Why Raising the Minimum Wage isn't Necessarily a Good Idea

Published on 11/8/2013.

The other day when I was on my way to work, taking a cab as usual, the driver was listening to a morning radio show. It was one of those shows where the host gets a bunch of calls from everyday citizens telling him about their problems. It’s often sad to listen to some of the problems that people face, but I’m going to underscore what one gentleman said on the radio.

This gentleman was telling the story of his son, Joe, who is a high school graduate and is unemployed for over a year. This gentleman shared his idea to solve the unemployment problem in Jordan (official estimate: 12.2%, unofficially it’s probably much higher than that). He said (and I’m paraphrasing): “I call upon the government to raise the minimum wage, this will ‘kill’ the unemployment problem in Jordan so people can work”.

Now as an economist by heart, it felt uneasy hearing this guy sound utterly convinced about the validity of this idea. The effect of raising the minimum wage is in constant debate by economists for as long as I can remember. Therefore I want to address this issue and try to explain the history and the nature of this debate.

In my last post, I explained the nature of wages, and how they are theoretically determined. If you are a factory owner and are considering hiring Joe to work in your assembly line, then his wage can be up to the value of the additional revenue that Joe is responsible for. That is, if you hire Joe and you revenue goes up by $100 with no additional expense, and then you can pay Joe up to a $100 and still call the decision economically rational.

So let’s start with an example, let’s place ourselves in the Jordanian economy where the minimum wage is about $270 per month. Assume that you’re a factory owner and are considering hiring Joe to work in the assembly line that you own which produces Real Madrid shirts. You analyze this decision and figure out that if you hire Joe, your revenue will increase by $280. So therefore, it makes sense for you to hire Joe at minimum wage, and unless his productivity increases, his pay will remain the same as long as the revenue Joe is responsible for stays at $280.

Now let’s say we want to apply the gentleman’s suggestion which was mentioned earlier. The government issues a decree and increases the minimum wage to $350. You as a factory decision look at Joe’s case. He’s bringing you $280 in revenue, and you’re paying him $350 now. So you’re losing $70 for every month for which Joe is on your payroll. Since you want to make profit from your factory so you decide to fire Joe. Also, it is unlikely for you to hire a person with the same skill set as Joe since the money they bring in ($280) is lower than what you will pay them ($350).

What this example illustrates is that raising the minimum wage will cause some employers to refrain from hiring more people since the cost outweighs the benefit. Thus more people will be unemployed or will join the ranks of the unemployed. This is the classic theoretical effect for raising the minimum wage, increased unemployment.

Note that this example works differently if placed in the context of the US economy. The minimum wage in the US is set as a fixed rate per hour of work. Thus raising the minimum wage may not cause unemployment to increase, but simply increases the cost of hiring labor for an hour, and thus is predicted to reduce the number of hours worked rather than the number of people who are working.

There are several people who advocate raising the minimum wage in order to lift people from poverty. However, as this previous example illustrates, this decision may actually hurt the poor. Poor unemployed people will not gain from a raise in the minimum wage (since they are unemployed), and as explained above, this decision will make them less attractive for employers. Thus, in my opinion, training programs and/or improved public/low-cost education for this group would be a better option to solve this problem in the long run.

But those advocates might find solace in the policy decision by Brazil to raise the minimum wage in the past decade to lift people from poverty and reduce income inequality. The graph below shows the minimum wage in Brazil (the straight black line), and a measure for income inequality (the triangle line) which seeing it decreasing is a good thing). Brazil's social programs have been championed by many economists, myself included, they're truly an incredible success story.

Economists have not yet reached a consensus on the effect of raising the minimum wage. A famous study by David Card shows that raising the minimum wage doesn't have a considerable effect on unemployment. This study has been used by many politicians in the US to advocate increasing the minimum wage. However, this study has been criticized by several economists and they poked holes in the approach used (the study and the criticisms are very technical, so I opted not to go in depth as to keep things simple).

In conclusion, I see that most calls for increasing the minimum wage are due to aspirations to reduce poverty and increase the disposable income for an individual (which is a great thing by the way). However, simply raising the minimum wage isn't the only solution. My friends, who often discussed economic issues with me, know that I’m a big proponent of education. In my view, the way to reduce unemployment, reduce the number of individuals in poverty, can be achieved by increasing the value of the skill set per individual.

Having a higher quality educational system at low cost (starting from primary up to university level), makes everybody better off. Education is important and in my view is the solution to everything. Increasing the quality of human capital in an economy increases the opportunity for entrepreneurship, starting new businesses, new ideas, new companies having more of an incentive to hire people, and sets the economy as a hub for international companies to set up shop and thrive in.