets most of its money elsewhere but that doesn't matter. A loss of productivity is a loss of productivity. And a dent is a dent--small or large. (But with so many stores in the US, I'd call the total effect quite large, and that's just for McD's.)

Exactly, the money goes back into the economy no matter what. That's why I called the movement of money from one worker (say the CEO) to another (say a McD's grunt) a wash. It's just transfer. But the real loss to society is the loss of productivity. Social totals fall.

David said...

Oops made a typo. Change my first sentance in Jenna's section to "Clearly if McD's could encourage them to go faster, they would without the law."