Higher wages, fewer jobs? It’s not that simple

January 30, 2015

By Stephen Koukoulas

The Institute of Public Affairs’ Chris Berg reckons set minimum wages are “creating a poverty trap”given the laws do not allow firms to pay a wage below the legislated minimum which at the moment is $16.87 an hour.

This is not correct.

In his article in The Drum, Berg rightly notes that the laws of supply and demand work in the labour market, and he refers to a range of research papers that conclude that if the price of labour is too high, driven by a minimum wage, then employers will “shrink their workforces” which means less employment and higher unemployment.

Like many other low-wage proponents, Berg looks at the market dynamics of the labour force only from the demand side; that is, how much labour firms will demand given a particular minimum wage. The higher the wage, the lower the demand for labour; and the lower the wage rates, the higher the demand for labour. The issue of supply, which is an individual’s willingness to supply their labour services for a given wage, is ignored.

The debate on wages and labour market flexibility needs to be framed around the fact that higher minimum wages increase workforce participation and when set with an eye to prevailing economic conditions, they increase the employment to population ratio.

Indeed, Australia’s recent economic history in the period around 2008 to 2010 shows that the high point for participation and the employment to population ratio coincided with high wages growth and exceptionally low unemployment. Minimum wages were not a deterrent to the unemployment rate hitting 4 per cent or the employment to population ratio hitting a record high of 62.9 per cent.

To try to make his point, Berg wondered what would happen if the minimum wage were $168.70 an hour and not the current $16.87. He said, correctly, that demand for labour would be very limited, but he ignored the prospect of many people who had been outside the labour force (retirement or study for example) offering to supply their labour services for that sort of pay. The participation rate would boom, even if most of the new entrants to the workforce would be unemployed. I mention this to emphasise that the supply and demand dynamics of the labour market cut both ways.

For the low wage proponents and using Berg’s musings again, how many workers would be willing to go to work if the minimum wage was cut to $8 an hour, or $4 an hour? What about zero dollars an hour, which is as ridiculous as the $168.70 Berg used to make his point. At these low wage rates, there is no doubt that demand for labour from employers would rise quite incredibly – firms would hire every possible worker at those rates, but how many workers would provide their services in such circumstances? At zero dollars, no one would.

This is the critical issue rarely, if ever, dealt with by those arguing against minimum wages.

It is also critical to note that periods of low wages growth generally coincide with falling workforce participation. Macroeconomic policy makers find this undesirable. The recent experience in the United States shows this all too clearly. The participation rate is currently below 63 per cent, down from 68 per cent before the financial crisis. Over these last seven years, wages growth has plummeted to rates at or below the inflation rate. In other words, low wages encourage people to withdraw their labour – stay out of the labour force.

In Australia, the same phenomenon is unfolding, albeit less starkly. The workforce participation rate has dropped by half a percentage point since late 2012 during which time annual wages growth has fallen from above 3.5 per cent to record lows of 2.6 per cent. Here is another example of workers reacting to disappointing pay prospects by withholding their labour.

There is a further critical element with minimum wage settings – savings to employers. When a firm is expanding and needs an additional worker, the minimum wage is the benchmark that it uses to hire extra workers. At the same time, the potential additional worker knows this wage when they apply for the vacancy. There is no expensive red tape for the business of drawing up specific contracts – negotiating the pay and terms and conditions with each applicant for the role – and there is no risk of disputes if the person successfully negotiates a higher pay rate than the existing workforce.

It would be time-consuming and expensive for large firms to negotiate with each worker on their appointment and as each contract came up for renewal. With a set minimum wage, this red tape is eliminated from the cost of doing business.

It is also possible that the minimum wage turns out to be lower than the worker might have negotiated with the employer if there was no set minimum wage. The more savvy negotiators might eke out a few extra dollars over and above the minimum which of course employers may be willing to pay without the guidelines of a minimum wage.

To suggest minimum wages are a path to poverty is emotive and arrogantly assumes workers will work for whatever pay is offered to them. Workers have some discretion to supply their labour or not, and if wages are too low, employment will be weaker and the economy poorer for it.