Winner of the New Statesman SPERI Prize in Political Economy 2016

Thursday, 23 July 2015

Raising the minimum wage

It is fascinating when two highly respected, internationally known economics professors at London universities (LSE and UCL) disagree about a policy on which they are both experts. The policy is the increase in the national minimum wage (NMW) contained in the last Osborne budget. The disagreement is not the one you might expect, and nor do I think it reflects underlying differences (if any) in the politics of the two individuals. 

The debate is often between those who appeal to standard theory that says raising the NMW must reduce employment, and those who appeal to the evidence which says this hardly happens. But in this case the theorist, Alan Manning, is arguing for the policy of a higher NMW, while it is the empiricist, Steve Machin, who disapproves of the policy.

Let’s start with Machin. As well as having published work on the impact of minimum wages, he also sits on the Low Pay Commission (LPC) which before the budget was responsible for setting the minimum wage. In a letter to the FT, together with another academic member of the LPC Robert Elliot, he writes:

“The path of the NMW has until now been determined by careful and considered recourse to the evidence. The chancellor has at a stroke removed the rationale for the LPC and ensured that the path of the NMW will be determined by the priorities of whichever party forms a government.”

Although the argument here is essentially about the politicisation of setting the NMW, you could argue that he is also implicitly suggesting that by setting a NMW substantially above levels recommended by the LPC Osborne will do more harm than good.

Alan Manning is a pioneer of the theory of monopsony applied to the labour market. The idea here is that the employer has considerable power over the employee. The example normally given is that of a large employer in a small town, where the opportunities to the employee to find alternative work are limited or very costly. However Manning argues that monopsony is more generally applicable. In his book on the subject he writes

“The existence of [labour market] frictions gives employers potential market power over their workers. The assumption that firms set wages means that they actually exercise this power.”

The kind of frictions he has in mind are the time, effort and costs involved in finding a new job. Of course the employer faces similar costs, but Manning argues they matter more to the worker than to the firm. This means that wages can be above or below the level they would be under perfect competition with no frictions, and the greater power of the firm means that in practice they will be below. As a result, the outside imposition of a higher wage will not necessarily lead to lower employment, but may simply alter the way the ‘rent’ caused by labour market frictions is split between employee and employer. [1]

This theory does not, of course, suggest that minimum wages can be set without limit, but Alan Manning is suggesting that the evidence is not strong enough to say that Osborne’s proposal goes beyond those limits. He does not pretend to know that the LPC has been wrong to set a lower NMW. Instead he argues that sometimes it is good to experiment. He writes:

Evidence-based policymaking does require experimentation with policies whose effects are unknown otherwise one simply preserves the status quo. It is as important to try new policies that one thinks have benefits as to have stringent ex-post analysis of those policies. I think the new policy is one well worth trying but I don’t pretend to know that there will be no substantial adverse effects.”

He argues that this experiment will give the LPC a new lease of life as it evaluates the results of the experiment.

I have no clear idea who is right. However we can make some progress by looking at which industries employ most on low pay. James Plunkett has a nice diagram here, and he argues that most sectors can easily afford to pay higher wages without reducing employment (or more precisely, that at the moment the rents that come from labour market frictions are mostly taken by the employer): sectors like retail or food and beverage services. An exception is residential care, but as he and Manning note, the price for these is largely determined by the government.

I agree with Machin that it is good to delegate complex economic issues like setting the NMW to expert bodies like the LPC. However it is also difficult to imagine such institutions ever saying why don’t we take a risk and do an experiment. It is also significant that the political intervention in this case does not fit the natural inclinations of the political party in power. In this case who turns out to be right will depend on whether this intervention is a one off or becomes a habit, and the reaction of whoever is Chancellor if the LPC judges the experiment to have failed.  

[1] An alternative argument is that both employer and employee will reap benefits from higher wages, because these will encourage higher retention and productivity. These efficiency wage arguments are discussed by Ben Chu.



39 comments:

  1. Following Manning's argument, the Chancellor could have done even better: he should have changed only the minimum wage and do nothing else, and preferably do so only in every other neighbouring county. This would have fulfilled many empirical economists' dreams :)

    On a more serious note: in the minimum wage debate, nobody seems to care about consumer welfare. It is fine to note that nobody gets sacked but then customers get to share much of the burden in terms of waiting times, pubs not serving food in the afternoon, or by being effectively employed as low-skilled labour at checkouts. In xenophobic Britain, it might be preferred that brain surgeons rather than immigrants work as cashiers but there is a clear role for welfare improvement there which is prevented by the minimum wage. In terms of the UK unemployed, having to be up at 5am and sober seems a bigger barrier to labour supply than the monetary gains from working which don't change that much anyway given that tax credits are taken away.

