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Politicians are proving Milton Friedman’s observation that “the government solution to a problem is usually as bad as the problem,” true once again (the Milton Friedman video below complements this blog post aptly). This time they are raising the federal minimum wage from $6.55 to $7.25 on July 24. This will be the third and final boost in a three-step plan by the federal government, based on legislation passed two years ago.
On the surface, this legislation sounds like a great idea. Who could be against paying low-wage earners more? But the bottom line is that this change will adversely affect consumer spending and unemployment. This is another example of politicians trying to buy a free lunch – the concept that nothing comes without a cost, even if it is hidden or dispersed.
One way to think about free lunches is to exaggerate the scenario to magnify its effects. If there were no downside to raising the minimum hourly wage to $7.25, then there could be no downside to raising it even higher to, say, $25 or $200 per hour. But obviously, widespread layoffs and price rises would ensue as a result, as employers would fire large swaths of the workforce and raise prices sky-high. This illustrates on a more noticeable scale why raising the minimum wage harms the economy – but the principles remain the same.
The minimum wage sets a ‘price floor’ the employer must pay in order to hire a worker. The higher the wage is, the less likely the employer will hire additional workers and the more likely the employer will fire workers, especially entry level service workers who can be fired and hired easily and marginal workers who add just enough value to merit their employment. This trend towards less hiring is amplified during an economic downturn when consumption falls and employers slash production.
This paradigm holds true across all products. Whenever a price is set at an artificially high level, consumption of that product will drop. What makes labor unique, however, is that production of labor cannot be slashed. If there were a price floor instituted for computers, then Dell and other companies could cut production to compensate for the lower demand. But labor is not like this – real people lose real jobs and suffer. The unemployment rate is already at about 9.5%. As the minimum wage boost takes effect later this month, unemployment will probably rise further.
Besides bolstering unemployment, forcing employers to pay employees even further above free market wage will reduce consumption. A higher minimum wage raises the cost of production. Employers often raise prices to partially compensate for the higher production costs associated with paying employees more. Thus, consumers end up footing the bill of higher employee pay. This is especially detrimental during a recession, as consumption is already falling.
As we Americans are presented with policy proposals like this minimum wage hike in the future, it would be wise to recall one iron law of economics: there is no such thing as a free lunch.
As Milton Friedman states in the video below:
"The fact is that the programs that are labelled as being for the poor, for the needy almost always have effects exactly the opposite of those which their well-intentioned sponsors intend them to have."