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Fallacy Friday: Raising the Minimum Wage
In and of itself, the idea that raising the minimum wage somehow benefits the working class is a form of the classic broken window fallacy.
If you aren’t familiar, the broken window fallacy is the idea that breaking a shop window with a brick produces economic productivity, as the shop owner is forced to spend money on a new window. Surely the shop owner does so or they place the rest of their business at risk. We see, in the short run, the benefit to the glass repairman, but we do not see the damage to the overall economy. The money the shop owner has spent to remedy the damage caused by the brick can now no longer be used to expand their business or purchase products for their own consumption from others. There is also the chance that the brick has done so much damage and/or the price of repair is so high, that the shop owner is forced to cut back the number of his employees, or go out of business altogether. Even if the owner can afford the new window, there is no economic growth, as instead of having a functional shop window and the things or investments the shop owner had planned to make, the owner simply has a replacement window and is devoid of the equivalent capital.
When it comes to the minimum wage, the government is the brick.
Let us flush this out a little more.
The 4 Scenarios of Fred
Imagine a store, Fred’s Foods, owned by… well, Fred. Fred has food items to sell, but can’t secure the store, stock the shelves and ring up customers all at the same time. So Fred hires a security officer, a stocker, and a cashier. Fred has to pay each of them to provide their services. To do so, Fred must give them what they want in exchange for what he needs. Fred could give them extra food that he has, but they have other needs such as shelter, clothing, transportation, etc. So in exchange for their services, Fred gives them money, dollars, that they can exchange for all of these things.
To have these dollars available, Fred’s Foods must sell its goods in exchange. From the amount of dollars exchanged for the goods, several things must be paid for:
-Utilities to power the store.
-The wholesale cost of the goods.
-The employees’ paychecks.
-Fred’s Foods profits. (For the sake of this argument, Fred is the outright owner and the profits are thus his paycheck)
All of these costs determine how much the store will need to charge per food item. For the sake of the argument, let us assume Fred has done everything to make sure that he is using his utilities the most efficiently and that the wholesale cost of the food is fixed.
Now there are only two variables left in determining the food price:
1. How much Fred pays his employees.
2. How much Fred pays himself.
Let’s say that when Fred initially hired his employees, he agreed to pay them each $5.00 while he has decided that he himself wants to make $9.
After sometime of operating at these costs, and selling food at a price determined by these costs, Fred’s senator calls him and says, “Fred, you must now pay each employee $6.00, or you can no longer do business.”
What are his options?
1. Fred could reduce his own pay, i.e. his profits, by $3.00 and give 1 extra dollar to each of his 3 employees, bringing his pay down to $6.00 (as it cannot be any lower) and brings each employees pay up to $6.00.
2. Fred could raise his prices enough to make another $3.00.
3. Fred could fire one employee and free up $5.00.
4. Fred could refuse to comply with the law, shut his doors or have the government shut them for him.
The typical progressive expects option one to be chosen without a moment’s hesitation and probably hasn’t even read 2 through 4. Yet even as the first option may sound, all four will result in negative consequences for the broader economy as well as have potentially more immediate impacts on Fred and his 3 employees.
Let us go in reverse order and evaluate each scenario:
4. Fred shuts/has his doors shut:
Well here the problem is obvious. Fred is out of business, people have one less place to buy food, and Fred’s three employees have no income and no jobs. How selfish of Fred… even though he’s lost his income too.
3. Fred fires one employee and frees up $5.00:
Well, from the outset, one of the employees is out of a job. Additionally troubling is that now the store will have to operate either without a cashier, a security officer, or a stocker. Sure, each of the two remaining employees plus Fred could enjoy however the extra $5.00 is split up in the short run. However in the long run, a major problem looms. With Fred managing the company, there are only two employees left… to do three tasks! Who wants to shop at a store where the shelves aren’t stocked? Or there is no one to ring you up? Or how will Fred protect his goods from being stolen?
Fred’s Foods will obviously lose its competitive edge. Without one of these three quintessential functions being performed, the store is likely to become unprofitable. This inevitably leads to Fred closing his doors, as he has no incentive to manage a store that will inevitably run out of money. In the long run, Fred and all of his employees are once again out of a job.
