Yes, Economic Laws Still Apply to the Minimum Wage
What is it with economic illiteracy and writing in the media? One explanation is obvious: media need to sell newspapers (or get “clicks”), so it makes sense to exploit people’s confirmation bias. In other words, tell people what they want to hear. And, as we know, economics is that science that reveals that things aren’t the way they may first appear. In fact, the mechanisms behind the phenomena we observe are often the very opposite of what the untrained eye thinks that it sees.
People tend to recognize that economics produces explanations they don’t want to hear (which, by the way, doesn’t make those explanations false). This makes economics a favorite science to hate and look down upon. It is also the science standing firmly in the way of wishful (but reality-devoid) policy — proper economic analyses more often than not show that a suggested policy cannot create the results it is intended to bring about.
Perhaps it is this dream-crushing ability of sound economic reasoning that explains why economists who confirm popular misbeliefs about the economy are so generally hailed. As an economist, it seems there are only two ways of getting famous: either declare economic untruths as the “real” truth (basically, be an economics-denier) or play around with data to produce something quirky, inane, and humorous (like “Freakonomics”). Both, of course, undermine the status of economics and play the “confirmation bias” card by boosting people’s economic illiteracy.
The Clueless World of "Empirical" Economists
Noah Smith, a trained economist who quit his academic career for economic commentary, provides a great example of this phenomenon in a recent column at Bloomberg. Whatever he is trying to prove is not clear from the actual argument, but he does a good job stacking untruths and making unfounded, illogical claims. And, of course, the column does a good job playing on people’s (and Smith’s) economic illiteracy.
The apparent conclusion that Smith draws in his column is that supply-and-demand analysis no longer explains the job market. It’s a quite amazing claim, and if it were true, then pointing this out should be worthy of a Nobel. It is not, of course. In fact, most claims in the column are rather outrageous in their ignorance of basic economics or Krugmanesque use of facts.
Smith starts by stating that “The battle over the effects of minimum wages has been one of the most protracted and bitter fights in the history of empirical economics.” This is just plain false. Only very recently have economists been able to torture data enough to “prove” that theoretical truths about price floors in the job market (but not elsewhere, apparently) are not true. Those studies have indeed created debate, but that should be the case: their supposed findings are outrageous. They do not “falsify” economic theory as much as they should be intriguing in terms of finding other causes for these interesting findings.
But Smith does not know this. He has been properly trained in the Whig tradition of economics, where it is believed almost religiously that anything economics has to say is what’s been published in the journals the last decade or two. (He also mistakenly believes that economics is somehow an inductive, data-driven, empirical science.) From that Whig perspective, his claim about the “history of empirical economics” (going back as far as the late 1990s?). Whoever has only cursory knowledge in the history of economics would be able to come up with better examples of “protracted and bitter fights” — for instance, the what causes economic crises and how they can properly be dealt with.
This is only the beginning, however, and not important for the argument – it is only a “hook,” as they say in media, meant to make you read the whole thing (and the ads).
The Real Effects of a Minimum-Wage Hike
Next, Smith refers to a study showing that “minimum wage hikes tend to decrease the number of jobs just below the new cutoff, but increase the number above the line — implying that the wage hike isn’t killing jobs, but simply giving people raises.” Now, who would be surprised that the number of jobs below the new legal minimum decrease? Nobody. And that’s exactly what we should expect.
We should also expect the other claim, that the number of jobs above the legally required wage level increase. Why? Because some employers might believe (right or wrong) that they can increase wages for those just below the cutoff point to keep them on staff, but instead cut down on something else. And new jobs might emerge just above the minimum wage not as a result of raising people’s wages but as a result of not offering higher (or increasing) wages in other employments. In other words, a redistribution of wages.
But doesn’t this confirm Smith’s thesis that supply-and-demand analysis no longer holds? No. It shows that the equilibrium analysis doesn’t hold. The result of a minimum wage is, obviously, disequilibrium: it is a restriction on markets that has consequences.
The next quoted study finds that “minimum-wage increases tend to raise incomes for people at the bottom of the distribution” and that “the probability of people losing their income entirely … isn’t significantly affected.” These are good reasons to further investigate the causes of these results, not to throw out supply-and-demand analysis.
These things don’t happen in a vacuum, and the job market is far from an equilibrated free market. And we should expect changes to jobs due to for example economic growth. Also, with investments in capital the productivity of labor goes up, which means they’ll earn higher (market) wages. In fact, minimum wage increases can cause shifts from low-productivity labor to investments in capital, as McDonald’s recently illustrated. That’s a potential explanation for the empirical “evidence” referred to in Smith’s column.
There’s really not anything strange with these findings, but Smith still claims that “it’s forcing us to rethink our basic understanding of how labor markets work.” How so? Well, Smith notes that there are indications that the reason higher minimum wages don’t cause unemployment is that “it’s so costly and difficult for workers to find new jobs that they simply accept lower wages than they would demand in a well-functioning market.” Yes, it’s called regulation. That’s why the market isn’t “well-functioning.”
Smith goes on: “evidence is showing that employers have more market power than economists had ever suspected.” There are studies showing that “in areas where there are fewer employers in an industry, workers in that industry earn lower wages.” The studies’ “findings are completely consistent.” Imagine that. It’s almost as though more competition between employers for labor increases wages! Who would have thought?!
But to Smith these results are an abnormality that “suggests that the competitive supply-and-demand model of labor markets is fundamentally broken.” I actually have no idea how he could come to that conclusion, so I will not try to explain it.
Somehow the conclusion is that economists “should [change] the baseline model of labor markets that gets taught in class” and “start with a model of market power.” Isn’t it strange how much this sounds like the imperfect competition analysis of Joan Robinson? Robinson famously published The Economics of Imperfect Competition in 1933. But somehow imperfect competition didn’t do away with supply-and-demand analysis, as Smith says it should.
Smith has a point, however. Maybe there is something wrong with how economics is taught. But what’s wrong is not the intuition — economics as a structured way of thinking. Economics professors generally get things right in the principles courses. It is the unthinking mathematical modeling and data meddling in courses on the intermediate and advanced levels that is completely out of touch with fundamental economics.
In other words, what’s wrong with how economics is taught is exactly the type of advanced education that Smith has (a PhD). The same thing makes him, at least in the eyes of unsuspecting readers, an authority on the subject. But it allows him to write nonsensical columns on “economics” that play on people’s confirmation bias.