24 October 2018

Does the minimum wage work? It’s more complicated than you think


The minimum wage. At two points in my life I thought it was so simple. During my lefty student days I thought increasing it was the perfect solution to poverty. Then, when I had learnt more about economics, I was certain that any increase would almost inevitably lead to inflation and heavy job losses.

More recently, I’ve realised that things are not that simple. The merits and consequences of a minimum wage is the subject of a huge and important debate among economists and policymakers, with studies — and volumes — being written on the subject.

A study published this week is a great example. It looked at the impact of Seattle’s minimum wage and found that, on the one hand, it raised hourly wages by an average of $8 to $12. On the other hand, it led to a significant reduction in the rate of new entries into the workforce.

So, what is the impact of the minimum wage? Who are the winners and losers? Does it increase wages for some at the expense of others?

First, let’s have a look at the impact of minimum wage on prices. Obviously, as Sara Lemos points out, increasing the minimum wage increases costs for businesses and they have three possible responses to this: either take the hit on their profits, reduce employment, or pass on the cost to consumers in the form of higher prices. As such, the minimum wage acts like a tax on businesses, and they act accordingly.

However, as Lemos found in her meta-analysis, firms will not always act in an identical manner, and when prices do rise, they tend to do so to varying degrees. For example, she concluded that a 10 per cent increase in the minimum wage would increase food prices by up to 4 per cent, and overall prices by no more than 0.4 per cent.

Later studies have found similar results, especially that food prices seem to be more sensitive to increases in the minimum wage. The reason for this is likely to be the fact that the hospitality industry has lots of workers on the minimum wage relative to other sectors of the economy, and these companies respond by passing the price onto consumers.

Jonathan Wadsworth found that in a UK context, prices in several minimum wage sectors — notably takeaway food, canteen meals, hotel services and domestic services — do appear to have risen significantly faster than prices in non-minimum wage sectors. These effects were particularly significant in the four years immediately after the introduction of the minimum wage.

This is supported by Draca et al, whose research revealed that in sectors such as restaurants and hotels, companies pass on the higher wage costs in the form of higher prices to consumers.

This is also the case in other countries. For example, a study by Aaronson et al, found that a 10 per cent increase in the minimum wage could lead to approximately a 0.7 per cent increase in prices at US restaurants. Moreover, a study by Fougere et al, found a positive and significant impact of the minimum wage on restaurant prices in France.

Of course, this is not always the case. A minority of studies find no discernible increase in prices, even for food while others find that an increase is very small, even when the increase to the minimum wage is large.

However, things get even more complicated. Not all foods are equally impacted by increases to the minimum wage. This is even the case for similar types of food prepared by the same types of restaurants. For example, a study looking at the impact of minimum wage increases on fast food prices in the US found that increases to the minimum wage had a significant impact on the prices of pizza and burgers. Interestingly, it had no impact on the price of fried chicken.

So, when it comes to the impact of minimum wage, we can say that there is strong evidence that it tends to increase prices, especially for food. It is not, however, clear cut and different studies have reached different conclusions.

What about the impact on employment opportunities? Again, it’s complicated. Last year, two studies from leading academics at top universities, both looking at data from Seattle, reached conclusions which were diametrically opposed to each other.

Some studies suggest that increasing the minimum wage has no impact on employment opportunities, while others find the opposite. However, there is more of a consensus about the impact of the minimum wage on low skilled workers.

For example, Clemens & Wither examined the impact of increasing the minimum wage in the US during the great recession. Their study found that raising the minimum wage reduced the national employment-to-population ratio.

This is supported by a plethora of other academic studies. For example, Meer & West found that increases to the minimum wage in the US resulted in firms being far less likely to hire new staff. Moreover, Neumark & Wascher found that increases to the minimum wage results in fewer employment opportunities, especially for low skilled workers.

What will the impact in the UK be of the recent increase to the minimum wage? Well, it’s probably too early to say. A paper released in April this year from the London School of Economics had a look at the impact of the new minimum wage legislation on the care home industry. The authors found that it has contributed to a significant deterioration in the quality of care for patients.

As for prices, no major study has been conducted. In regards to employment opportunities, the UK is currently enjoying a jobs miracle. Like I said: it’s complicated.

There are two big takeaways from all of this. First, increasing the minimum wage is often seen as a solution to reduce poverty and a way to increase the standard of living, especially for people in low paid work. However, as we have seen, there is evidence which suggests that it increases the cost of living by raising prices, especially for food. What is more, it can also reduce job opportunities for low skilled workers.

Therefore, despite the best intentions of its advocates, a minimum wage can have unintended consequences, which hurt the poorest in society the most.

It also serves as a warning to people both on the left and the right. It’s complicated. Meddling around in the economy can impact the economy in a way which was neither forseen nor intended. It is humbling for those on the right, such as myself, who might be tempted to say that any increases to the minimum wage will lead to job losses or higher prices. It might. It might not. It could mean prices rise, or lead to fewer job opportunities, or lower standards. It could lead to any combination of these things, or none at all. The consequences are likely to be negative, but we can’t say confidently in advance what those negative consequences will be.

The debate surrounding the minimum wage is fascinating. It’s also complicated — just like most of the economy, business, and humanity. As is ever the case, interfering in the market can have very negative consequences. However, we can’t always say what those will be in advance.

Ben Ramanauskas is a Researcher at the Taxpayer's Alliance.