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    1. http://johnhcochrane.blogspot.ch/2015/07/minimum-wage-and-mechanization.html?spref=tw&utm_content=buffer38d38&utm_medium=social&utm_source=twitter.com&utm_campaign=buffer

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  2. My take is that this power definitely exists.

    Even in a 5-employee company, having a worker leave only 'costs' 20% of functionality, yet for each worker their wage will be near 100% of income.

    Plus, of course, surplus workers don't do the correct thing, market wise, and drop dead, thus removing themselves from the pool of labour. (Selfish, I know). This creates a near permanent oversupply of labour, made worse by government policies designed to push people into work. Imagine a situation where widgets were in oversupply, but widget factories were kept open even when they were not producing any widgets. The result would be widget prices probably below the production cost... and treating labour the same, people finding that jobs at the more easily replaced end of the spectrum not paying enough to live on.

    So - assuming a basic respect for human life and dignity - there have to be interventions in the labour market. Deliberate full employment policies, and/or deliberate redistribution.

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  3. I read somewhere that had the American minimum wage kept up with productivity growth it would be worth $28 per hour instead of $7-8 per hour. That's the problem in manufacturing industry it's relatively easy to keep wage growth in pace with productivity growth, however since we are now mainly a service economy, that becomes very much more difficult , (you cannot serve more coffees if no one comes into your shop).
    Employment is generally dynamic , this recession being unusual in that employment did not hit the high levels associated with previous recessions. Could we now be seeing the down side of having abandoned our once mighty manufacturing base, lower wages , poor prospects , part time contracts , zero hour contracts , more and more jobs relying on the minimum wage to even think about surviving, let alone living well.
    Whatever happens Ossy has pulled yet another dead rabbit from his thread bare hat.

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  4. Why is the monopsony argument (or Chu's productivity one) specific to wages at the bottom end? If we really believed it, surely the best policy response would be for the state at (unpredictable) intervals to legislate that everyone gets, say, a 10% payrise?

    The policy and the arguments being made to justify it don't seem to me to line up.

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    1. Go read a textbook: Single buyer and multiple sellers. Seems reasonable to me. At the "top end" the argument reverses. CEOS have all the bargaining power and it's a ceiling that should be applied not a floor.

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    2. I agree that the situation reverses at the top, but in the middle? This is actually a potential argument in favour of unions. While the cost of replacing an individual to the firm is small, so the firm gets the frictions rent, the cost of losing the entire workforce for a time is much greater. The problem of course is when unions push this advantage too far, and do more than just capture the rent.

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    3. Shmagnus

      I well understand how it will reverse at the top (CEOs pose specific problems of corporate governance I would have thought. Premiership footballers are a better example).

      I was actually thinking, selfishly I admit, of myself. in asking.

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    4. Is demarcation a (partial) answer?

      If you push up the bottom, you'll have to pay the next rung up more, and so on?

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    5. SW-L
      "The problem of course is when unions push this advantage too far, and do more than just capture the rent."

      Is there any known case of that?

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    6. I think many labour market economists would argue, based on empirical evidence, that the apparent rise in the natural rate of unemployment in the UK until the 1980s was partly due to growing union power.

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    7. Or maybe due to women entering workforce,
      Maybe due to union enforced entrance to proffessions,
      Also maybe that many rural unemployed finaly got to enjoy urban benefits of unemployment by allowing ther eligibility
      There was a lot of institutional changes at the time to expand eligibility to all more equally.
      What was the labor participation rate doing at the time?

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    8. "I think many labour market economists would argue, based on empirical evidence, that the apparent rise in the natural rate of unemployment in the UK until the 1980s was partly due to growing union power."
      Hmm the "natural rate" of unemployment. Ya think. Better ask Bill Mitchell ;)

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    9. The name of this concept is, I admit, poorly chosen, but its interest nonetheless stands. Even if it is a theoretical construction with a rather peculiar use, its measure and the evolution of this measure still brings in stylized facts to a certain extent. Science without facts is not science, it is philosophy.

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  5. Labour is at a disadvantage vs capital because year on year there's always more labour. Shrink the labour force - lower worldwide populations - and you will see how quickly the advantage returns to labour.

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    1. If I am not mistaken, the explanations typically revolve around specialization, policy changes and biased technological changes. Moreover, capital also grows. All you need to verify that are lengthy investment series, lifetime series (I don't know how to call them them, but they indicate how long a typical equipment lasts) and basic knowledge of difference equations -- and you hypothesize equilibrium value at time zero to be able to isolate capital.

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  6. You say that "the political intervention in this case does not fit the natural inclinations of the political party in power". Au contraire.

