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Increasing productivity, not the minimum wage, is the way to increase worker’s pay

Marginal productivity – The real ‘iron law of wages’

When an employer hires a worker, they don’t ask themselves “What is the cost of living?” They don’t ask “Will this enable them to cover their student loan payments?”, as Rep. Keith Ellison seems to think they should. They ask themselves “Will this hire add more to my revenues than to my costs?”

To see why this is true, think about an employer who estimates that a worker will add $20ph to their revenues. Why would they pay them more than that? Doing so would add more to their costs (the wages) than their income. An employer who did that wouldn’t be in business very long.

The key figure in employment is the employer’s estimation of what a worker will add to revenue; their productivity. They won’t hire at a wage (benefits such as health insurance included) above that estimate. This is the real ‘iron law of wages’.

A number of factors go into forming this estimate. These include an estimate of the worker’s skill and the tools the employee has to work with. Low skilled workers in labor intensive industries will tend to be low paid. Lacking the skills to generate much value, they also lack the capital inputs which would enable them to amplify what skills they do have. Other factors include the employer’s own estimate of how well they can utilize these inputs and of what demand for the output will be.

If a minimum wage is set above the employer’s estimate of productivity, the hire will not take place. An employer who estimates a worker’s productivity at $13ph will not hire that worker at $15ph. “All workers”, Rep. Ellison argues, “deserve one fair wage of $15 an hour”. The economic facts are that, if their productivity isn’t at $15ph, they will not get a wage of $15ph.

Minimum wage laws do not make employers pay above the estimate of worker productivity. All they do is outlaw the hiring of workers who lack the skills to generate enough value to cover the cost of hiring them. These would include younger workers who have yet to acquire skills and workers with less education.

Minimum wages in Minneapolis

Minneapolis City Council’s proposal to raise the minimum wage to $15 over five years will hurt these people. It will damage the economic prospects for the young and the less skilled. What makes this worse is that the Council itself implicitly acknowledges this. Their proposal includes a “training wage” exception for younger workers starting jobs. This acknowledges that less skilled workers generate less value than skilled ones and that wages depend on the value generated. If the Council understands this then it must also understand that arbitrarily hauling the wage up to $15ph will harm the employment prospects of workers without the skill or capital to generate that amount.

This is standard economic theory, but a large and growing body of empirical evidence bears it out. In 2008, economists David Neumark and William L. Wascher surveyed two decades of research into the effects of minimum wage laws. They found that “minimum wages reduce employment opportunities for less-skilled workers…a higher minimum wage tends to reduce rather than to increase the earnings of the lowest-skilled individuals…minimum wages do not, on net, reduce poverty…(and that) minimum wages appear to have adverse longer run effects on wages and earnings”.

How to really raise the wage

We all want to see higher wages for workers like Maggie McCaffrey. It is tempting to think that we can legislate wages higher with the wave of a lawmaker’s wand.

But we can’t. Wages are prices and prices are generated by underlying economic forces of supply and demand and productivity. We cannot raise wages without acting upon these forces. To borrow an analogy, trying to raise wages by dictating prices is like trying to slow your car by pressing down on the speedometer’s needle.

Higher wages will only come from higher productivity. That means better training and education. It means more investment friendly tax policies to increase the quantity and quality of capital that employees have to work with. It means pro-growth policies to ensure a buoyant demand for worker output.

These policies are harder work than simply signing a law and they do not fit as well on a placard. But they do work, and that is what matters for lower paid workers.

John Phelan is an economist at Center of the American Experiment.

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