[An updated version of this article can be found at Minimum Wages in the 2nd edition.]
Minimum wage laws set legal minimums for the hourly wages paid to certain groups of workers. Invented in Australia and New Zealand with the admirable purpose of guaranteeing a minimum standard of living for unskilled workers, they have been widely acclaimed as both the bulwark protecting workers from exploitation by employers and as a major weapon in the war on poverty. Minimum wage legislation in the United States has increased the federal minimum wage from $.25 per hour in 1938 to $5.15 in 2001, and expanded its coverage from 43.4 percent of all private, nonsupervisory, nonagricultural workers in 1938 to over 87 percent by 1990. As the steady legislative expansion indicates, the minimum wage has had widespread political support enjoyed by few other public policies.
Unfortunately, neither laudable intentions nor widespread support can alter one simple fact: although minimum wage laws can set wages, they cannot guarantee jobs. In reality, minimum wage laws place additional obstacles in the path of the most unskilled workers who are struggling to reach the lowest rungs of the economic ladder. According to a 1978 article in American Economic Review, the American Economic Association's main journal, fully 90 percent of the economists surveyed agreed that the minimum wage increases unemployment among low-skilled workers. It also reduces the on-the-job training offered by employers and shrinks the number of positions offering fringe benefits. To those who lose their jobs, their training opportunities, or their fringe benefits as a result of the minimum wage, the law is simply one more example of good intentions producing hellish results.
To understand why minimum wage policies have such pernicious effects, one must understand how wages are determined in the free market. Consider, for example, the owner-operator of a small diner. To stay in business, he has to make sufficient profits to provide adequate support for his family. The market dictates how much he can charge for his meals because people can choose to eat at other restaurants or prepare their meals at home. The market also dictates what he must pay for food, restaurant space, electricity, equipment, and other factors required to produce his meals. Although the restaurant owner has little control over either the prices he can charge for his meals or the prices that he must pay for the inputs needed to produce them, he can control his costs by changing the combinations of inputs that he uses. He can, for example, hire teenagers to wash and slice raw potatoes for french fries, or he can purchase ready-cut potatoes from a large company with an automated french-fry production process.
The combination of inputs used and the amount that the diner owner can afford to pay for each one depend both on the productivity of the input and on the price that customers will pay for the product. Suppose that a trainee french-fry cutter can peel, cut, and prepare ten orders of fries in an hour, and that the diner's customers order about ten orders of french fries an hour at $1.00 each. If the minimum profit required to keep the owner in business plus all costs except the cutter's labor amounts to $.80 for each order, then the owner can afford a wage of up to $2.00 per hour for one trainee. Legislating a minimum wage of $4.50 per hour means that the diner owner loses $2.50 an hour on the trainee. The owner will respond by firing the trainee. The minimum wage prices the trainee out of the labor market. Similarly, other employers will respond to the increased minimum wage by substituting skilled labor (which does not cost as much more than unskilled labor as it did before the minimum wage) for unskilled labor, by substituting machines for people, by moving production abroad, and by abandoning some types of production entirely.
Australia provided one of the earliest practical demonstrations of the harmful effects of minimum wages when, in 1921, the federal court institutionalized a real minimum wage for unskilled men. The court set the wage by estimating what employees needed, while ignoring what employers could afford to pay. As a result unskilled workers were priced out of the market. These laborers could find work only in occupations not covered by the law or with employers willing to break it. Aggressive reporting of violations by vigilant unions made evasion difficult, and the historical record shows that unemployment remained a particular problem for unskilled laborers throughout the rest of the decade.
The same type of thing happened in the United States when a hospital fired a group of women after the Minimum Wage Board in the District of Columbia ordered their wages raised to the legal minimum. Ironically, the women sued to halt enforcement of the minimum wage law. In 1923 the U.S. Supreme Court, in Adkins v. Children's Hospital, ruled that the minimum wage law was simple price-fixing and an unreasonable infringement on individuals' freedom to determine the price at which they would sell their services. Although the peculiar logic of the last seventy years has seen this line of reasoning completely abrogated, the battle over allowing people to work at whatever wage they choose continues.
One skirmish occurred in 1990 when the U.S. Department of Labor ordered the Salvation Army to pay the minimum wage to voluntary participants in its work therapy programs. The programs provide participants, many of them homeless alcoholics and drug addicts, a small weekly stipend and up to ninety days of food, shelter, and counseling in exchange for processing donated goods. The Salvation Army said that the expense of complying with the minimum wage order would force it to close the programs. Ignoring both the fact that the beneficiaries of the program could leave to take a higher-paying job at any time and the cash value of the food, shelter, and supervision, the Labor Department insisted that it was protecting workers' rights by enforcing the minimum wage. By the peculiar logic of the minimum wage laws, workers have the right to remain unemployed but not the right to get a job by selling their labor for less than the minimum wage.
In addition to affecting how many people will be employed, minimum wage laws may also leave workers worse off by changing how they are compensated. For many low-wage employees fringe benefits such as paid vacation, free room and board, inexpensive insurance, subsidized child care, and on-the-job training (OJT) are an important part of the total compensation package. To avoid increasing total compensation, employers react to arbitrary boosts in money wages by cutting other benefits. In extreme cases, employers may convert low-wage full-time jobs with fringe benefits to high-wage part-time jobs with reduced benefits and fewer hours. Employees who prefer working full time with benefits are simply out of luck.
