Three Cheers for the Minimum Wage

I’m taking an econ class for my MBA program right now, and we covered minimum wage. The intro econ view is that the labor market is like all efficient markets. There is a labor supply curve, and a labor demand curve, and there is an equilibrium price. 

There is also a wage floor, the minimum wage. I’m pretty left wing, and I know that some of my own peers are too, and they seem to have drunk the Kool Aide on the problem with the wage floor – that being it created structural unemployment.  This has distressed me.

So I was thinking about the problem with intro econ stuff, namely that it is a vast simplification and has a lot of normative biases towards conservative leanings. There’s a saying in econ circles to counter Colbert, that “Facts have a conservative bias.” That is true, but only at the level of simplification.

What econ as taught, at least in the intro econ classes I’ve had, doesn’t talk about enough is the simplifications that have taken place to illustrate the concept. The example here is the labor market.  The labor market supply and demand curve intersection graph assumes four big things that are not true. First is that all workers are the same. Second is that all jobs are the same. Third that there is no such thing as search and the markets clear.  Finally, they assume that there is no government to act as an agent of redistribution. 

That’s just not true.  There are many labor markets, and for most the equilibrium price is above the wage floor, so the wage floor only sets a standard. Those where the wage floor is above the clearing price, the jobs and the pay are horrible. A government should step in, as ours does to a limited extent, to make better the lives of those workers who work and those who are locked out of the labor market through structural unemployment. The problem is that a certain party has demonized those at the bottom of the wage scale, calling them takers are welfare queens. That means people want to work; there is a cultural and monetary advantage to working where there is not to just relying on benefits.

The other option is to look at the labor markets that do clear. Here I’m thinking of migrant farm workers. They are paid less than the minimum and have no guarantee of employment. When Alabama cracked down on undocumented workers, farmers couldn’t get people to harvest their fields because the national market price of farm labor was too low for people used to some labor protection. The jobs are that bad. That’s why I think a minimum wage is good, because it helps pull those shadow wages up, and there is less poverty overall with transfers even with structural employment.

Overall, the question should be about the appropriate level of the minimum wager, and stricter enforcement of wage and labor laws, not less.


Addendum, 12/7/2014

Another problem popped up in Facebook reply to a former student of mine: The other problem. The econ 101 view is also a market with perfect information. The employer has an information asymmetry in that area, in that it knows more about the labor market than the potential employee -- this is helped in some form by sites like Glassdoor, but it is imperfect. There is also the power gradient in that the employer can take someone down to the clearing price, but in some labor markets it is not possible to live at the clearing price for labor. Thus the government-mandated wage floor.

Data in Economics

Economic indicators are useful and reliable for predicting the future state of the economy as long as they have been collected long enough with the same methodology. At that point, it is possible for economists to look at the overall trend of the indicator and then to look at the pattern in the past. For example, Figure 4 is the four-week moving average for jobless claims.

Figure 4

There is a lot of useful information to be gleaned from figure four. Looking at the current state of the jobless claims, it looks as if the state of the economy is strong. People are not losing their jobs at a rate that existed in recent memory. The problem is that the past does not necessarily reflect the future. The current trend is down, which in isolation is good. However, looking at the graph shows that the current level is also near the lowest jobless claims have come since the early seventies. The question then is if the localized trend is the prevailing trend, and the jobless claims will keep going down, or is the larger cyclical trend the stronger part of the equation, where the current economy is at its localized peak. If the short-term trend prevails, then businesses can use that information and invest because the economy is only getting stronger. If the long-term trend prevails and the economy is at a natural low, then it is time to retrench because jobless claims will go up, then unemployment will increase, and then GDP will shrink.

            The jobless claims are just one indicator. By having more information, and having more indicators, then an economist can look at all of the information and discern the larger patterns and even fit the current information to which past economic situations were more like the current one. Total information awareness can only help professionals use this data and harness the predictive force of the economic indicators. Of course, even with all the information and all the historical examples, even the best-trained scientist can be wrong but overall tracking this various data has been smart for the country and has helped the government and the central bank make good decisions by moderating the business cycle. Modern macroeconomics was born of the great depression, and so far has prevented another one from happening. It would not have been possible without good data.

More, Not Less Government

           The federal government’s largest expenditures are on insurance and defense. Through Social Security, Medicare, and Medicaid, the federal government takes care of the sick and poor old. Through the Departments of Defense, State, and Homeland security the people of the United States are protected from outside threats. So much of what people would like to remove for their own ideological ends are rather incidental when it comes to the overall budget. Some on the right are not fans of the Federal Reserve or the Departments of Education and Energy. Some on the left would see the Defense Department or the various law enforcement agencies shelved.

