The Free Market 24, no. 9 (September 2004)
A recent article in the Wall Street Journal is a perfect example of how bad economic arguments in support of good ends can be easily twisted and used to confuse the general public (Gwendolyn Bounds, “Argument for minimum-wage boost,” 7/27/04, p. B3). When we engage in poor reasoning and faulty economic logic in support of a noble cause, we can end up doing much more harm than good in the pursuit of liberty and economic freedom.
Examples of this dilemma abound, and conservatives are especially prone to this type of error in reasoning. For instance, we frequently hear arguments in favor of free trade because free trade “boosts exports,” ignoring the real benefits in the form of cheaper imports and a better use of scarce resources. Arguments against socialism are often made on the basis that the system creates poor incentives rather than the bigger problem identified by Ludwig von Mises: socialism’s inability to permit rational economic calculation.
In this political season, we hear daily arguments in favor of tax cuts as a means to “stimulate” the economy, rather than on the basis of efficiency in resource use and private property rights. And, especially relevant to the topic at hand, arguments are often made against raising the minimum wage on the basis that an increasing minimum wage will elevate prices or harm small businesses.
The news article in question was written as a response to just such an argument. This argument goes as follows: An increase in the minimum wage cannot be justified because it will unfairly and disproportionately harm small businesses that, unlike large firms, cannot absorb the additional costs imposed by mandated higher minimum wages. Dynamic small businesses are responsible for a relatively large part of employment. If they cannot afford these higher labor costs, they will fail and go out of business, and workers will lose jobs. Ergo, a hike in the minimum wage cannot be justified.
As with most arguments, this one contains a kernel of truth. Indeed, the scenario it portrays is certainly possible and may result for some small business owners. However, using this argument against minimum wage laws puts one on very shaky economic ground, because it skirts the chief problem of minimum wages and diverts attention instead to that hallowed and sacred institution known as “small business.” This may seem like an easy sell to the American public, but it is a lazy argument that fails on its economic merits, as the news article makes patently clear.
In response, the author of the article points to a recent study released by the Small Business Administration’s Office of Advocacy which finds that, surprise, small business firms in America are not in fact the low-wage sector of the economy that many people believe them to be. On the contrary, the report finds that, on average, small businesses tend to pay above the minimum wage in order to compete in the labor market and attract workers.
In reality, according to the SBA study, it seems that larger wholesale and retail discounting firms employ a proportionately higher number of minimum wage workers, in part enabling them to keep their prices low. Small businesses, on the other hand, must pay wages well above the minimum in order to attract and retain reliable and productive employees. The theory is that by paying higher “efficiency wages,” small businesses may be able to reduce worker absenteeism and turnover, and also cut down on labor search and retraining costs associated with employee churn.
The author of the article does not reveal the details of the SBA study or suggest why it would be necessary for smaller firms to pay higher wages than larger firms to attract and retain workers with similar levels of skill and education. However, it is plausible that some form of “compensating differential” is at work in larger firms that is not available to employees in smaller firms.
Hence, the higher wages paid by smaller firms are necessary to offset the non-wage benefits of working for a large firm. For example, it could be that larger firms pay lower wages but offer better health care or sick-leave benefits as non-wage compensation. Or, it might be that larger firms have the capital resources to invest in a safer, cleaner, and more inviting workplace, offsetting lower wages. The prestige associated with working for a larger and more well-known enterprise might also play a role. Either way, some form of amenity in larger firms (or its absence in smaller firms) must explain the wage premium paid by smaller firms, or it would not persist.
However, the conclusions of the Small Business Administration study, as reported in the newspaper article, are very revealing, and clearly indicate the extent to which even small business owners are infatuated with turning the power of government to their own private advantage.
Contrary to the arguments made by so many well-meaning but misguided opponents of the minimum wage, small business owners actually favor an increase in the minimum wage. The reasoning is that it would force their larger rivals to pay higher wages, thus making it more difficult for large firms to offer discount prices on wholesale and retail products. In other words, according to this news article, many small business owners desire an increase in the minimum wage as a way to hamstring larger firms that offer lower-priced goods and services and out-compete them in the marketplace. Small business owners who push for an increase in the minimum wage see it as a tool to prevent their larger rivals from realizing efficiencies in labor costs, partially insulating themselves from the intense competition created by large-firm economies of scale.
Of course, this tactic should be seen for exactly what it is: typical rent-seeking behavior by less efficient firms who, rather than finding creative ways to cut costs and lower prices, reach for the lever of government coercion to hamper their more efficient rivals. This has been the history of government regulation for at least the last 100 years. Business firms support government intervention on some ostensibly noble grounds, such as reducing poverty or raising wages or enhancing consumer safety. In reality, their intent is usually much less dignified, supporting intervention only to create barriers that insulate them from competition.
Beyond this issue, however, the reasoning of the pro-minimum-wage argument made by some small business owners is itself dubious because, again, it ignores the primary problem associated with minimum wage laws to begin with. Minimum wage laws create unemployment among the lowest skilled and least educated workers. As any freshman economics student knows, wages mandated above the market-clearing equilibrium wage will create a binding price floor that causes the quantity of labor supplied to exceed the quantity of labor demanded, resulting in a surplus of labor. And, a surplus of labor leads to unemployment for those whose productive skill value is below the legal wage floor. The larger the increase in the minimum wage, therefore, the greater the labor surplus and the more detrimental the policy becomes.
For example, ask yourself if, all else equal, you would hire me for $7 per hour if I can only generate an average of $5.15 per hour of revenue for your firm. Clearly you would not. As a result, many unskilled workers who seek employment cannot find a job precisely because the government tells them that they must be paid more than they are worth to a potential employer. Teenagers, and especially minority teenagers, are the most likely to fall into this low-skilled category. It should thus come as no surprise that teenage and minority teenage unemployment rates are among the highest of any demographic group, topping out, respectively, at 16.8 percent and 32.6 percent in June 2004, according to the Bureau of Labor Statistics. This compares poorly to a national unemployment rate of just 5.6 percent in the same month.
Thus, forcing larger rival firms to pay higher minimum wages will not necessarily lead them to raise prices for their goods and services, as some small business owners apparently believe. If the demand in the market for these products is price elastic (which is highly likely), these firms will not be able to raise prices and pass on higher labor costs to consumers. After all, this explains why small business owners despise paying “efficiency wages” in the first place: the inability to raise prices. Instead, it is probable that large firms faced with artificially higher labor costs will find it more advantageous to invest in additional technology and capital equipment that would replace the lowest skilled employees who earn the minimum wage.
In the end, the singular most likely outcome is that a hike in the minimum wage will harm low-skilled employees who currently have a job working for a large firm by throwing them out of that job.
This recent news article and the story it tells is highly instructive for those who care about promoting free markets and economic liberty. Making bad economic arguments for noble economic ends puts us on shaky footing and opens the door for those arguments to be used against us. Arguing against minimum wage laws because they harm small businesses or lead to rising prices opens us up to just the kind of counterargument so vividly pointed out in this story. If minimum wage laws are not found to harm small businesses or lead to rising prices, then they must be ok. Of course, this is wrong. We must learn to always make the strongest and most consistent arguments against the enemies of free markets, or we will lose the battle. As Mises himself always reminded us, that requires constant study and a steadfast pursuit of the truth.
Tom Lehman is associate professor of economics at Indiana Wesleyan University (Tom.Lehman@indwes.edu).
