Krugman on the Minimum Wage

by Reihan Salam

Paul Krugman is very good at not linking to the argument he “takes on,” in part, I have to assume, because it would complicate his narrative. Today he’s written a post in which he “takes on” a mysterious and amorphous group of people.

It seems that more and more Serious People (and Fox News) are rallying around the idea that if Obama really wants to create jobs, he should cut the minimum wage.

Let’s find an actual person who has been talking about the effect of the minimum wage on employment, like Casey Mulligan of the University of Chicago. Note that most of the “Serious People” who are talking about the minimum wage make note of the following:

In July 2007, the federal minimum hourly wage was increased for the first time in 10 years, to $5.85 from $5.15. It was increased again a year later to $6.55, and increased yet again this July to $7.25.

That is, we’ve increased the minimum wage in the middle of a severe economic contraction. As Mulligan notes, Many economists expect the minimum wage, if it has any effect, to (among other things) raise employer costs and therefore reduce employment, especially among those who are likely to work in minimum-wage jobs, like teenagers and restaurant workers. But of course this isn’t necessarily true. In The Natural Survival of Work, economists Pierre Cahuc and Andre Zylberberg survey the empirical evidence on the minimum wage and they find that the effect of a minimum wage increase depends on a variety of other factors, as you’d expect.  George Stigler in a fundamental article published in 1946, had already explained why a rise in the minimum wage could increase the number of hires if “an employer has a significant degree of control over the wage rate he pays.” This slightly opaque sentence refers to the degree of competition prevailing on the labor market. Stigler had noted that economists were generally assuming that the labor market functions according to the rules of “perfect competition” when they pondered the effects of the minimum wage. In a situation of perfect competition, employers would engage in a fierce struggle to attract highly mobile manpower. … But reality seldom resembles this situation of perfect competition. … In reality, every employer thus holds a monopsony power from which she can benefit by setting a wage lower than the wage that perfect competition would have produced. … If the state then decides to set the minimum wage very slightly above the wage chosen by the employer, the latter sees her margin appreciably reduced. The margin does remain positive, though, and so there is no reason for the employer to let the employee go. But there is more: the increase in the minimum wage will give some people who are out of work an incentive to look harder for a job, and to consider offers they had previously turned down. We will then observe more people wanting to work, in order to get the minimum wage set by the state, than there had been who were willing to work to accept the (lower) wage chosen by an employer exploiting her monopsony power. … Alas, this sequence cannot be reiterated indefinitely. Each new increase in the minimum wage attracts new workers but reduces the margin of benefit on those already employed. If the state continues to increase the minimum wage, some workers will wind up costing more than they bring in, and they will then be let go. That is, a rise in the minimum wage will have different effects depending on the structure of the particular labor market. This is not an ideological argument made by “Serious People” and “Fox News.” It is made by economists who study actual labor markets. Now back to Paul Krugman

So let me repeat a point I made a number of times back when the usual suspects were declaring that FDR prolonged the Depression by raising wages: the belief that lower wages would raise overall employment rests on a fallacy of composition. In reality, reducing wages would at best do nothing for employment; more likely it would actually be contractionary.

Here’s how the fallacy works: if some subset of the work force accepts lower wages, it can gain jobs. If workers in the widget industry take a pay cut, this will lead to lower prices of widgets relative to other things, so people will buy more widgets, hence more employment.

But if everyone takes a pay cut, that logic no longer applies. The only way a general cut in wages can increase employment is if it leads people to buy more across the board. And why should it do that?

Who exactly is suggesting that we mandate an across-the-board wage cut? Krugman is obviously presenting a stylized example here, and that’s fine. The real question is whether suspending or rolling back the last minimum wage increase might prove beneficial to teenagers, ex-offenders, and other workers with marginal attachment to the labor force. The answer isn’t obvious, but there is good reason to believe that lowering the cost of employing these workers might increase their level of attachment, and that would have all kinds of salutary consequences. There are a variety of ways to lower the cost of employing these workers, including payroll tax cuts and wage subsidies. But giving states more discretion to set their own wage floors is one straightforward approach.

 Then again, we can just hurl random insults and oversimplifications. Why not?

The Agenda

NRO’s domestic-policy blog, by Reihan Salam.