Saturday, February 16, 2013

My defense for an increase in the Minimum Wage to $9.00. I speak of one element of the labor market I don't hear ANYONE refer to and I think it is important to understand...

There is lots of talk, for and against, regarding the recent proposal by the President to increase the minimum wage from $7.25 to $9.00 per hour.

Economic theory suggest that when you increase the price of something (wages) the quantity demanded (workers) decreases, hence unemployment increases and if the price (wages) decreases the quantity demanded (workers) increases, hence unemployment decreases. 

Even with an increase in the minimum wage I believe I can make the case that employment will INCREASE rather than decrease using the principles of Price Elasticity of Demand and the Total Revenue (Income) Test for Elasticity of Demand.

It might be a "stretch" but I think Elasticity of Demand for Labor factors into the equation.
I will use a series of graphs to illustrate my case.
The first graph shows a labor market in equilibrium at an hourly wage of $7.25 and the current level of employment at that wage 100 workers (obviously a made up number for simplicity).  $7.25 is the current minimum wage in the US. I will use this wage rate as my base and compare it to the new minimum wage of $9.00 proposed by President Obama in his State of the Union Address.  It also shows the TOTAL amount of income earned by these workers at that wage rate--$725.00 PER HOUR
Graph #2 shows the imposition of a new $9.00 per hour minimum wage ABOVE the current wage.  This would establish a new PRICE FLOOR. This is a 24% increase in the wage rate. The quantity demanded for labor DECREASED to 75 workers. This is a 25% decrease in Quantity Demand for Labor.  Using our formula for Price Elasticity of Demand (%chg in Qd/%chg in P) this suggests the Demand for Labor in this market is slightly ELASTIC, just over 1.  If we apply the Total Revenue Test (in this case Total Income), we find that as the wage increased the Total Revenue (Income) DECREASED to $675.00. This suggests the Elasticity of Demand is ELASTIC—as the price increases the Quantity Demanded decreases by a greater amount.

The policy implication of this increase in the minimum wage is we have REDUCED the income of these workers overall.  Less income, less spending in the economy overall, less GDP, hence less employment.
However, I think we have to look closer at the Elasticity of Demand (even for low income workers) in the SHORT RUN. The Short Run is the operative 2 words.  
I don’t believe businesses will significantly change their hiring or lay-off decisions in the immediate after-math of the increase in the minimum wage.  They must serve current customers and fill current and future orders.
Given this condition, In Graph #3 I suggest the Demand for Labor is relatively INELASTIC.  Business will NOT reduce their Quantity Demanded for Labor by more than the Increase in the Price of Labor. 


If Demand for Labor is relatively INELASTIC, then an increase in the Minimum Wage (+24%) will reduce employment to 90 workers from 100, or 10% LESS than before.  Using the formula for Price Elasticity of Demand (%chgQd/%chgP)  will yield a number LESS than 1 (-10%/+24%= -.41).  Performing the Total Revenue (Income) test, we find total income earned by these workers is $810.00, $85.00 MORE than before.  Fewer workers, higher overall income, in spite of the decrease in employment.

Assuming Demand for Labor is relatively INELASTIC, even for low skilled workers in the short run, by increasing the minimum wage will increase total income earned by these workers.

If total income increases these workers have more money to spend.  An increase in income will tend to move them to buy more “normal” goods and fewer “inferior” goods.  Normal goods tend to be higher value goods purchased as income increases.  Spending more money will create an increase in demand for new “normal” goods and services.  Hence, businesses will sell and produce more goods and services.  They will likely need to hire additional workers (at the margins) to produce and sell those additional goods and services.

As illustrated in the graph below, the Demand for Labor will INCREASE. The Demand Curve (D2 for Labor) will shift to the RIGHT.  As represented by Point “D”, at $9.00 the Quantity Demanded for Labor is 110 workers, a level of employment HIGHER than before.

Elasticity of Demand for low-skilled minimum wage workers seems to me mirrors the condition of the economy.  If the economy is doing well and unemployment is relatively low, then an increase in the minimum wage may actually be productive for the economy, as the demand for that labor will be relatively inelastic.

However, in an economic downturn it seems to me the demand for low-skilled labor becomes relatively elastic and an increase in the wage rate will have a higher negative impact on employment.

Bottom line for me:  Gotta pay attention to Elasticities and less to politics when it comes to this issue.
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