    The LPC has historically been cautious about the NMW, however it was genuine a site of contest between the interests of employees and employers. By making the wage level a matter of government discretion, Osborne is decisively shifting the bias towards the interest of employers, so the short-term levy on their "rent" should be seen as the price of increased control (and that's without taking into account the offsets in benefits and corporation tax).

    Over the longer term, "business confidence" will surely exert an even stronger downward pressure on the minimum wage, and that will be the case whether it is a "business-friendly" Labour government or a Conservative one. This move is entirely consistent with Tory strategy in that it moves the definition of "affordability" from evidence to sentiment, much as has been done with the national debt.

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  7. If an increase in the minimum in fact only "alter[s] the way the ‘rent’ caused by labour market frictions is split between employee and employer" won't this still have the affect of causing workers at the margin not be employed who otherwise would be employed ?

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  8. Surely people will realise that Osborne is taking money away from their annual salary by this jiggery-pokery, rather than the hypothetical £4,000 plus they have lost by electing the Coalition rather than Labour in 2010?

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    1. Which £4000 is this? A magical Labour promise they have no problem making now they are not in power? I don't remember them more than doubling the income tax threshold for the lowest paid in their 13 years.

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  9. There is an additional argument in favor of the rise in the NMW, depending of course of the increase in wages: Economies have the driving corporations or sectors, that haul the often less sophisticated sectors. The driving sectors have wages well above the MW so the effect is in the lower echelon, but these sectors are mostly non tradable, and wage increase will affect to all of them in the same way.

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  10. Simon,

    As a suggestion for your next post, how about a reply to this utterly ridiculous piece by James Bartholomew in the Spectator (link below) entitled - wait for it -

    "British economics graduates have left a trail of misery around the world"

    Which contains such pearls of wisdom as this:

    "Varoufakis was a product of British universities. He read economics at Essex and mathematical statistics at Birmingham, returning to Essex to do a PhD in economics. With the benefit of his British university education he returned to Greece and, during his short time in office, obliterated the nascent recovery. "

    At which I'm not sure whether to laugh, or weep.

    http://www.spectator.co.uk/features/9589072/how-british-universities-spread-misery-around-the-world/

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    1. That kind of silliness does not deserve a response. I might be tempted to write something similar about the British army and corrupt African dictators, but I have more important things to do.

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    2. I can understand how you feel, Simon.

      But if you did, it would give lots of us pleasure.

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  11. There is an experiment in the US as New York and other government raise the minimum wage.

    http://www.nytimes.com/2015/07/24/opinion/a-big-victory-for-fast-food-workers-in-new-york.html

    The “Fight for $15” effort for higher pay won a major victory on Wednesday, when a wage board formed in May by Gov. Andrew Cuomo proposed raising the minimum wage for fast-food workers in New York to $15 an hour. The increase would be fully phased in by the end of 2018 for workers in New York City and by mid-2021 for those in the rest of the state. Currently, fast-food pay in New York is about $9 an hour.

    Under New York law, the governor can appoint a wage board, composed of business, labor and public representatives, to recommend raises in occupations where pay is judged to be too low to support a basic living; the state labor commissioner can then order the increasewithout legislative approval. In the past, the process has been used to raise pay for tipped workers and young workers.

    The acting labor commissioner, Mario Musolino, is expected to promptly approve the board’s recommendation, which applies to about 140,000 workers in New York, who are employed by restaurants with 30 or more locations nationwide.The first of the incremental increases — to $10.50 within the city and to $9.75 elsewhere — is expected in December.

    ...

    Pay has long declined or stagnated for the vast majority of workers, with low-wage workers particularly hard hit. Three major cities — Seattle, San Francisco and Los Angeles — have enacted minimum wages of $15 an hour. With the pay raise to $15 an hour for fast-food workers, New York will join their ranks and provide momentum for more victories to come.
    '

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    1. I believe pay is set more by politics and bargaining power than by supply and demand. Plus with economies suffering from a lack of aggregate demand, increased incomes for those with the marginal propensity to consume will increase demand and possibly spur the growth of employment in other industries.

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  12. See this comment on the minimum wage.

    http://www.nytimes.com/2015/07/17/opinion/paul-krugman-liberals-and-wages.html?rref=collection%2Fcolumn%2Fpaul-krugman

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    1. Yes the American consensus on the left seems to be different. In other words, academics already studied experiments.

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    2. I think neither of you have read this post properly. It is not is the NMW a good idea, but about how it should set - should we set it higher than the evidence suggests?

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  13. "The problem of course is when unions push this advantage too far, and do more than just capture the rent."

    This is a weird statement.
    The production cost is income and therefore demand and therefore profit producing function.
    Supply is afected by demand and at the same time demand afects supply. Demand and supply are in circular feedback.
    Just as the cost of production is the source of demand.

