Thursday, September 19, 2013

The Impact of Minimum Wage

During recent travels abroad I was confronted with sky high prices in Australia.  The extreme costs of some items wasn't a surprise, but it got me thinking about the root cause of such price differences. Locals provided reasons such as high taxes, transport costs, low population density and high minimum wage laws as possible root causes.  All of these likely drive up prices for at least some products, but in reality only one of them is a major cause. Sales tax for example isn't all that much higher than in the US (10% for non food items and no tax on grocery items). Transport costs are irrelevant for many items (digital downloads are still expensive) and a small portion of the cost for others.  Finally, overall population density doesn't seem terribly relevant for the highly populated coastal areas which still maintain high prices. In reality, high prices are likely a product of a high median wage which  research shows seems to be about 40% higher for a full time worker in Australia than in the United States.

Of course, there was one suggested reason which has yet to be addressed. Is the high Australian minimum wage driving prices up? The Australian federal minimum wage is currently $16.37 in Australian dollars or $15.32 as opposed to the US federal minimum of $7.25 (state laws often demand a higher minimum than the federal minimum). Clearly this is an extreme difference, but is it a large part of the reason for Australia's high prices?

There are a number of effects of minimum wage laws. Like many economic ideas the fact that these effects occur is generally agreed upon. However, the degree of the effects is a topic of hot debate. The consensus is that minimum wage laws:
  • Increase unemployment: There must be some set of workers that a business is willing to pay X for but is not willing to pay Y. Thus increasing the required wage from X to Y will result in the loss of their jobs.
  • Increase prices or reduce profits: Increasing the cost of labor necessarily increases the cost of production. The firm must either accept reduced profits or pass these costs on to the consumer.
The degree of a potential price increase would clearly depend upon the amount of minimum wage labor that a given industry employs. As food service is an industry that uses a larger than average proportion of minimum wage workers it should be impacted significantly by minimum wage differences.  In fact, studies have indicated that an increase in the minimum wage of 10% results in between a .5% and 5% increase in food prices and between a .5% and 1% increase in overall prices. 

Given Australia's minimum wage is approximately 100% higher than the United States we can expect 5% to 10% higher overall prices.  Certainly this is a significant impact and a major contributor to the higher prices Australians must pay. Of course, they pay these higher prices with their higher wages and thus aren't too burdened by prices that would shock many Americans.

An important note is that most studies investigating the impact of the minimum wage on prices look at a single moderate increase as opposed to a large difference such as that between the US and Australia. It is highly likely that price effects of minimum wage increases scale in a non-linear fashion. In other words, studies show a 10% increase in the minimum wage increases price levels by .5% to 1%. However, multiplying that wage increase by a factor of ten is likely to result in a much larger price increase than 5% to 10%. This is because larger increases in minimum wage regulations will impact more workers, thus causing a larger total effect.

As an example, imagine the world contained one thousand workers. Workers earn with a fairly normal distribution (a bell curve) within a range of one to a hundred dollars an hour. Further, assume all workers are going to remain employed for the purpose of this example.  If the government institutes regulations requiring a minimum wage of five dollars an hour there is little in the way of price effects. After all, very few workers are earning below five dollars an hour anyway, thus the impact is small. However, if the government instituted a requirement that workers be paid fifty dollars an hour the price effect would be enormous. Nearly half of the population would see their wages increase, some by an order of magnitude.

An interesting aspect of minimum wage laws is that they are simply a disguised wealth transfer. Everyone in society pays higher costs which are then distributed to the lowest paid workers via a required minimum wage. It's a rather roundabout system which unfortunately prices some workers out of the market (resulting in higher unemployment) but is functionally similar to social security of unemployment benefits.

Ultimately Australian's higher prices are a result of their higher earnings.  While the other mentioned factors do make a difference, those differences pale in comparison to the price increases caused by higher minimum (and moreover median) wages.  Unfortunately, visitors from countries with lower wages are still stuck paying the inflated Australian prices.  

That's all for this week. Until next week stay safe and rationale. 

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