Orthodox Economic Arguments against the Minimum Wage

Orthodox Economic Arguments against the Minimum Wage

Stephen Rojak McKinney, Texas

Abstract

Orthodox economic theory, taught to thousands of undergraduates, states that minimum wage

laws cause unemployment for the very people they are designed to help. Many economists also

argue that the minimum wage represents an unwarranted government intrusion into private

market relations. This paper examines the assumptions that underpin these claims and tests the

validity of the conclusions on that basis.

Orthodox Economic Arguments against the Minimum Wage

Traditional arguments against the minimum wage rest on one or both of these assertions:

1. An employment relationship with a commercial firm is by nature a private

enterprise, and the establishment of a minimum wage by the government is an

intrusion by the government into what ought to be a private agreement between

employer and employee.

2. Establishment of a minimum wage causes, through the market mechanism of supply

and demand, unemployment among the very people that minimum wage laws are

meant to help.

These assertions are also supported by others which are worthy of examination:

3. The management of a firm makes business decisions with the single purpose of

maximizing profit.

4. Because the management of the firm acts in a profit-seeking manner, its actions are

not arbitrary or capricious, but are dictated by the realities of the business

environment.

5. The worker is a full participant in the market, able to enter or leave the market in

response to price signals.

The 1992 study by Card and Krueger attempts to justify minimum wage laws within the

above framework:

Contrary to the central prediction of the textbook model of the minimum wage, but

consistent with a number of recent studies based on cross-sectional time-series

comparisons of affected and unaffected markets or employers, we find no evidence that

the rise in New Jersey's minimum wage reduced employment at fast-food restaurants in

the state. Regardless of whether we compare stores in New Jersey that were affected by

the $5.05 minimum to stores in eastern Pennsylvania (where the minimum wage was

constant at $4.25 per hour) or to stores in New Jersey that were initially paying $5.00

Orthodox Economic Arguments against the Minimum Wage 2

per hour or more (and were largely unaffected by the new law), we find that the increase

in the minimum wage increased employment. (Card, 1994, p. 792)

As might be expected, other in the field challenged these findings on both methodological

and theoretical grounds. James Buchanan wrote in 1996:

Just as no physicist would claim that “water runs uphill,” no self-respecting economist

would claim that increases in the minimum wage increase employment. Such a claim, if

seriously advanced, becomes equivalent to a denial that there is even minimal scientific

content in economics, and that, in consequence, economists can do nothing but write as

advocates for ideological interests. (quoted in Leonard, 2000, p. 137)

However, Thomas Kuhn explained that even natural sciences do not experience consistent

linear progress. In his landmark 1962 work The Structure of Scientific Revolutions, he observed:

No process yet disclosed by the study of historical study of scientific development at all

resembles the methodological stereotype of falsification by direct comparison with

nature. … The decision to reject one paradigm is always simultaneously the decision to

accept another, and the judgment leading to that decision involves the comparison of

both paradigms with nature and with each other. (Kuhn, 1970, p. 77)

The analogy to the development of physics is not entirely merited. We lack an alternative

paradigm to the standard orthodox model of supply and demand. Perhaps we should really make

the comparison to a physicist in 1870 claiming that a body in space does not experience ether

drag.


The Orthodox Economic Theory of Minimum Wages

We analyze the market for low-skilled labor in terms of supply and demand. Figure 1

illustrates this.

Figure 1. Minimum Wages in Theoretical Market

If the equilibrium wage were above the minimum wage, the minimum wage would be

superfluous, as it is for more highly skilled workers. Since the minimum wage is above the

equilibrium wage, more workers are drawn into the market through the price signals, while

demand for labor is reduced. Therefore, the artificial price floor that is created leads to

unemployment, because a condition of excess supply is created and the market cannot clear it by

responding to price signals. To be sure, the Q1 workers who do obtain work are better off,


because they receive a wage rate that is Wmin instead of WE, but there are Q2 – Q1 workers who

are out in the cold.