2. Fred raises his prices to gain another $3.00:
The situation again becomes even more complicated. There are a number of scenarios that are inevitable to some degree as a result of this action. Fred’s prices go up, thus $1.00 can no longer buy as much as it did before at Fred’s store. At a certain point, the pay increases to his employees will begin to have negative returns for them, as each new dollar they earn results in a greater reduction in the purchasing power of that dollar. Further, Fred still has the same employees doing the same things at the same rate, but less money. We’ll come back to this.
These new higher prices begin to affect the broader economy. Fred’s customers may no longer be able to afford the new prices. They either stop shopping there, or Fred’s customers go to their employers and demand more money. Should they accept to do so, this forces them to take one of the 4 actions we are currently pondering. Should they choose option 2. (to raise their own prices) we see the beginning of inflation across the economy.
Progressively, a single dollar will be able to purchase less and less, forcing further increases in employee payment which again results in price inflation or layoffs and unemployment.
As an aside, inflation reduces the purchasing power of money that has been saved by other individuals in the economy, reducing their wellbeing and shrinking the economy in real terms.
1. Fred could reduce his own pay, i.e. his profits, by $3.00 and give 1 extra dollar to each of his 3 employees:
The progressive dream: “Can’t everyone just make the same amount of money?”
There are an incalculable number or reasons why this scenario is not ideal, but let’s stay central to Fred.
Fred is the owner and manager of Fred’s Foods. He has either taken out the loans or prepared the business plan for his investors. He makes sure he is using the utilities as efficiently used as possible, and deals with payroll and pricing at the store, along with every other imaginable aspect of managing the store. Where is Fred’s incentive to do all of this, and thus provide the gainful employment to his 3 employees, if he could make the same amount of money just stocking the shelves somewhere else?
You could put a gun to his head, but I think we all agree that hasn’t played out so well over the course of history.
There’s something else to consider. To paraphrase the economist Henry Hazlitt, there are only 3 places profits can go:
1. Personal consumption.
2. Business expansion.
3. Investment in other businesses.
Without having the ability to keep his extra profits, Fred is less likely to increase his personal consumption, invest in his business, or loan his money to another.
The result is that Fred doesn’t buy a suit from Sally’s Suits, so she has less money to hire tailors. He doesn’t have the money to expand Fred’s Foods staff, or even open up a chain of stores. Finally, if Fred’s friend Carlos approaches him about investing in his new car dealership, Fred doesn’t have sufficient capital available, and Carlos’s Cars will never open. All of these things thus result in lower employment in the economy.
Further, being forced to divide up his profits reduces the rate at which single sources of capital can be accrued. In order to invest in the equivalent of what Fred could have, his employees would all have to agree to put their money into one suit, or give it back to their employer to expand, or Carlos would have to triple his efforts to gain the same level of investment. Thus the rate economic growth is stunted.
Looking Beyond Fred
Obviously the example is far simpler than the situations that countless business owners and employees in this country face. We have yet to consider the implications caused by taxes and other government regulations. Further, we haven’t considered the proximity of places where Fred could move his business where he would be allowed to keep his profits.
But at the core of the issue, the government arbitrarily forcing businesses to pay more for something, or someone, and get no greater equivalent in return than they previously had is the same as breaking a window with a brick and paying to have it replaced with just another window.
Further, ideal compensation of employees must not be thought of in terms of how many raw dollars can be squeezed into their paychecks. This, at best, only provides short-term benefits to the employee, as, in the long-term, the value of those dollars is depleted by the fact that it takes an increasing number of dollars to purchase the equivalent of minimum-wage labor. What must instead be considered is how to provide compensation that provides the most value to the employee in the long run.
Indiscriminately deciding a numerical figure, without careful consideration of future value or the external effects it may have on employers’ ability to continuing employing, does no service to the working class. It simply sets in motion one of, or a combination of, the 4 Fred scenarios discussed earlier. None of these scenarios, given varying timetables, result in a net gain for the economy over what market forces can provide.
Thus compensation must be driven by private agreements and economic indicators, rather than the whims of politicians and central planners.