The reduction in benefits may be substantial. Masanori Hashimoto used data from the 1967-68 U.S. minimum wage hike to calculate its effect on the value of on-the-job training received by white men. Hashimoto estimated that the 28 percent increase in the minimum wage reduced the value of OJT by 2.7 to 15 percent. Because OJT is an important source of education, particularly for those with limited formal schooling, Hashimoto's findings have ominous implications. By reducing OJT, the minimum wage law increases the number of dead-end jobs and effectively consigns some of the unskilled to a lifetime of reduced opportunity.
Estimates of the overall effect of increases in the minimum wage on total U.S. employment often focus on teenagers, who, as a group, contain the highest proportion of unskilled workers. Most studies suggest that a 10 percent increase in the minimum wage decreases teenage employment by 1 to 3 percent. Using these estimates to forecast small increases in unemployment from future minimum wage increases is risky because most of the estimates rely on data from the sixties and early seventies, when minimum wage legislation applied to fewer occupations.
Raising the minimum wage when it applies to a relatively small proportion of occupations will not necessarily increase unemployment. Some people will lose their jobs in covered occupations and withdraw from the labor market entirely. These people are not included in the unemployment statistics. Others who lose their jobs or are offered fewer hours of work will seek jobs at lower pay in uncovered occupations. This labor influx drives down wages in the uncovered sector, but people do find jobs and unemployment remains constant. As minimum wage legislation expands to cover more occupations, however, the shrinking uncovered sector may not be able to absorb all of the people thrown out of work, and unemployment may increase. In the United States the 1989 minimum wage legislation brought this possibility one step closer by extending coverage to all workers engaged in interstate commerce regardless of employer size. Small businesses previously exempt from the minimum wage faced an 11.8 percent increase in money wages. If the repeal of the exemption that affected more than 6 percent of the nation's hourly workers substantially reduces the number of uncovered jobs, then overt unemployment caused by the minimum wage could become a more serious problem.
Estimates of the overall effect of minimum wage increases also tend to blur the regional and sectoral shifts that average together to produce the national result. A federal minimum wage of $4.25 an hour may have little effect in a large city where almost everyone earns more. But it may cause greater unemployment in a rural area where it substantially exceeds the prevailing wage. Regional and sectoral studies leave little doubt that substantial increases in the minimum in areas with lower wages can cause industries to shrink and can inhibit job creation. The growth of the textile industry in the South, for example, was propelled by low wages. Had the federal minimum wage been set at the wage earned by northern workers, the expansion might never have occurred.
This explains why unions, whose members seldom hold minimum wage jobs, encourage minimum wage legislation and, as in the Australian case, assiduously help enforce its provisions by reporting suspected violations. Unions have historically represented skilled, highly productive workers. As has been demonstrated in the construction industry, employers facing excessive wage demands from union members may find it less expensive to hire unskilled workers at low wages and to train them on the job. Unskilled workers often benefit: accepting lower wages in return for training increases their expected future income. With high minimum wages like those specified for government construction by the Davis-Bacon Act, the wages plus the training cost may exceed the total compensation that employers can afford. In that case the employer would prefer the union member to his unskilled competitor, and passage of a minimum wage law reduces the competition faced by union members.
In spite of evidence indicating that minimum wage laws reduce the number of jobs and distort compensation packages, some people still argue that their benefits outweigh their costs because they increase the incomes of the poor. This argument implicitly assumes that minimum wage workers are the sole earner in a family. This assumption is false. In 1988, for example, the vast majority of minimum wage workers were members of households containing other wage earners. Moreover, only 8 percent of all minimum wage workers were men or women who maintained families, and not all of those families were poor. The simple fact is that most minimum wage workers are young and work part-time. In 1988, 60 percent of minimum wage workers were sixteen to twenty-four years old, and about 70 percent worked part-time.
In view of what minimum wage laws actually do, their often uncritical acceptance as a major weapon in the war on poverty stands as one of the supreme ironies of modern politics. If a minimum wage set $.50 above the prevailing wage helps the working poor with no ill effects, why not eliminate poverty completely by simply legislating a minimum wage of $10.00? The problem, of course, is that pricing people out of a job does not reduce poverty. Neither does skewing compensation packages toward money wages and away from training, or encouraging employers to substitute skilled workers for unskilled workers, part-time jobs for full-time jobs, foreign labor for domestic labor, and machines for people. Minimum wage laws do all of these things and, in the process, almost surely do the disadvantaged more harm than good.
Linda Gorman is a Senior Fellow with the Independence Institute in Golden, Colorado. She was previously an economics professor at the Naval Postgraduate School in Monterey, California.
Brown Charles. "Minimum Wage Laws: Are They Overrated?" Journal of Economic Perspectives 2, no. 3 (1988): 133-45.
Eccles, Mary, and Richard B. Freeman. "What! Another Minimum Wage Study?" American Economic Review 94 (May 1982): 226-32.
Forster, Colin. "Unemployment and Minimum Wages in Australia, 1900-1930." Journal of Economic History 45, no. 2 (June 1985): 383-91.
Hashimoto, Masanori. "Minimum Wage Effects on Training on the Job." American Economic Review 72, no. 5 (1982): 1070-87.
Rottenberg, Simon, ed. The Economics of Legal Minimum Wages. 1981.
Welch, Finis. Minimum Wages: Issues and Evidence. 1978.