A National Minimum Wage probably should be set to reduce employment

Thanks to Alan Beattie at the FT for prompting me to think about this. He tweeted an extract from the mandate of the UK’s ‘Low Pay Commission’, which sets a UK NMW.  This extract states that the aim is to ‘recommend levels for the minimum wage rates that will help as many low paid workers as possible without any significant adverse impact on employment or the economy.’

My thought is that this is probably too conservative an objective for an aggregate minimum wage.

There are political motives one could attach to a minimum wage relating to wage inequality, or notions of a minimum that a country might want to tolerate based on what it views as civilised or just.

But the economic motive for a minimum wage is to counter rent extraction – exploitation is an ok word for it – by employers with monopoly power as buyers.  (Monopsonists, as they are termed).

The example I remember from British economic history modules is the idea of a ‘company town’.  A town whose job possibilities are dominated by one large employer.  And in an era when it is costly to travel to search for or attend employment in another location;  more costly than it is for employers to relocate to another town.  These circumstances allow (allowed) the company in the company town to bid down wages below workers’ marginal product.

The target of policy is the deficit of market wages below marginal product and not the deficit of wages below some aggregate level.  The non-exploitative market wage will vary by sector, firm, location, age cohort, qualification level and even by individual.

A policymaker with perfect information would tax the rent from the monopsonist employers and give it to the employees, and there would be no further consequence for employment.  (That is probably not strictly true as there might be knock on consequences in general equilibrium).  This may be where the wording in the Low Pay Commission mandate comes from.  But that policymaker would set as many minimum wages as there were individuals exploited.

For reasons of practicality – not least not having the requisite information or adequate enforcement – a single National Minimum Wage was chosen.  If, even for perfectly good reasons, one constrains oneself to a single aggregate minimum wage, I conjecture that it is not then appropriate to set a wage that has no discernible effect on employment.

Imagine a hypothetical wage distribution.  The further down we go, the more likely it is that we encounter wages that reflect some exploitation deficit.  At the top, no recorded wages are depressed by exploitation.  At the bottom, all of them are.  If we set the minimum wage equal to the lowest wage, it has no effect on employment or exploitation.  If we set it a fraction above the lowest wage, it transfers some rent from employers to employees, but has no effect on employment.

It does some good, with no harm.  It is not a Pareto optimal policy, because some exploiters lose out.

As we raise the aggregate minimum wage further into the next part of the wage distribution, we force up a lot of wages that were depressed by monopsony power, and force up a few that were not.  In making this step, policy has traded off the gains of the formerly exploited against the losses of those who were just low paid and are now out of a job (and of course against the losses of a new lot of exploiters covered by the increase in the NMW that we can presume most of us don’t care about).

If we raise the NMW further, we encounter the same trade-off.  But, plausibly, each further increment means less additional exploitation stopped and more competitively priced jobs lost.

At some point, the gains from raising the NMW further are more than offset by the losses of competitively priced labour.  Avoiding depressing employment at all is highly unlikely to be the right policy, unless the function we use to weight the winners and losers involves no say for the winners.

An optimally set aggregate minimum wage therefore involves a trade-off.  We need to push the minimum wage far enough up the wage distribution that the weight of exploitation is eliminated, at the expense of some employment.

For this reason – as pointed out by Jonathan Portes on Twitter – this is likely to be a tough thing to delegate wholesale to an institution of technocrats like the LPC, because they need instruction by politicians (which in a democracy we expect them to digest from our voting behaviour) about how they should weight the exploited against those who will lose their jobs.

Currently, the Low Pay Commission have a mandate written for them by the government, involving the avoidance of adverse affects on employment (not appropriate, if I am right), and choose a level for the NMW to ‘recommend’ which the government is free to alter or ignore.

A NMW level set so low as to avoid adverse affects on employment could be delegated wholesale to technocrats, but such a wage would be ineffectual.  The task of finding a higher level closer to  the optimal could not be delegated further, since LPC employees could not make the political judgements required to assess how many jobs should be destroyed.

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3 Responses to A National Minimum Wage probably should be set to reduce employment

  1. The above argument rests heavily on the “company town” example where of course the employer has monopoly powers. Trouble is that company towns scarcely exist. I.e. isn’t the reality that about 95% of the UK’s workforce live in or within “travel to work” distance of a large conurbation, where there are at least a thousand employers to choose from?
    I suggest the source of “exploitation” is in-work benefits. That is, every employer knows that if they cut the wages of the low paid by a pound, relevant employees will only lose about 10p because in-work benefits makes up the remaining 90p.

    • Forgive me if I’m misunderstanding, but I think the “company town” was used only to simplify the example. When you’re looking at the aggregate, it doesn’t matter if you have a single employer or a thousand.

      • Tony Yates says:

        Correct. Company town is the old fashioned textbook example. It highlights the mechanism: leverage over the worker who has limited information about, or resources to pursue search. The widespread finding that minimum wage policies have not adversely affected unemployment can’t be explained except by positing that there are rents extracted through this kind of leverage, even if it is not as extreme as in the company town example.

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