Calls for an increased minimum wage have grown louder in recent years. Concerns over the lack of a living wage paid to sweat-shop workers have also been raised. Can raising wages by government fiat create employment, or is it counterproductive?
How can raising wages create jobs? Won’t firms hire less people…if they cost more? Is minimum wage an intellectually lazy answer to economic problems by socialists who don’t understand economics? They can be proven wrong with a simple supply-demand diagram! Duh.
Well, not quite. Make no mistake, a rise in wages usually leads to job losses for the obvious reason: you need to be paid more, so hiring you is less lucrative. (For the more bookish reader: demand is inverse related to price). This reasoning is often used to counter demands for a minimum wage. After all, what’s the point of increased pay if you lose your job?
But this sort of neat supply-demand trick only holds under a special case – competitive labour markets.
Big words! What does it mean? In less verbose terms, it means that no worker or firm has control over the wage. When does this occur? When there is a huge number of firms hiring workers and a large number of workers looking for jobs.
Why does this occur? Suppose you are a worker, and want to raise your wage. What does the firm do? It hires one of the other ‘large number’ of workers instead. Suppose you are firm, and try to lower the wage. What do the workers do? They go to one of the other ‘huge number’ of firms.
So the wage is pre-determined (or deterministic. or exogenous). Under this framework, the government artificially hiking up wages is bound to leave people unemployed.
Did you find this weird? After all, firms do lower wages and employees do ask for raises without being fired right away! That’s because perfectly competitive labour markets rarely exist in the real world. Despite that, many markets are indeed highly competitive, and so neither the firm nor the worker is exploited, since they can always switch to some other firm/worker.
Let’s take an example: the market for IT workers in Bengaluru. Suppose a firm, Infosys, slashes salaries by half. Will the employees remain? No! They’ll go to one of the other tech companies based there. On the flip side, suppose an Infosys engineer asks for a 200% raise. I think you can complete the rest of the argument… In such an industry, raising the wage artificially means it is above the optimal level which was pre-determined.
Let’s use some numbers and get a feel for this. Suppose the exogenous (sorry, couldn’t resist) wage is Rs. 30,000 per month, and the government sets a wage floor at Rs. 40,000. Engineers who are valued at less than 40,000, who would’ve otherwise got a job, become unemployed!
So, why do we even need a minimum wage? It seems like a terrible idea.
To answer that, we need to take the case when the competitive structure has broken down. This can happen when there is a monopsony or oligopsony in the labour market, ie, when there are only a few (or just one) firm hiring workers.
This is where the neat supply-demand tricks grind to a halt, since workers no longer have bargaining power.
Imagine you are a steelworker in Jamshedpur, a town in Eastern India founded by a company called Tata Steel (and named after its erstwhile patriarch) and where almost everybody is employed, directly or indirectly, by them. In economics lingo, Tata Steel faces an upward sloping supply curve. It can lower wages. Where do you go if it does?
Or, suppose you are a semi-skilled worker in a Third World country with few employment opportunities and you are hired by a sweatshop. Where else do you go if they do not offer a living wage or safe working conditions?
Typically, such a situation leads to underpayment and underemployment of workers. Raising the minimum wage by law in such circumstances creates employment, because firms no longer have the incentive to underpay and under-hire. Since they have to pay a certain wage even if they hire very few workers, it is more profitable for them to hire more and sell more output (this can be proven with a little bit of math and some graphs, but that’s not important). Indeed, this is why many U.S. states that have enacted minimum wage legislation have seen an increase in employment.
And there you have it. As you will soon see, the answer is rarely black and white when dealing with social phenomena. If you think minimum wages are always good for workers, you are wrong. If you think they are always bad, you are wrong.
The answer, like with most other correct answers, is it depends.