Minimum Wage and Economics for Bakers
This is clearly a sensitive issue and it’s considered politically incorrect to say you’re against an increase in the minimum wage. Once again, I will take this risk because we must be honest and straightforward: as any other price in the economy, salaries cannot be set by decree.
A minimum wage that is too high only leads to inefficiency, unemployment, low economic growth and/or inflation. It is a question of basic economics: the laws of supply and demand cannot be abolished, as much as populist politicians would like to convince us otherwise. What is occurring today in Venezuela is just one example of what can happen when a government tries to go against elementary market forces.
Let's look at a simplified example, albeit a bit extensive.
Part 1: Labor demand
Let’s suppose that John owns a bakery and his employee, Ernesto, generates the equivalent of 100 pesos of bread per hour (ten pieces at a price of 10 pesos each). Let’s also assume that John is a bit stingy and decides to offer a low salary, of 20 pesos per hour. If the direct costs of production -eggs, flour, yeast, energy, etc. -represent 1 peso per piece of bread, Juan’s profit will be 70 pesos per hour (100 pesos in revenue – 10 pesos in direct costs - 20 pesos in salary) or 560 pesos for an eight-hour day.
But rarely are such questions in the life of a businessman so easy. Pedro, the baker on the next street over, is a brutal competitor, who is always on the prowl for opportunities. He talks to Ernesto and offers him a salary of 30 pesos per hour, because even with the higher wage, Pedro would still earn 60 pesos per hour (100 pesos-10pesos-30 pesos).
Juan does not sit idly by and fights with his competitor to retain a good employee such as Ernesto and offers him 40 pesos per hour. Pedro promises 50 pesos and so on, until Ernesto receives slightly less than the total value that his work generates per hour, since even paying this salary, the baker will continue posting a profit. Let’s suppose that under these conditions, the salary that Juan is willing to pay is 80 pesos per hour, with which his earnings will be 10 pesos per hour.
A similar dynamic occurs in any open labor market. Employers fight each other for labor power, an essential resource that enables them to produce, up until the point that the salary approximates the value generated by the employee.
If we take into account the needs for labor power of all the bakers in a city, who depend on the expected earnings generated by each employee, then we have a representation of the demand curve for labor by this group of companies.
In this representation, typical of a demand curve, we can see that the higher the hourly wage, the amount of labor demanded will be less. If the hourly cost of labor is too high, no one would hire employees in the bakeries.
Part 2: Labor supply and equilibrium
By definition, those who offer their labor power are employees. Therefore, the labor supply curve indicates the number of hours that employees are willing to work for a certain salary. The higher the salary, of course, the more hours each of them would be willing to work. If someone offers Ernesto five pesos per hour, he will probably not leave home to work. Most likely he will also not do so for ten pesos an hour.
Some employees may consider working for 15 pesos per hour, but there are not many of them and they definitely will not be enough to meet the demand for labor in the city’s baking industry, and therefore wages must increase.
Obviously this depends on the needs, capacities and circumstances of each, but at the aggregate level, the higher the salary, the greater the availability of labor -in the bakery industry and any other. This reasoning allows us to represent labor supply as an upward curve. The higher the hourly wage, the greater the number of people who will be willing to work longer hours in the bakeries.
Let’s suppose that, given the economic conditions in the city’s bakery industry and the preferences of potential employees, the equilibrium wage, in which the supply and demand curves intersect, is about 80 pesos per hour. That is, at this wage level, workers will be willing to offer 8.000 hours a day and bakers are willing to hire them for the same number of hours, and thus the market will be in equilibrium.
If, in this case, the city’s bakery industry employed workers who put in a total of 8.000 hours daily, in an eight hour day it would provide jobs to 1,000 people. The daily aggregate income of all employees in the bakeries would reach 640,000 pesos (8.000 hours X 80 pesos per hour).
Populism and “do-gooders” in action
Let’s suppose now that a populist politician takes office, supported by the "do-gooders" and "decrees" that the minimum wage should be set at 100 pesos per hour throughout the city and for all industries, regardless of the key differences between them.
In this case, workers will be willing to put in 10,000 hours (equivalent to 1,250 employees) but bakers only want a total of 6.000 hours (750 employees). The difference between these two figures is called unemployment, in this case equivalent to 500 workers (1,250 willing to work vs. 750 who finally obtain employment in the industry).
In the end, the bakers will only hire workers for 6,000 labor hours, so that the value of the labor market will decrease from 640,000 pesos in the previous equilibrium (8,000 labor hours, at a salary of 80 pesos per hour), to 600,000 pesos (6,000 labor hours, at a salary of 100 pesos per hour). With the exception of the 750 employees who could obtain jobs with a salary of 100 pesos, the unemployed, the bakers, and the consumer will lose out.
