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.