Saturday, December 09, 2006

Wages And Employment Not Determined By Supply And Demand

You will often find people fooled by incorrect teaching of introductory microeconomics into believing that minimum wages are a hindrance to increased employment.

The invalid argument behind this position is shown in a simple diagram of the labor market. The x axis is the level of employment. (In other words, the x axis is the flow of labor services.) The y axis is the wage, that is, the price of labor services. We are only interested in the region where both employment and the wage are positive. The supply of labor is typically drawn as an upward-sloping line, showing more people want jobs at a higher wage. The demand for labor from firms is a downward-sloping line. The point of interestion shows the market-clearing wage (on the y axis) and the level of employment when the market clears. A law imposing a minimum wage is represented by a horizontal line above the level of the market-clearing wage. Since labor demand slopes down, this line intersects the demand curve at a level of employment less than the market-clearing level. Furthermore, the horizontal distance along this line between this point of intersection and the point of intersection of this horizontal line with the supply curve shows the level of unemployment ultimately created by the imposition of a minimum wage.
Figure 1: An Incorrect Model
But it has been known for at least a third of a century that wages and employment cannot be explained in competitive labor markets by the interaction of well-behaved supply and demand curves.

Consider firms in a vertially integrated industry producing some quantity of net output. The firms know of various processes for producing commodities in each sector of the industry. Given prices, including wages, they choose the cost-minimizing technique. In a situation of capital-reversing (also known as a positive real Wicksell effect) firms adopt a technique which employs more labor per unit output at a higher wage.

Now this adoption of a more labor-intensive technique might be swamped by the effect on the level of output. But, as far as I know, nobody thinks that the income effect of a higher wage can be relied upon to lead to a decrease in the quantity of final output sold. Nor do I see any reason to think those receiving non-wage income will systematically want to purchase more labor-intensive commodities than the commodities purchased by those receiving primarily wages.

A large literature explains the analysis of the choice of technique. The above explanation of the implications of the arithmetic of cost minimization is one (non-novel) element of some recent papers, for example:So much for the validity of the theory behind the claim that an increase in the minimum wage leads to a loss of employment at the bottom of the wage ladder.

Update: Originally posted 27 April 2006. Updated 9 December 2006 to reflect movement of White URL and inclusion of drawing.


Anonymous said...

Robert, I may have to read more literature to grasp completely what you wanted to say, but in the meantime - can you calrify, how the fact, that some firms choose voluntarily a production process which employs people with higher wages, contradicts the "classical" law, that if you FORCE all firms to pay higher wages, than they otherwise would, some marginal firms will end up with negative profit, which forces them to end with some activities which in turn produces unemployment.

In other words - if you force the 'vertically integrated' firms to pay more then they would in the 'higher wage' production process, do you think, there is 'yet-another-production-process' with even higher wages for the employees? How do you know there doesn't exist a marginal firm, that just does not have a spare strategy to cope with higher labour costs?

Michael Greinecker said...

I would say there are several ways to give an example where a higher minimum wage leads to more employment. The simplest one would be to assume a monopsonist employer, and I guess that´s the most plausible case.

There is a paper on the wrongs of teaching the minimum wage story:

Teaching the minimum wage in Econ 101 in light of the new economics of the minimum wage
Alan B Krueger. Journal of Economic Education. Washington: Summer 2001.Vol.32, Iss. 3; pg. 243, 16 pgs

Robin Hanson said...

Robert, I said "regarding a point estimate of an all-else-equal, causal long-run effect to be expected on overall employment from raising a minimum wage. ... I have asked around and found *no* economist who says that it is substantially positive." Have you found such an economist?

radek said...

But reswitching is a local result. Or do you really think that setting min wage = 1000$ would result in higher employment? That sucker DOES slope downwards sooner or later. And empirical work bears this out, Card and Krueger not withstanding (which is why I don't really buy into the monopsony story either, at least not in the here and now).

Robert Vienneau said...

Michael, thanks for the reading recommendation.

Robin, I can see why you would not want to discuss why higher minimum wages would be destined to cause higher unemployment. Anyway, I have found economists - see links in post - who don't see why firms would be any more inclined to hire less workers at higher wages than they would be inclined to hire more.