As you can be seen in the graph, if the minimum wage is higher than the equilibrium wage, this only creates unemployment: the difference between point (a) and point (b), is equivalent to 500 people.
In addition to 500 bakery employees losing their jobs with the new minimum wage, the city will produce much less bread than previously, so other industries, such as the restaurant industry, will be affected. Naturally, with a smaller supply of bread, the price of this basic commodity will rise, so that families will also experience a drop in their purchasing power, especially those at the Base of the Pyramid (BoP).
In the graph we can see that the higher the minimum wage, the more unemployment will increase. In an extreme case, if the salary were set at 200 pesos per hour, no baker would be willing to hire anyone. All bakeries would close, at least temporarily, while automating all their processes. Eventually, the baking industry would resurface, but would hire very few workers.
In contrast, if a bakery were to offer wages that were too low, it would not have enough labor power to compete. In fact, if the "minimum wage" is set below the equilibrium wage (80 pesos in this example), nothing will happen because in any case the workers in this industry would earn more at the market price. Nevertheless, many politicians find it quite profitable to "decree" that no one can earn below 50 pesos per hour. In this case, the minimum wage will then only be a simulation, which is what occurs on many occasions.
Part 3: Conclusion, wages cannot be set by decree
Like any price, salaries represents an equilibrium between supply and demand, so a salary that is different from the equilibrium wage will only create unemployment. Thus, wages cannot be set by decree. For a populist politician, it is very easy to say that a "fair" wage should be set at 100, 300, or 1,000 pesos per hour, but we cannot repeal the laws of supply and demand.
As Murray N. Rothbard reminds us: "In truth, there is only one way to regard a minimum wage law: it is compulsory unemployment, period. The law says: it is illegal, and therefore criminal, for anyone to hire anyone else below the level of X dollars an hour. This means, plainly and simply, that a large number of free and voluntary wage contracts are now outlawed and hence that there will be a large amount of unemployment. Remember that the minimum wage law provides no jobs; it only outlaws them; and outlawed jobs are the inevitable result.” After all, if the minimum wage is so effective in ending poverty, why leave it at 100 pesos? Why not raise it to 300, 400, or 10,000 pesos per hour?
If an employee seeks to earn more than 200 pesos per hour, he will have to receive training, study, and gain experience in order to boost his human capital. If this person studied computer science, a minimum wage of 200 pesos would be irrelevant, because the value of his work in the market will probably be much higher.
By the same token, investment in machinery and infrastructure will result in more items being produced per hour, businessmen obtaining greater value per person employed by boosting worker productivity, and a natural increase in salaries. If the government really seeks greater prosperity then it must create the conditions suitable for businesspersons to invest and for people to increase their human capital.
Among the conditions necessary for businessmen to invest are the rule of law, that laws be few in number and easy to comply with, minimum government intervention in the economy, and clear and firm property rights. That is, regulations must be reasonable and transparent and entrepreneurs must not perceive a threat, however remote, of expropriation, as occurs in Venezuela. For the employer to assume "uninsurable risks" requires a certain optimism that is necessary in order to face a fragile environment that can easily deteriorate.
So as long as a worker is increasing his human capital, he will be climbing an imaginary "wage scale." I have seen hundreds of such success stories in my companies. On the contrary, however, setting a minimum wage is equivalent to breaking the first steps of this ladder of opportunity with a sledgehammer. It is totally unfair for those with little human capital, who were unable to finish high school and had these steps of the ladder existed, they would have had the opportunity to gradually ascend this imaginary ladder over the course of their lives.
So who wins and who loses? Setting a minimum wage too high will only lead to unemployment, lack of opportunities, inefficiency, low economic growth and many other undesirable consequences, while only a minority of (well connected) employees will benefit and voter support for some irresponsible politicians will also rise , temporarily.
This measure will mainly affect those at the Base of the Pyramid, workers with the lowest "human capital," who will be the first to lose their jobs. Bakers without access to credit and capital, the "marginal producers," will also be seriously affected by this measure that requires them to hire labor at a considerably higher price.
The economists who propose increasing the minimum wage are unaware of the basic principles of their profession, and therefore they are unable to see the consequences of this type of public policy. To design them we must take into account not only the immediate effects, but the secondary and tertiary consequences.
What we should encourage to permanently boost family income is productive investment, education, and infrastructure development. Minimum wage policies, like many others promoted by populist politicians and those who I call the "do-gooders," are only a simulation that terribly and permanently affect people at the Base of the Pyramid. In implementing public policies, we should fully understand the dynamics and the economic environment and consider the possibility that the "solution" can be much worse than the supposed disease.