It should be noted that these curves are abstract. This is the textbook explanation, and the

textbook that I had as an undergraduate offers it (Mansfield, 1982, p. 380).

But does the theory correspond to reality?

The Labor Supply Curve

The labor supply curve assumes standard commodity supply characteristics. Suppliers

respond to price signals, increasing or decreasing the amount of the good provided. In this case,

the good is low-skill labor.

However, what is the big picture here? If we observe a low-skilled person who is idle, how

do we respond?

1. “Apparently he has withdrawn his services from the market in response to price

signals.”

2. “That person is a layabout and should be working for whatever he can get.”


I have yet to hear response #1 under any circumstances.

Figure 2. Supply Curves for Low-Skilled Labor

Thus, the traditional upward-sloping supply curve is not warranted for this population.

There is only one allowable quantity of labor that can be on the market: all of it. Figure two

shows the comparison between the supply curves. The actual supply curve from conditions we

will tolerate is Smoral.

Justification of this supply curve does not depend on any claim that the low-skilled laborers

are economically coerced into the market. We simply ask what the laborers live on if they

respond to price signals and withdraw their services from the market. This population is not

making enough to permit substantial saving, so they typically do not have a savings cushion to

draw down when not working. Do they go on public assistance? This was never envisaged as a


means of supporting people who could work, but who could not obtain what they considered to

be a satisfactory wage. Only if we are willing to accept a revision of our norms to permit workers

to use public assistance to support such withdrawal of services could we claim that price signals

are available to laborers in this market. I am not recommending this change, but without it the

assumptions behind Smarket are utterly invalid.

Figure 3. Market with Corrected Supply

Thus, the supply curve Smarket does not accurately reflect supplier conditions. Figure 3

shows the market with the supply curve replaced by Smoral. There is still material unemployment

created by the artificial wage floor, but there is also substantial improvement in the conditions

enjoyed by the Q1 people who are working.


How Are Wages Determined?

One could easily graduate from an economics program and emerge with the belief that

firms are monolithic entities whose managers have a group mind and act with singleness of

purpose, striving for financially measured results with a laser focus. This is not the way business

actually works.

Firms do not hire; people do. A firm is completely dependent upon the managers who act

as its agents. The individuals who make decisions and have command over resources have their

own purposes as well as those of the firm. They blend purposeful, rational pursuit of financial

goals for the organization with plans for personal advancement. A manager integrates business

realities with her worldviews and her expectations of other people.

A firm is also a social setting in which people assemble for a variety of purposes. Managers

can be observed executing actions that demonstrate that financial results are not always first

priority in their decision calculus. Social standing and related group dynamics issues also weigh

in, and this is particularly true when discussing compensation.

Caps on Sales Commissions

Commissioned salespersons are not only allowed but expected to be openly motivated by

money. Their efforts lead directly to the economic success of the firm that employs them. So

then, why would a firm attempt to limit the amount of commissions that a salesperson could

make?

A business writer confronted this very question:

My first question was “Why do you want to cap commissions?” The owner explained that

he didn’t believe that staff should make more than he did as the CEO. (Marr, 2012)


One could not ask for more direct evidence of compensation behavior that is at odds with

the rational economic interests of the firm. In social terms, however, it is perfectly

understandable, although not constructive. This is not an isolated instance; the practice of putting

caps on sales commissions is well-known and well-documented. It is not motivated by business

considerations, such as sales outrunning productive capacity, but by the idea that a mere

salesperson might make more than an executive is an offence against all propriety (Weaver,

2011; Rector, 2013; Stanton and Buskirk, 1987, p. 316).

What has the structure of compensation for commissioned salespersons got to do with

minimum wages? It provides a proof statement that compensation decisions are motivated by

social considerations as well as economic benefits to the firm, that these forces conflict and that

the decision-maker will often resolve the conflict in favor of the social constraints. The analysis

of decision-making in a traditional microeconomics course of study makes no allowance for this

behavior.

A Compensation Structure Is a Social System

A compensation structure within a firm is a social system: an expression of who is valued

more than whom, and by how much. This definition is upheld by the managed as much as by the

managers.

