There's one simple reason we need to raise the minimum wage

It would be nice if labor markets worked the way they do in economics textbooks.

Market forces would cause workers to be paid an amount equal to the value of what they produce – what economists call the value of their marginal product – and wages would rise one to one with both changes in inflation and changes in productivity. 

Of course, the real world doesn’t work this way.

Wages are often determined through a bargaining process between workers and management. If there is unequal bargaining power and management has the upper hand, there is no guarantee that workers will be paid according to the value they add to the firm’s product. 

An example might help. To make it simple, suppose the firm’s only costs are from labor, and that its total sales over a particular time period are $10,000. Workers contribute $8,000 of this value and are paid this amount. The $2,000 that is left over goes to the owner as a reward for the risk of his or her investment in the firm as well as management and entrepreneurial abilities.

Ideally, as with workers, this reflects the contribution of the owner to the production of the goods and services the firm sells in the marketplace. 

Now suppose worker productivity rises so that workers can produce more per hour, and this causes the value of production to rise to $12,000 over an equivalent time period. According to the textbooks, worker pay should rise to reflect this increase, but that is not what has happened in recent decades.

Instead, the lion’s share of the additional revenue has gone to the owners and managers of firms instead of to workers. The working class has not been able to bargain effectively and capture its share of the gains when productivity increases, and this has contributed to the rise in inequality. 

REUTERS/Noah BergerHow can this be changed? One answer is the return of unions. When unions were strong worker pay was much more closely aligned with changes in productivity. But politicians, particularly those on the political right, have enacted legislation that has undermined unions and membership has fallen drastically.

In addition, the threat of moving abroad as production has become globalized along with the ability of firms to move to states within the US where union power has been reduced (e.g. through right to work laws) has further eroded the bargaining power that unions once had. 

Another way to increase worker bargaining power, what I want to focus on here, is increases in the minimum wage. Minimum wage workers have very little ability to effectively negotiate over wages, and an increase in the minimum wage can serve as a substitute for their lack of bargaining power.

When the minimum wage is increased, firms do not have the option of threatening to replace workers with other workers who, due to their circumstances, would be willing to work for less than they are worth to the firm. In addition, when the minimum wage is increased at the federal level, firms cannot relocate to take advantage of lower minimum wages elsewhere. 

But doesn’t an increase in the minimum wage reduce employment? The answer appears to be no, at least not to any significant degree. It’s possible to find evidence on both sides of this question, but the preponderance of the evidence suggests that the employment effects are minimal. 

REUTERS/Noah BergerThis is just what you would expect if minimum wage workers are paid less than the value of their marginal products, i.e. less than their value to the firm. In such a case, an increase in the minimum wage does not push workers’ compensation beyond the point where they remain valuable to the firm. The main effect is to redistribute income from managers and owners to workers in a way that better reflects the contribution of each to the production of goods and services. 

Large increases in the minimum wage may push wages past this point, but if minimum wage workers are paid less than they are worth to the firm – as I believe most are – then smaller increases in the minimum wage should not have much of an impact on employment. 

Free market economists who object to increases in the minimum wage based upon the potential employment effects from labor market distortions must first convince me that these workers are paid what they are worth to begin with. If they are not, if the wage they are paid is lower than the value of their marginal product, then increasing the minimum wage does not create distortions, it removes them. 

An increase in the minimum wage will not solve the income stagnation problem that has plagued working class households for the last several decades on its own. That will require other means of balancing power in wage negotiations between workers and firms. But it is certainly a step in the right direction.

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