    Increased wages increase demand and employment, or in other words, it increases investment which creates aditional demand.

    It is really strange statement that unions can go too far, especially from a leftist economist as presented.

    If it still not clear what i wrote there let me use hypothetical example.
    Imagine an island state with fixed population, fixed supply of money and a single company that produces all that population needs.
    What is the fiscal source of demand for products of the company?
    Only what company spends is how much people can buy.
    Total cost of production is total income of the island. So if wages increase, that will increase income and people will buy more, inflation eats away any increase but only in given time depending on velocity of money. Usually, the both increase at the same time, velocity and inflation but people produce and consume more then before.

    That is the point, unions can not go to far by demanding higher wages because that will also increase profits automaticaly.

    Credit enters the picture and afects constricion of fixed money supply... there is a lot to learn from expanding this hypothetical simplified story.

    But, total wages (income/cost/demand/investment/spending) is the function of profit.
    This leads to something of a fiscal theory of prices, wages, incomes, investment i.e. economy.

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  14. Worth noting that as Osborne's minimum wage raise is to be staggered over the 5 years, it only outstrips a conservative estimate of the LPC reaction to inflation etc. by a small amount.

    The 2020 end state difference is about 5%, IIRC. That of course is not nothing, but it's hardly ground-breaking. Esp. once you factor in the tax credit changes...

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  15. It is difficult to expirement at a national level. But in the US where labor mobility is by far the largest (though not as much when I was a kid in the 70s) in the OECD.

    So now Seattle , LA, and New York are enacting 15 dollar an hour min wage. Is McDonald's in NYC gonna close up shop? I'd bet no. But if these laws hurt employment opportunity you would expect immigration to states like West Virginia.

    Of course these are prestige cities, people want to live there. But at least workers there can survive. Costco pays way better than Wallmart and does well. Same with In and Out which the best fast food burgers

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  16. I'll raise again the obvious point that a significantly *national* higher minimum wage will have a significantly different impact on UK north and UK south, and will boost significantly migration to the south of the UK both of northern UK job seekers and foreign job seekers, and especially illegals.

    In other words it will support residential property prices and rents in the UK south and undermine employment in the UK north:

    * Many more low end jobs in the UK south are *already* at the new minimum wage than in the UK north. By effectively raising the cost of labour in the UK north but not as much in the UK south it will reduce significantly the incentive for businesses to hire more workers in the UK north.

    * By driving more employment to the UK south at the same or higher wages it will put even more pressure on the existing (and not growing) residential property in the UK south, so that much of the benefit of higher minimum wages will be boosting residential property rents and thus prices.

    This at the same time as social insurance cuts will hit mostly the UK north.

    UK governments do evaluations on regional and distributional impact of their policies...

    But like trade balances, regional impact is "not a thing" for Economists. :-)

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  17. We know how to get full employment regardless of the minimum wage

    The first issue must be that minimum wage should be a living wage

    After that figure it out

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  18. Large swings in wages may effect small changes in product price -- and very little or very much change in profit. If labor is 10% costs and ups that price 50% (5% more cost), sales and profits may suffer 5% -- but labor is way ahead while the firm is not much harmed. Conversely, If labor costs are 15% and the firms can squeeze 5% (33% cut) out of that the firm may double profits at the same product price.

    Labor must sell what it has to offer every day or what it offers disappears. If labor does not sell what it has to offer labor itself may disappear (into the "workhouse").

    Given the giant incentive to squeeze labor costs and labor's intrinsic vulnerability in the market -- some mechanism(s) must be put in place to give labor an chance to extract the highest price the market (truly meaning the CONSUMER) will pay for its efforts. Which means collective bargaining function and/or a sensibly calibrated minimum wage.

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  19. It only took a week for the Chancellor's announcement of an increased minimum wage to cause a rise in unemployment.

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  20. «some mechanism(s) must be put in place to give labor an chance to extract the highest price the market»

    A large number of rentier voters in the South have the opposite wish: to give employers a chance to pay labor the lowest price it can. Consider pensioners, property owners, mortgage debtors, investors, especially investors in margin: to them everybody else's wages are a cost, or the risk of wage rises pushing up inflation and then interest rates.

    Government policy in the past 30 years has been to satisfy the interests of those rentier voters in the South.

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  21. Surely in a competitive market the monopsony 'rent' would not go to either the employee or the employer, but to the customer. In such a market an increase in costs (from whatever source) must lead to an increase in prices, hence a reduction in demand, hence less employment.

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  22. Monopsony is awkward word for what manning book is about, which is search frictions with random matching and no scale economies to recruitment.

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