I have the experience of having hired and administered salaries. There is no measurement

of marginal productive benefit available to guide the business decision, contrary to what one

might expect after having taken a microeconomics course. There is always a salary structure and

a manager disrupts it at her peril. Even if the management team strictly enjoins the employees

not to compare salaries, the ill-considered move that a manager makes, for example to give a


team member a raise to prevent him from leaving at an inopportune moment, will inevitably leak

out and poison morale in the department.

Perceptions of Low-Skilled Workers

I have also sat and listened to my share of lunchroom and restaurant conversations where

persons having the authority to hire made their perceptions known. There are many people in

such positions whose mindset is that people who make minimum wage do not even deserve that.

There are a variety of reasons for this belief, and a full exploration is outside the scope of this

paper.

While the persons in these positions of authority may have reasons that they feel are

justified and compelling, as I have previously shown, they have the power to unilaterally

determine compensation within legal limits. The persons whom they hire have no negotiating

power and are not even accorded the notional right to walk away.

Comparison with Anti-Marginalism

Students of economic history may recall a dispute in the late 1940s over the issue of

whether managers really use marginal costs to make management decisions. The anti-marginalist

case was made by Richard Lester, an economist whose work was cited by Card and Krueger,

who began:

The conventional explanation of the output and employment policies of individual firms

runs in terms of maximizing profits by equating marginal revenue and marginal cost.

Student protests that their entrepreneurial parents claim not to operate on the marginal

principle have apparently failed to shake the confidence of the textbook writers in

the validity of the marginal analysis. (Lester, 1946, p. 63)

In his rebuttal to the anti-marginalists, Fritz Machlup wrote:

That a business man is motivated by considerations other than the maximization of

money profits does not necessarily make his conduct "uneconomic." The economic

theorist finds no difficulty in fitting into the pattern of "economic" conduct (that is, into


the conceptual scheme of consistent maximization of satisfaction within a given

preference system) the householder and consumer who makes donations to friends or the

church; or the seller of labor services who chooses a badly-paying but less strenuous job

in preference to one that pays more but calls for more exertion. Likewise, there is nothing

essentially "uneconomic" in the conduct of a business man who chooses to pay higher

prices for raw material purchased from a fraternity brother, or to sell at a special

discount to members of his church, or who refrains from embarking on a promising

expansion of his business because he prefers an easier life. (Machlup, 1946, p. 526)

However, Machlup then went on to argue against the inclusion of considerations such as he

had cited in the models of business decision making on methodological grounds:

If whatever a business man does is explained by the principle of profit maximization-

because he does what he likes to do, and he likes to do what maximizes the sum of his

pecuniary and non-pecuniary profits-the analysis acquires the character of a system of

definitions and tautologies, and loses much of its value as an explanation of reality. It is

preferable to separate the non-pecuniary factors of business conduct from those which

are regular items in the formation of money profits. (Ibid)

So economists have known for decades that the purely financially motivated model of the

firm is incomplete, but have disregarded that fact because it would be inconvenient to model. I

can even generalize a rule about economic models:

Factors for which the data is difficult to collect or which make the math unpleasant will

be disregarded in the model.

I acknowledge that it would be prohibitively difficult to measure the non-financial benefits

of a decision, possibly requiring the mythical utilitometer. However, failure to include the non-

financial factors impairs the effectiveness of the economic model as a predictor of behavior. An

economic model that is limited in this manner cannot serve as a justification for public policy

decisions.

The ultimate settlement to the marginalist controversy at which economics arrived in the

early fifties was that marginal analysis was modeling outcomes, not intentions or decision


processes. A slalom skier does not solve a series of mathematical equations to pick her line

through the course — she would not have time to, even if she wanted to — but a sophisticated

computer simulation of slalom skiing would have to. Similarly, the economic model does not

attempt to reflect the simplifications and rules of thumb that decision-makers use, but only to

predict results.

