The Minimum Wage vs. Welfare: Band-Aid or Salt?
By Bryan Caplan
“In theory, I’m against it, because people should have the freedom to
contract at whatever wage they’d like to have. But in practice, I think
the alternative to higher minimum wage is that people simply end up
going on welfare.”
“And so, given how low the minimum wage is — and how generous the
welfare benefits are — you have a marginal tax rate that’s on the order
of 100 percent, and people are actually trapped in this sort of welfare
“So I actually think that it’s a very out of the box idea — but it’s
something one should consider seriously, given all the other distorted
incentives that exist.”
Is he right? Maybe. A key insight of welfare economics is that one inefficient policy can counter-act another inefficient policy. But does this insight apply in this particular case? Let’s work through matters step by step.
First, imagine laissez-faire. There’s no welfare and no minimum wage. The low-skilled labor market looks just like this:
Figure 1: Low-Skilled Labor Market Under Laissez-Faire
There’s no involuntary unemployment, and the big black dot reveals the wage and quantity of labor.
Now imagine adding a minimum wage – but no welfare – to the mix.
Figure 2: Low-Skilled Labor Market With Minimum Wage But No Welfare
The big black dot still reveals the wage and quantity of labor. Thanks to the minimum wage, though, there’s now a lot of involuntary unemployment, marked in red. This is true despite the fact that the minimum wage increases the incentive to work. Why? Because the minimum wage also reduces the incentive to hire! Since a deal only happens if both demanders and suppliers of labor consent, the quantity of hours worked is the smaller of quantity demanded and quantity supplied.
Under laissez-faire, any able-bodied worker can get a job and stand on
his own two feet. The minimum wage deprives the unfortunate workers
shown in red of their ability to support themselves. Given this involuntary unemployment, the case for welfare is suddenly easier to make. What happens if the government in its mercy puts the unemployed on the dole?
Figure 3: Low-Skilled Labor Market With Minimum Wage and Welfare
With a binding minimum wage, the only clear-cut effect of welfare is to transform involuntary unemployment into voluntary unemployment. That’s why the red line shrinks: Some – though not all – of the workers who craved a job at the minimum wage now shrug, “Eh, now that I’ve got free money, why interview?”
On Thiel’s story, though, Figure 3 doesn’t fit the contemporary labor market. He claims that welfare is now so generous that workers no longer desire minimum wage jobs. Diagrammatically:
Figure 4: Low-Skilled Labor Market With Minimum Wage and High Welfare
Notice: Sufficiently high welfare makes the minimum wage irrelevant. The market now clears at the intersection of the old demand curve D and the new supply curve S”. Since the intersection exceeds the minimum, the minimum has no effect. Thanks to welfare, employment is low. But whatever unemployment you see is voluntary.
OK, now we’re ready to see if Thiel’s story makes sense. Figure 4 roughly describes the world he thinks we’re in. What would happen if, swayed by Thiel’s argument, government raises the minimum wage to counteract welfare’s disincentive effects?
Figure 5: Low-Skilled Labor Market With High Minimum Wage and High Welfare
The answer, as Figure 5 clearly shows, is utterly orthodox: wages rise, employment falls, and involuntary unemployment revives. How is this possible? Simple. Generous welfare benefits do nothing to vitiate the truism that the minimum wage simultaneously raises the incentive to work and cuts the incentive to hire. And as usual, a deal only happens if both demanders and suppliers consent. The market therefore goes to the intersection of quantity demanded and the new minimum wage, with unemployment shown in red.
The lesson: When the minimum wage causes involuntary unemployment, raising welfare can serve as a band-aid for the labor market. Workers deprived of the right to provide for themselves can subsist on government money. Yet when welfare convinces people to abandon honest toil, raising the minimum wage is no band-aid. Instead, raising the minimum wage salts the wounds. The reason, to repeat: While a higher minimum wage does indeed make workers more eager to work, it also automatically makes employers less eager to hire.
I have great respect for Peter Thiel, but his concession to minimum wage advocates is confused. While some inefficient policies can offset the effects of other inefficient policies, the minimum wage is not such a policy. It doesn’t matter if welfare is high, low, or non-existent. The minimum wage causes unemployment by making marginal workers unprofitable to employ.