Radek, I don't see your point. If at least one commodity is basic in my favorite models, a maximum wage exists at which the interest rate is zero. Firms will not undertake production above that wage. Any switch point below that wage can be "perverse". I don't see why one would want to describe this as a labor demand curve that ultimately decreases.

h.e. said...

"The point of logic that makes the neoclassical theory unacceptable to post Keynesians is not the mutually agreed upon possibilities of reswitching or capital reversal, but the lack of an adequate causal mechanism for explaining the process of change. Without the specification of such a causal mechanism, no amount of empirical evidence will convince a post Keynesian, just as the empirical evidence that evolution had occurred did not convince scientists about the theory of evolution until the causal evolutionary mechanism was fully specified." Avi Cohen (1984), "The methodological resolution of the Cambridge controversies," Journal of Post Keynesian Economics, vol VI, No. 4.

"...we find no evidence for a large, negative employment effect of higher minimum wages. Even in the earlier literature, however, the magnitude of the predicted employment losses associated with a typical increase in the minimum wage are relatively small. This is not to say that the employment losses from a much higher minimum wage would be small; the evidence at hand is relevant only for a moderate range of minimum wages, such as those that prevailed in the U.S. labour market during the past few decades. Within this range, however, there is little reason to believe that increases in the minimum wage will generate large employment losses." Card, David and Alan B. Krueger (1995), Myth and Measurement: The new economics of the minimum wage, pg. 393.

dsquared said...

The really annoying thing is that the use of a "demand" curve encourages people to think that labour is consumed, and that the demand schedule demands on something resembling a family of indifference curves rather than a set of production functions (of course, even when you persuade people that labour demand is determined by production functions, you then have all the problems Robert identifies with respect to production functions).

It's a theory of the demand for masseurs and prostitutes, unless anyone can think of any other employees whose labour is consumed directly rather than as the result of a production process.

Russell said...

There are some levels of minimum
wage at which the loss of
employment is not discernable.
Unless you are willing to assert
that the demand curve is perfectly
vertical, with no slope at all,
then it is dishonest to say that
there is NO unemployment, or
worse, added employment.

Mike Fladlien said...

In his book, Greenspan's Fraud, Ravi Batra gives pages of data that supports Robert's statement. My guess is that sometimes a higher wage rate displaces workers and other times it increases employment. One would have to look at the aggregate to see the effects. A firm's resources are finite in the short-run. I agrue that an increase in the wage rate will cause a decrease in the demand for another resource if the firm is efficient.

Anonymous said...

I agree. Let's outlaw all jobs below £1000/hr -- then we'll all be rich!

dictateursanguinaire said...

@ Anonymous

hearty congratulations on having a grasp of logic and logical fallacies that is surely the pride of your kindergarten class.

Magpie said...

Radek's comment is quite useful, although perhaps in an unintended way.

"But reswitching is a local result. Or do you really think that setting min wage = 1000$ would result in higher employment?"

Let's assume his example. Then, reswitching is a local phenomenon. This means that there is at least one region where higher wages NEED NOT lead to a higher aggregate unemployment level. (Incidentally, note that this is a deliberately weak, conservative, formulation of the actual result: higher wages lead to lower unemployment within this region)

Maybe a large increase in wages (say, to $X, where X is somehow considered high; consider the hypothetical figure, $1000, Radek used as an exemple) would change this effect, as Radek suggests.

However, this is altogether different from the proposition that:

(1) higher wages INEVITABLY lead to higher unemployment, and;
(2) that this is trivially so.

And I submit that what one sees, at least in economic policy discussions, is both (1) and (2).

Further, I'd suggest that the discussion should center in determining empirically where those regions are. Using Radek's example: one would need to determine the dollar value of $X, say $1000.

And this most definitely is not what one sees in economic policy discussion...

Anonymous said...

Whoever wrote this is stupid and has no data to back up this crud up. Try owning a business where your largest costs are labor, then have some quacks come up to you and say its in your best interest to double the salary of your lowest wage workers who are unskilled, uneducated and come and go on a regular basis. If you double the wage of these workers, you'll simply just hire workers that are more skilled and more educated... those proponents of raising the minimum wage are lobbying themselves out of a job!

Robert Vienneau said...

I thank Anonymous for providing us with amusement.