Nevertheless, a model that excludes material non-financial factors that influence decision

makers will have limited relevance. The user of the model will make wrong predictions of

actors’ decisions. The models based on marginal costs and supply-and-demand relationships are

in this predicament with respect to minimum wage employment. There is no way to incorporate

into the model decision maker beliefs such as, “A person doing job X is only worth $Y an hour,”

particularly if these beliefs are based not on compressed financial calculations but on personal

preferences or social norms.

A Note about Indexing

There has been some discussion, promoted by Senator Elizabeth Warren, of studies

concluding that the minimum wage should be indexed to inflation or productivity growth

(Schmitt, 2012). This is not justifiable in economic terms. The various factors of production —

land, capital, labor and the entrepreneur — will take shifting proportions of the proceeds of

production over time, as economic conditions cause the bargaining power of the holders of these

factors to shift relative to one another. It is not constructive to attempt to legislate these

proportions and freeze some idealized yesterday in place. Attempting to do act upon the

observations of the Schmitt paper would move the wage more than incrementally and provoke

meaningful movement along the demand curve, leading to measureable reductions in demand for

low-skilled labor.


Schmitt uses the period 1945-1968 as a baseline, but this is an artifice. During that period,

the economy of the United States was substantially isolated from competition, as most

economies were attempting to crawl back into the industrial age after World War II. Labor in all

forms took a high share of income as compared to current conditions. There were a number of

reasons for this, including the post-Depression political settlement, absence of substitutionary

alternatives and the desire to buy labor peace. The only way that preservation of such a baseline

could be contemplated would be to repudiate integration in the global economy, discussion of

which is outside the scope of this paper.

Furthermore, everyone who was working fell behind during the inflation of the seventies.

Welcome to the club; we have jackets. Nobody gave the ordinary people working in the

seventies a commitment to index their salaries, and people were falling behind inflation during

that time. Let’s not experience that again – oops, too late, the money is already printed (Figure

4). Attempting to index the minimum wage on this basis will result in a massive backdoor

redistribution.


Figure 4. Adjusted Monetary Base, 1984-2014

(St. Louis FRB, 2014)

Precedents for Government Intervention

Readers with legal backgrounds may have noticed that the labor market depicted here does

not allow the supplier, i.e., the minimum-wage worker, any bargaining power and drawn

analogies to the principle of unconscionable contract. This is a condition where the terms of a

contract are so one-sided that it shocks the conscience of the court, and the court will not enforce

the terms of the contract. A contract would not be considered unconscionable when one party has

obtained unfavorable terms simply by making bad business decisions, failing to foresee

contingencies or being an inept negotiator. For a contract to be unconscionable, one party must

have grossly superior bargaining power to the other at the time of offer and acceptance.


Unequal bargaining powers and the absence of meaningful choice on the part of one of

the parties, together with contract terms which unreasonably favor the other party, may

spell out unconscionability. — Brooklyn Union Gas Co. v. Jimenez, 371 N.Y.S 2d 289

(1975).

The minimum-wage labor market that was previously described would meet such tests. We

grant no negotiating power to the minimum wage laborer, even so far as to decline to participate.

In writing another important decision in the history of the doctrine, Williams v. Walker-

Thomas Furniture Company, the D.C. Court of Appeals found support not only in the recently

enacted Uniform Commercial Code, but also in common law:

In other jurisdictions, it has been held as a matter of common law that unconscionable

contracts are not enforceable. While no decision of this court so holding has been found,

the notion that an unconscionable bargain should not be given full enforcement is by no

means novel. In Scott v. United States, 79 U.S. (12 Wall.) 443, 445, 20 L.Ed. 438 (1870),

the Supreme Court stated:

'* * * If a contract be unreasonable and unconscionable, but not void for fraud, a court

of law will give to the party who sues for its breach damages, not according to its letter,

but only such as he is equitably entitled to. * * *'

— 350 F.2d 445 (1965)

In addition to unconscionable contracts, there are a variety of situations in which courts

will not enforce a contract that was agreed upon by the parties:

Courts will not enforce contracts whose subject matter is illegal;

Courts will not enforce many terms of contracts upon minors;

Many contracts, including those involving real property, must be in writing;

Many jurisdictions will not uphold exculpatory clauses, which attempt to transfer

risk of one party’s negligence to the other party.

