Why Raising the Minimum Wage Will Not Cure Poverty – A Simple Example

iceberg-lettuce-headI’ve written several blog posts explaining the economics of why raising the minimum wage will cause a great deal of pain for those in minimum wage jobs.  As an example, please see The Fundamental Economic Principles of Wages, which goes over the economics of a minimum wage hike.  In a nutshell, raising the minimum wage will hurt those currently in minimum wage jobs and those who will be trying to find a first job in the future.  Since a lot of those people will be teenagers. we’ll soon see a lot more mischief and downright crimes as teenagers are left to hang around home instead of getting a summer job in places where “living wage” statutes are enacted.

The predictable effects of a minimum wage hike include:

1.  Loss of jobs (both lay-offs and a reduction in the number of jobs available).

2.  Reductions in hours.

3.  Increases in prices (meaning people may get paid more but be able to buy less).

4.  Automation of things like ordering and even cooking food, meaning a lot of jobs will never come back.

5.  A lot of things becoming self-service (look at airline ticket counters).

We’re finding out from real life examples in Seattle and San Francisco, where “living wage” legislation has raised the minimum wage to unsustainable levels, that businesses will move or close and people will lose jobs.  If minimum wages were set to “living wages” everywhere, most businesses would stop hiring low-skilled workers and prices would be such that only the relatively wealthy could afford to eat out or buy anything but absolute necessities.

At first the logic in support of a living wage seems simple and makes sense: People don’t have enough money to pay for things.  Companies make lots of money.  Make the companies pay their workers more.  Then these people will be able to buy things and we can take them off of welfare.  Some people even go so far as to say:  The workers have more money to spend, so they buy more goods, creating more business, so the economy grows.  My, what a perpetual motion machine this is.  Why not raise wages to $1M per hour and really get the economy humming!

This argument is entirely specious, however, and the failure in the logic can be seen with a simple example.

Let’s say we have two people, Bob and Sam.  Bob runs a produce stand and Sam grows lettuce .  Sam goes to Bob to sell his lettuce since Sam knows that he would have a difficult time selling his lettuce on his own.  Bob’s stand location, regular supply of customers, and salesmanship allow him to sell a lot more lettuce than Sam could at his farm.  Plus, Sam is good at growing lettuce and that’s what he wants to do.  Bob is good at selling lettuce and that’s what he wants to do.

Just to make the example clear, Bob pays Sam in lettuce.  Of course, in actuality Sam would have lettuce to start with and would want to trade his lettuce for something else he didn’t have, but the point is to look at the value of things.  Paying for lettuce in lettuce makes this clear.  Let’s first say that Bob agrees to pay Sam one head of lettuce for each head he sells.  In other words, Sam keeps the entire value of what is sold and Bob gets nothing.  Obviously this would not work out because Bob would need to feed his family but he would spend all of his time selling lettuce for Sam and keeping none for himself, so he would quickly close up shop and do something else.

So, instead of paying Sam one head of lettuce for each head he sells, let’s say Bob pays Sam nine heads of lettuce for every ten he sells.   In other words, he gets a 10% fee for his trouble, which is a greater percentage than most employers get for each employee they hire.  Because Sam can sell maybe a hundred heads of lettuce per day with Bob, versus maybe 20 heads per day on his own, and because all he has to do is show up with his lettuce instead of needing to create a stand, advertise, and man the stand, he thinks this is a good deal.  Bob is now earning something for his trouble and is able to feed his family, so he agrees.  Bob and Sam each get to do what they do best.  Bob may make this same deal with hundreds of farmers, taking 10% from each one, and thereby earn hundreds of heads of lettuce each day.  He sells a lot of lettuce to a lot of customers, and helps a lot of farmers sell their lettuce, and therefore he makes a lot of green.  He may make 1000 heads of lettuce per day, while the farmers are only make an average of 90 heads of lettuce a day.

Let’s now say that the government decides that Sam and the other farmers need to be paid more heads of lettuce per day as a living wage.  They see Bob making hundreds or thousands of heads of lettuce a day and figure they could just require that he pays Sam more heads of lettuce.  Let’s say that Sam was originally selling 100 heads of lettuce a day, collecting 90 heads, but the government decides that he needs 150 heads of lettuce per day to survive in the city.  Not only must Bob do this for Sam, but he must do it for every other farmer.

Now, Bob is paying out 150 heads of lettuce a day to each farmer, the average farmer (Sam is average) only sells 100 heads of lettuce.  This means that Bob is losing an average of 50 heads of lettuce per farmer.  No matter how much lettuce Bob was making before, he can’t do this for long before he runs out of lettuce.  Bob must change things fast.

One thing he could do is to only sell for farmers who are exceptionally productive and sell more than 150 heads of lettuce per day.  This would allow him to stay in business, but it would mean that farmers who were less productive like Sam would no longer be able to sell their lettuce through Bob and would suffer.  Bob would also be very selective in who he would allow to sell lettuce since he would need to pay 150 heads of lettuce per day no matter what the farmer sold, so he would only select farmers whom he knew had a record of selling at least 160 heads of lettuce a day.  This makes it tough for any new farmers to start to sell lettuce.  (Note, one reaction that governments have when people start losing their jobs because the government is mandating wages is to make it difficult to fire people.  That has the effect of making employers very reluctant to hire, which only makes things worse for those looking for work.  See the Great Depression for an example.)  The other thing Bob could do would be to close his produce stand down quickly before he had to pay out all of his previous profits and then close up shop anyway when he ran out of lettuce in the bank.

So the bottom line is that you can’t simply dictate a wage because people on average cannot be paid more than they produce.  Creating a “living wage” will just put less productive people out of work and raise prices.  Both of these things will hurt the working poor and make them non-working poor,  If you want to help people at the bottom of the economic ladder, which are the ones who produce the least and therefore are the first to lose their jobs when you mandate a wage, you make them more productive.  This means training to develop skills and the creation of inventions that allow them to produce more.  The more they can produce, the more they can make in salary.   Production comes from experience, training, tools, and work ethic.  People get most of these things from working and will never get them if governments set barriers to entering the workforce like a living wage.

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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.


    • To an extent. The thing about a “living wage,” meaning a wage based on someone’s concept of what constitutes necessities and the amount of money needed to pay for those necessities, is that those proposed such as $15 per hour are way above the amount of income most people in minimum wage jobs produce, making it impossible to pay those wages even if the company made no profit at all. For example, see my example analysis of McDonald’s in this post: https://smallivy.wordpress.com/2013/08/31/can-mcdonalds-pay-15-per-hour/

      Obviously people do produce more than the amount of value represented by the minimum wage or no employer would be able to hire them. Most people quickly rise above the minimum wage once they have shown that they are good workers because they are providing more value so the employer can pay them more because it is currently low enough. If the minimum wage is raised, however, it will have the effect of encouraging employers to automate things and also be more choosy in whom they hire because they need the people they hire to produce more than they are paid. Certainly some jobs will be lost as the minimum wage is raised, but the number will depend on how much it is raised, how much employers can raise prices to make up for the lost income, and the ability of the employer to move elsewhere and his desire to stay in the same location. It will always be those with the fewest skills, abilities, and experience who will lose jobs or not be hired, so if you want to help the poor, ironically raising the minimum wage is not a good way to do it.

      • I see. Good explanation, thanks. I guess the other way that is resolved is through inflation? Everything goes up in price to accommodate the new artificial floor in costs…

      • Exactly. People get higher wages, but those wages don’t buy as much, so they end up getting paid the same amount of value for their work.

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