Minimum Wages and Market Forces

Can Market Forces Principles Be Applied to the Labour Markets? 


Listener: 27 May, 1995 


Keywords: Labour Studies; 


Myth and Measurement: The New Economics of the Minimum Wage is already controversial in the United States. It is also likely to be so here. Written by David Card and Alan Krueger the study argues that minimum wages do not necessarily cause fewer jobs. The Princeton University professors of economics pursue their campaign with military precision: marshalling the evidence, launching new studies, and demolishing old ones. A couple of examples will give a flavour of the 422 page book. 


When in 1992 the state of New Jersey increased its minimum wage, the researchers found those restaurants which were forced to increase their wages had higher employment growth (yes, higher) than those already paying above the award. Second, the book also examines the traditional econometric way of using time series data and shows that the studies measuring the effect of minimum wages are methodologically faulty. If these faults are remedied, the studies conclude a rise in minimum wages does not reduce employment. 


Of course the writers are not arguing that an unlimited hike in any minimum wage does no damage. They are cautious about drawing any policy conclusions. Undoubtedly many will, arguing that the minimum wage should be increased in order to increase the income of the lowest paid, without – so the research seems to indicate – having any adverse employment effects. 


Already there has been a heated reaction to the publication. Over 90 percent of American economists believe the opposite to the research, and that minimum wages destroy jobs for the low paid. Card and Krueger are challenging a central tenet of American economics. (The New Zealand figure is under 70 percent.) For the nub of the matter is not a policy issue, but whether labour markets behave like conventional markets, such as those that determine the price of wool. 


Economists tend to be brought up with the principle that all markets operate in broadly similar ways. But there is another tradition which argues that labour markets work differently. The book provides further support. 


At issue is the extent to which each labour relationship is different, because people are different, and it is not possible to have a standardized human commodity, in the way that wool can be measured and standardized. This heterogeneity undermines the simple market theory. The difficulty with such “efficiency wage” theories, as they are sometimes known, is that they are far from elegant. It is easier to use the simple standard market model taught in elementary economics, even if that means making assumptions which are far from the reality of actual market experience. 


It is too early to predict the outcome of the dispute between the idealists and the realists. Given the ideal of the market has such a widespread hold in the economics profession, the realists cannot win overnight – or by one book, no matter how impressive it is. On the policy side there may be more movement. Krueger is now the US Department of Labour’s chief economist. The Clinton administration has proposals to increase the minimum wage, although a republican led congress is likely to stall them. The initiatives will be with the states. 


In New Zealand, a time series study by Tim Maloney of Auckland University is widely quoted as demonstrating that minimum wages have increased unemployment in New Zealand. However it is subject to the Card-Krueger criticisms. It will be interesting to see what happens when they are addressed. But there is another major weakness in the study. Not only does it find that increasing minimum wages reduces employment, but it also finds that increasing unemployment benefit levels (financed out of higher taxation) increases (yes, increases) employment. 


Any competent econometrician could have suppressed this benefit effect, but Maloney, who is one, instead left the anomalous outcome in his work. Full marks for integrity. 


The result is so bizarre that it is difficult to take any of the conclusions of the study seriously. What the research seems to say that hiking the minimum wage and increasing benefits at the same time can increase employment with a fairer income distribution. 


To introspect a moment. Notice my different reactions to the two findings. I am prepared to accept the possibility of Card and Krueger being correct, because of the widespread evidence and an underlying theory. However I am unhappy with the Maloney conclusion about the effect of benefits even though my political preferences would be very comfortable with such a finding. One swallow does not make a summer, nor one study a conclusion. It may be that Maloney’s benefit finding is correct, but we need a lot more evidence. 


<>It would be good if this sort of pragmatic combination of theory and empirical investigation (which the book beautifully illustrates) were the basis of the discussion here, and in the US, on wages and labour markets. I fear however, that the debate is likely to be dominated by ideologists who will insist that the empirical evidence be disregarded if it contradicts the ideal of their political prejudices.