Archive for November, 2010

The True Economic Impact of Raising the Minimum Wage in Canada

November 18, 2010

The True Economic Impact of Raising the Minimum Wage in Canada

Economists often argue that minimum-wage research is more of a support than a basis for policy-making. The reason is obvious. It is seen as a test rather a gauge of the applicability of neoclassical theory to the determination of wages and employment. It is considered as an alternative methodological arrangement used for assessing the impacts of selected macroeconomic variables (Lemos 5). Minimum-wage research, however, is not just a technical dispute over the direction and magnitude of economic parameters. It is an important vignette for resolving methodological disputes which arise from conflicting economic assumptions.

Minimum wage is generally the ‘lowest legal rate at which employers can remunerate their workers’ (Leonard 120). Minimum wage varies across countries over time. In the United States, the nationwide minimum wage is $7.25 an hour, although some states mandate a higher rate. In Canada, the minimum wage, on the average, is $7.79 an hour (this is because the minimum wage varies across states). In developing countries, minimum-wage is $2.1.

The Goal and Philosophy of Minimum Wage

Historically, minimum wage had been used to improve the working conditions of the urban poor. In England, administered wages[1] were used to offset both inflation and declining standards of living. In the United States, minimum wage was used to decrease income disparity between classes. In Continental Europe, the institutionalization of wage floors was a measure to decrease the influence of labor unions and prevent excessive economic growth. In Canada, minimum wage serves two purposes. First, it is created to impose an enforceable standard that would secure a minimum level of income for unskilled workers. And second, minimum wage is designed to prevent laborers from undercutting each other by agreeing ‘to work for less than someone less’ (Mankiw 198).

The first laws institutionalizing wage floors can be traced back to Australasia. In 1894, the District Conciliation Boards of New Zealand was created to settle labor disputes. This included the arbitration of labor remuneration. In 1896, the state of Victoria passed the Factory and Shops Act to fix minimum wages in selected industries. In the United States, the first laws which institutionalized administered wages were enacted in 1909 and 1938.  In Canada, the first legislation on administered wages was passed in the late 1910. However, this only applied to selected industries.

The current controversies over the efficacy of the minimum wage as an economic aid can be traced back to the classical era. Adam Smith, for example, argued that setting wage floors will lead to distortions in the economy (Rocheteau and Tasci 1). For him, a free market model must exclude provisions for administered wages[2]. J.S. Mill took the similar stand against administered wages. According to him,

If law or opinion succeeds in fixing wages above the competitive rate, some laborers are kept out of employment; as it is not the intentions of the philanthropists that these should starve, they must be provided for (Leonard 122).

For Mill, if workers received some form of fixed income, then there would be no incentive to work; hence, there would be no drive for sustainable economic growth. Moreover, institutionalizing administered wages would, in the long run, lead to labor cuts – a scenario which Mill considered wasteful. Some economists though argued that the problem lies not on the institutionalization of minimum wage but on the assumption that wages are flexible in the short-run. In the General Theory, John Maynard Keynes argued that long run changes in output levels do not automatically adjust wages in the short-run. According to him, wages tend to be permanent in the short-run. Sustained employment, according to him, results not from fixed wages, but from uncontrolled economic growth which drives prices to fall in the long-run.

Arguments for Raising the Minimum Wage

Proponents for an increase in the minimum wage claim that the policy will stimulate consumption in the long-run. By putting more money in the hands of low income consumers, this will increase their standard of living and thus decrease government’s payout for social welfare services. They also argue that a raise in the minimum wage leads to increases in workers’ productivity. Refer the first graph in the Appendix. Consumption is a function of income, ceteris paribus. An increase in fixed income leads to an increase in consumption. An increase in fixed income means that more money will be available for the purchase of goods and services (from Q0 to Q1). Now, an increase in consumption means an improvement in the standard of living. The assumption, however, is that prices and output levels are constant.

Institutionalizing administered wages reduces government expenditures on social welfare services in the long-run. The reason is quite obvious. In the past, governments provide cash transfers to families who live below the poverty line. Institutionalizing administered wages provide unskilled workers with guaranteed income which would elevate them from poverty. Government expenditure is then reduced by the amount equal to total cash transfers.

Arguments against Raising the Minimum Wage

Most economists do not support raising the minimum wage. They claim that raising the minimum wage will increase the input costs of firms in the short run, and thus, reduce total economic output. Refer to the second graph in the Appendix. An increase in the minimum wage shifts the marginal cost curve of firms upwards. Initially, the firm produces output equal to Q0 at MC0.  A raise in the minimum wage means a shift of the MC curve upwards, at MC1. To produce the same output (Q0), the firm has to face a higher marginal cost. In a recent study conducted the Canadian Chamber of Commerce, raising the minimum wage would double the input costs of Canadian exporting firms (even if there is already an established market of Canadian exports)

Raising the minimum wage also increase labor surplus. Refer to the third graph in the Appendix.  An increase in the minimum wage results to an increase in the supply of labor and a corresponding decrease in the demand for labor. The result is a labor surplus. Firms have to cut labor costs in order to compensate other workers. As a consequence, unemployment increases, more people will starve, and total economic output decreases.  The claim that raising the minimum wage prevents poverty is a notorious claim. According to a study conducted by the Canadian Chamber of Commerce, higher minimum wages cost jobs for young and unskilled laborers. Since most jobs in Canada are for skilled and white collar workers, it would be imprudent to raise the minimum wage and apply it to all industries. There are also studies which indicate that a 20% increase in the minimum wage results in a 5% increase in unemployment (Lemos 11).

Conclusion

For most economists, instead of raising the minimum wage, it would be more prudent to increase the jobs available for unskilled workers. This can only be achieved by stimulating the economy through appropriate fiscal and monetary policies. If, indeed, raising the minimum wage improves the standard living of the poor, then what are the costs? Clearly, the costs would be an increase in unemployment and government expenditure on social welfare services, and a decrease in total economic output.

Appendix

Graph 1. Wage vs. Consumption

Consumption Curve

W1

W0

 

 

 

Q0 Q1

 

Graph 2. Wage vs. Marginal Cost                                             MC1

MC0

 

W1

 

W0

 

 

Q0

Graph 3. Demand and Supply of Labor

S

W1              c                                              d

W0                        a                           b

 

 

 

 

D

(Note that the initial amount of labor surplus is equal to ab. An increase in the fixed wage leads to an increase in the surplus – to cd. Note that cd > ab).

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Works Cited

Lemos, Sara. The Effect of the Minimum Wage on Prices. Institute for the Study of Labor, March 2004.

Leonard, Thomas. The Very Idea of Applying Economics: The modern minimum-Wage Controversy and its Antecedents. New York: Macmillan Publishing Company, 2004.

Mankiw, Gregory. Macroeconomics. Harvard: Harvard University Press, 2005.

Rocheteau, Guillaume and Murat Tasci. The Minimum Wage and the Labor Market. Federal Reserve Bank of Cleveland


[1] Also called minimum wages

[2] In neoclassical economics, the minimum wage is an integral part of economic modeling.