One can find judges objecting to exculpatory clauses not only regarding explicit contracts

but also with reference to terms of employment, on public policy grounds:


And it is for the welfare of society that their employers shall not be permitted, under the

guise of enforcing contract rights, to abdicate their duties to [workers]. The consequence

would be that every railroad company, and every owner of a factory, mill, or mine, would

make it a condition of the employment of labor, that the laborer should release all right

of action for injuries sustained in the course of the service, whether by the employer’s

negligence or otherwise. The natural tendency of this would be to relax the employer’s

carefulness in those matters of which he has the ordering and control, such as the

supplying of machinery and materials, and thus increase the perils of occupations which

are hazardous even when well managed. And the final outcome would be to fill the

country with disabled men and paupers, whose support would become a charge upon the

counties or upon public charity. — Little Rock & Fort Smith Ry. Co. v. Eubanks, 3 S.W.

808 (1886).

The oft-repeated claim that minimum wage laws represent undue and unwarranted

intrusion by government into private contracts does not find support in review of black-letter

law. Our common law tradition does not tolerate any two parties reaching any agreement under

any terms. Our legal system incorporates both law and equity. The history of this tradition

predates political movements such as progressivism or contemporary judicial activism. The roots

go deep into the Anglo-American legal heritage.

In A Letter to a Member of the National Assembly, Edmund Burke wrote:

Men are qualified for civil liberty in exact proportion to their disposition to put moral

chains upon their own appetites,—in proportion as their love to justice is above their

rapacity… Society cannot exist, unless a controlling power upon will and appetite be

placed somewhere; and the less of it there is within [the individual], the more there must

be without.

It is regrettable that we have the need for minimum wage laws. Ours would be a better

society if those who controlled the demand side of this market were to exercise some restraint.

However, we have not yet arrived at such a condition. In its absence, the weak are driven to the

wall in such a way as shocks the consciences of courts as well as ordinary citizens.


Summary and Conclusions

We have reviewed the orthodox economic analysis of minimum wage laws and considered

this analysis in the light of the larger situation in which the participants operate. The supply

curve that used in the orthodox representation is not accurate when one considers the imperative

to work and the consequent denial to the worker of the option to respond to price signals by

withdrawing from the market. This observation leads to a reckoning of the relative bargaining

power of the parties. We have examined black-letter law for similar situations where we have

found that the law does not obediently uphold the terms obtained in the market, but intervenes in

the interest of equity and public policy, and that this legal tradition is over a century old and

therefore predates contemporary political movements. It cannot be ascribed to legal activism on

the part of a group of modern judges.

Having established that the firms who employ minimum wage labor have all the initiative

in the market, we have looked at the social aspects of compensation within the firm. We have

discussed published evidence demonstrating other situations in which factors other than

maximization of profit guide managers in determining compensation levels. These

considerations are not discussed in the typical presentation of microeconomic decision-making,

but they are very real to the practicing manager who has hiring and salary administration

responsibilities. The typical microeconomic model does not adequately represent the factors that

influence managers when making hiring and compensation decisions.

The working poor are trying to do what we want them to do: they are working. Although

the scope of policy to achieve positive results is not unlimited, there is a valid place for minimum

wage laws to provide more equitable compensation to such workers than they would obtain in

the unregulated marketplace.


References

Card, David, and Alan B Krueger (1994), “Minimum Wages and Employment: A Case Study of

the Fast-Food Industry in New Jersey and Pennsylvania”, The American Economic Review,

Vol. 84, No. 4 (Sep 1994), pp. 772-793.

Leonard, Thomas C. (2000), “The Very Idea of Applying Economics: The Modern Minimum-

Wage Controversy and Its Antecedents”, accessed 20 Jul 2014,

http://www.princeton.edu/~tleonard/papers/minimum_wage.pdf

Kuhn, Thomas S. (1970), The Structure of Scientific Revolutions, 2nd

Edition: Chicago:

University of Chicago Press.

