13 December 2009

Error: Circular Reference

In 2007 Oregon amended its wage laws to peg minimum wage increases to the Consumer Product Index (read the Press Release). This was and remains a bad idea. To start with most people on minimum wage are single and many still live at home. According to a Joint Economic Committee Report issued in 1996 more than half of workers earning minimum wage were single and a third were still living with their parents, thus not requiring as much money to live. More specifically the report states: "Minimum wage workers are not parents struggling to feed their children. Rather, they are high school or college students living at home." While this report is a little old, it is not yet too old to be completely irrelevant. My real problem with having minimum wage tied to an inflation index is what Excel would call a 'circular reference' error. These are nasty errors that loop back on themselves and have to be used with caution. (In all my Excel experience I have never purposely used a circular reference in a spreadsheet, and I can barely imagine why they would be helpful.)

The Cascading Effect

A circular reference is a set of equations that reference each other in a loop. The looping causes the formulas to repeat infinitely and are thus difficult to use. For example, I calculate the cost of my widgets (a generic and fictitious product that economists often use in their models) by adding together my labor, facilities and materials costs times 1.5 so I can make some profit (the formula would be (l+f+m)*1.5). Let us say that each widget takes an hour to make and so they cost: $8.40 for an hour at minimum wage, $5.00 for the facility (building and utility costs), and $10.00 for the materials. At my 50% markup the finished product would cost $35.10 each. Next year, because the CPI increased, minimum wage increased to $9.00 an hour. My widgets now cost $36.00 each, a 3% increase. The next year minimum wage increases by 3% because I charge 3% more for my widgets and the new minimum wage is $9.27 an hour, my widgets now cost $36.41 each. These calculations do not take into account the increased expense of materials (labor increase affect the cost of raw materials as well) and so each year's minimum wage increase adds to the next year's inflation rate and thus the minimum wage endlessly increases except in a reccesion. In the Oregon law, minimum wage remains the same if the CPI is negative and so even in a recession or when a market is flooded with cheaper product the minimum wage remains the same.

The Soaking Effect

Remember the Joint Economic Committee Report said the employees getting paid minimum wage are: high school and college students working part-time, not people with families working full-time. Allow me to summarize what students spend money on in order of cost: school, toys and fun. Schooling, like most markets, is subject to the laws of supply and demand and most students can't dream of paying for school by themselves and so it should not be part of the discussion. That leaves us with: fun and toys. This means that most of the minimum wage increase goes to pay for non-essential items that, while providing a higher quality of life, are really luxury items (e.g. iPods, cell phones, text messaging plans, music downloads, etc.). While money spent in these industries does reenter the economy, they are industries with incredibly high margins that reflect the level of demand rather than the cost of manufacturing. For example, no matter how many times a song is downloaded there will be another copy available for download for the next customer. The producers' only worry is making sure they meet the original investment costs; everything past this amount is profit. Another example, the price of the highly popular iPhone isn't a markup based simply of original developments and continued production costs but instead is based on the most the company can charge for the phone while increasing market share at an acceptable rate. Consumers pay the added expense for the "coolness" factor.

Basically, these markets are much more flexible at soaking up disposable income than normal consumable products.

The Squishing Affect

Minimum wage increases affect more than just those on minimum wage; they affect everyone paid more than minimum wage. Imagine an employee getting paid $9.50 an hour instead of the $8.40 minimum wage. In theory this employee makes 13% more than the average cost to live, not bad for an entry level job. The next year, because my widgets increased the CPI, minimum wage increased to $9.00 an hour. Now the employee only makes 6% more than the average cost to live, in essence the State has issued pay cuts to all non-minimum wage employees. Continue to the next year when minimum wage increases again to $9.27 an hour and the employee only makes 2% above the average cost of living.

A job that used to give an employee about $216 a month ($2,588 a year) as disposable income (money beyond the cost of food, transportation, residence, etc.) changed to $91 a month ($1,098 a year) then to $41 a month ($490 a year). While increasing the wages of part-time students (the ones the Joint Economic Report says is making minimum wage) the State is decreasing the wages of full-time working families (the ones who make more than minimum wage). The State has pushed the lower class towards to upper class and in the process squished the middle class and lower class together.

The Triple Jeopardy Affect

As minimum wage continues to increase each year, employers have to make a choice: increase wages, decrease wages or fire employees. This is a triple no-win situation for employers.

The employer may not want to increase employee wages for two reasons. The first is that consistently increasing a worker's wage gives the worker the impression that they are entitled to raises, which is often not the case. The second reason is that in most cases the worker is not worth any more year to year. Except in cases involving unions and minimum wage, the going wage for any job is determined by supply and demand. For example, a chain store may pay more for cashiers in a metropolitan store than in a suburban store because it is harder to find qualified workers in the larger market than the smaller market. Another example, doctors and lawyers don't get paid a lot of money because their jobs are particularly hard but because there are not a lot of them to do the job. Job markets obey the laws of supply and demand for everything more than minimum wage.

If the employer chooses to not increase employee wages, they have in essences chosen to decrease them. In theory the minimum wage increase is due to an increase in the cost of living and if the employee makes the same this year as they did last year then the employee has less disposable income. This effect may not be noticed the first year, but will be noticed before too many years. Upon noticing this trend employees are likely to work less and become less loyal, demand a raise or search for other employment. Of course the employer may decide that with the spiraling increases in minimum wage the position is no longer worth the added expense and therefore the worker is expendable. Expendable employees don't often last long.

Minimum wage always makes showing the value of a job more difficult. If an employer wants to get an entry level worker that is above average they often offer to pay the position a little above minimum wage, say $9.00 an hour instead of $8.40 an hour. Being a little higher than minimum wage becomes increasingly more expensive as minimum wage increases.

The Market Correction Effect

I hate going through great lengths to identify problems in a system without suggesting possible fixes, so here is my suggestion: get rid of minimum wage.

"But Daniel, if there is no minimum wage capitalist pigs will take over and the economy will be destroyed." No, no my weak believer. I argue that if minimum wage were to be abolished that the job market might tank and but would then correct itself. Every free market (free from government intervention) always, always corrects itself. If wages plummeted so would income and costs. As income dropped margins would increase, making capitalists happy for a while but a lack of income would force prices down until local job markets balanced out paying employees what they should be paid. Getting rid of minimum wage might also take a significant dent out of unemployment because companies could afford to hire workers for things that don't justify the expense of current minimum wages.

"But Daniel, workers were abused before there was minimum wage." Not so my young believer, well not because of a lack of minimum wage. Workers were abused because they had no right to safe working conditions but now we have things like the Bureau of Labor and Industry (BOLI) to enforce wage payments to employees and Occupational Safety and Health Administration (OSHA) to make sure employees are working in safe conditions. The problem of employee abuse was more of a problem of no enforcement of wage contracts and abuse of human rights than a problem of not paying them enough.

Free markets always, always correct themselves.


A compilation of Joint Economic Committee reports about minimum wage can be found here.

Disclaimer: I fully understand that there are exceptions in every case, especially in statistics. I fully understand the words of Doug: "You can't manage to the exception." They're exceptions, not the rule and even if all our time is dedicated to handling exception we still would not be able to address them all. It is best to manage to the rule, especially when talking about a state full of people, and let the exceptions be handled on a case by case basis.

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