            One problem is that politically, none of the agencies will be closed even if a large number of people wanted them to be. There are so many incumbents who will rise to protect their own turf and justify their position’s existence, even if there are duplications over what they do and another person does – and they both draw paychecks from the federal government. The other problem is that some point along the line there were debates on certain expenditures that were justified at the time and the expenditures were voted on through our democratic process, no matter how messy it is. So we have the government in the citizen’s lives in so many ways that the government is just part of the air to be breathe instead of an intrusion – see the worries about the government involvement in health care and the old woman wanting the government to take their hands off their Medicare.

            This is important, because even though looking at the budget and wanting to strike through different line items, it illustrates an important point. The government is not some separate foreign body, but the government at the federal level is the agent of the people as a whole. The government is the collective will of the people. By banding together, government leverages the money and the abilities of the collective to build roads and to defeat Hitler. That is not to say that sometimes the leaders of the government forget that they are serving at the will of the people and not at their own will. Fewer bullets should be bought for the soldiers and fewer soldiers should draw paychecks, but the people need protection and to say otherwise would be utopian dreaming.

            The debate is what levels of spending should there be and where to prioritize that spending. Could the federal government spend less on defense and keep us safe? Most likely it could be. The real question is where the government is failing to provide goods where it could be the most efficient provider. The most obvious is in education. Most schools for primary and secondary levels are funded at the local level. Tertiary education had been funded largely at the state level with assistance from the federal government in terms of subsidized loans and direct grants. The issue is that the federal government uses these loans not as a cost center, but receives income from them when their rates are greater than what the government can borrow for.  The current state is that the cost of education is born by the individual. The problem is that it lowers spending on goods and services and prevents household formation. If the federal government would instead fund education directly, youth would have a better start to their lives instead of worrying about an overhang of debt. By investing in human capital, the government could make the country better down the line by making it more productive and more capable. This could come from all new spending or it could come from cost shifting in a shifting of some priorities.

Overall, there is no one place the federal government needs cut. Government is good, and there is not enough of it.

The Keynesian Cross

The figure below shows a simplified representation of an economy with a fixed price level, no government, no net exports, and a fixed interest rate. The simplification is done to illustrate the relationship between consumption and business spending in investment. At all points on the blue line, aggregate expenditure equals the planned aggregate expenditure that in this model equals GDP. The red line is the planned aggregate spending, represented by the consumption function (fixed spending plus the marginal propensity to spend times free cash). It is a line with a slop that is the MPC with a non-zero Y-intercept that is the fixed spending plus planned investment (Krugman & Wells p. 330).

Figure 3 adapted from Krugman & Wells p. 330

            These two lines only intersect at point E, and the spending at point E is known as Y* or the “income-expenditure equilibrium GDP”. At all other levels of real GDP, there will be an adjustment that businesses have to make. They will have to adjust their investment with an unplanned component. This unplanned component can be positive or negative, as represented on the graph by letters A and B on the x-axis.

            At point A, the level of planned business investment is greater than the 45-degree line, or real GDP. This will cause the unplanned component to be negative, and it will force real GDP to rise, as businesses have to replenish their inventories. Conversely, at point B, the level of planned business investment is below the 45-degree line, meaning the unplanned component of business spending is positive. Businesses are creating a surplus. In both situations, there will be a move towards equilibrium. If the economy is at point A, then businesses will have to replenish their inventories and that will grow the real GDP. If the economy is at point B, then the economy will have to slow down, lowering the level of real GDP as it moved back to point E, where the aggregate spending and the GDP are the same (Krugman & Wells p. 330).

Plugging the Inflationary Gap

The figure below represents an economy that has grown so quickly that the aggregate demand has been pushed to the right, beyond the long run aggregate supply curve. AD₁ represents the current state of the economy. It intersects with the short run aggregate supply curve at E₁. The intersection means that the overall price level has increased from what would be it is equilibrium level where the aggregate demand, the long run aggregate supply and the short run aggregate supply curve would all intersect at point E₂.

Figure 2 adapted from Krugman & Wells, p. 381

            The current equilibrium has raised the price level so that the economy is undergoing a period of inflation. To move the economy from the equilibrium from the point E₁ to E₂, the government in charge of this economy needs to undergo some contractionary fiscal policy to move the aggregate demand curve from AD₁ to AD₂, making the equilibrium point meet the line of potential output instead of outpacing it.  There are several options that this government has to enact its contractionary fiscal policy. One option is to decrease the amount of direct government purchases of goods and services. Another option is to increase taxes so that consumers have less money to spend. A second way to limit money in consumer hands would be to decrease the amount of transfers the government sends to consumers (Krugman & Wells p. 381).

            All three options would have the effect of lowering the aggregate demand so that the economy would be able to cool off and the period of inflation would dissipate, moving the aggregate demand curve to the point where the equilibrium point is on both on the short run and the long run aggregate supply curves.