Lester, Richard A. (1946), “Shortcomings of Marginal Analysis for Wage-Employment

Problems”, The American Economic Review, Vol. 36, No. 1 (Mar., 1946), pp. 63-82,

accessed 24 Jul 2014, http://www.jstor.org/stable/1802256.

Machlup, Fritz (1946), “Marginal Analysis and Empirical Research”, The American Economic

Review, Vol. 36, No. 4 (Sep., 1946), pp. 519-554, accessed 24 Jul 2014,

http://www.jstor.org/stable/1801722.

Mansfield, Edwin (1982), Microeconomics: Theory and Applications, 4th

Edition, New York: W.

W. Norton & Co.

Marr, Steve, 2012, “Does Capping Commission Make Sense”, Steve Marr’s Business Proverbs,

posted 17 Aug 2012, accessed 9 Mar 2014,

http://www.stevemarr.org/index.php/home/does-capping-commission-make-sense.html.

Rector, Bruce, 2013, “Cap your commissons, cap your sales: A misguided policy”, The Business

Journals, posted 29 Aug 2013, accessed 9 Mar 2014,

http://www.princeton.edu/~tleonard/papers/minimum_wage.pdf

http://www.jstor.org/stable/1802256

http://www.jstor.org/stable/1801722

http://www.stevemarr.org/index.php/home/does-capping-commission-make-sense.html


http://www.bizjournals.com/bizjournals/how-to/growth-strategies/2013/08/cap-your-

commissions-cap-your-sales.html.

St. Louis Federal Reserve Bank, 2014, “St. Louis Adjusted Monetary Base”, FRED, published

23 Jul 2014, accessed 2 Aug 2014, http://research.stlouisfed.org/fred2/series/BASE.

Schmitt, John, 2012, “The Minimum Wage Is Too Damn Low”, Center for Economic and Policy

Research, March 2012, accessed 9 Mar 2014,

http://www.cepr.net/documents/publications/min-wage1-2012-03.pdf.

Stanton, William J, and Richard H. Buskirk, 1987, Management of the Sales Force, 7th

Edition,

Homewood, IL: Richard D. Irwin.

Weaver, Terry, 2011, “Sales Commmission Out of Control – Do You Cap It?”, Chief Executive

Boards Blog, posted 9 Oct 2011, accessed 9 Mar 2014,

http://www.chiefexecutiveblog.com/2011/10/sales-commission-out-of-control-do-

you.html.

Legal Cases

Brooklyn Union Gas Co. v. Jimenez, Civil Court of New York, 371 N.Y.S 2d 289 (1975).

Little Rock & Fort Smith Ry. Co. v. Eubanks, Arkansas Supreme Court, 48 Ark. 460, 3 S.W. 808

(1886).

Williams v. Walker-Thomas Furniture Company, District of Columbia Court of Appeals, 350

F.2d 445 (1965).

http://www.bizjournals.com/bizjournals/how-to/growth-strategies/2013/08/cap-your-commissions-cap-your-sales.html

http://www.bizjournals.com/bizjournals/how-to/growth-strategies/2013/08/cap-your-commissions-cap-your-sales.html

http://research.stlouisfed.org/fred2/series/BASE

http://www.cepr.net/documents/publications/min-wage1-2012-03.pdf

http://www.chiefexecutiveblog.com/2011/10/sales-commission-out-of-control-do-you.html

http://www.chiefexecutiveblog.com/2011/10/sales-commission-out-of-control-do-you.html


Table of Figures

Figure 1. Minimum Wages in Theoretical Market ......................................................................... 3 Figure 2. Supply Curves for Low-Skilled Labor ............................................................................ 5

Figure 3. Market with Corrected Supply ........................................................................................ 6 Figure 4. Adjusted Monetary Base, 1984-2014 ............................................................................ 13

Orthodox Economic Arguments against the Minimum Wage

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