The harms of the minimum wage and its increase

Author: Martin Turpev

As of January 1, 2019, the state has given a gift to lower-skilled workers by increasing the minimum wage to 560 leva. Many people are welcoming this measure, which on a more abstract level seems normal. Who doesn't want to earn more money?

Beyond the rosy economic dreams, however, one economic fact stands firm and unwavering: The minimum wage is a politically determined amount of money. As such, it is definitely far removed – more or less – from the real price of the products of labor of every low-skilled worker.

This certainly means distortions in the labor market.

But because every market segment and every business is different, we remain to observe the specific parameters of these distortions.

However, we can now outline the logic of their manifestation.

This would be much more useful than the general talk of "finally the nasty capitalists will be forced to pay more to poor Bulgarian workers."

To explain the logic of these distortions, I will use fundamental logical constructs of the – for me – brilliant economist Murray Rothbard, described in much more detail in his book Man, Economy and State.

The idea is to consciously reduce things to their logical roots, with the aim of looking into the absurdity of the minimum wage and its periodic increases.

The minimum wage is set without regard to key business considerations

Since 2019, all companies have been required to pay a minimum of 560 leva to all their low-skilled employees. Even without complex economic theories, the absurdity of each company paying more to certain employees stands out, without changing the other elements and circumstances responsible for its profit - for example, increased preferences of end customers, reduced prices of other production factors, optimizations made in business processes that reduce costs.

But because, unfortunately, many people want scientific explanations and consider elementary business considerations to be nonsense, we need to explain more authoritatively.

As does the brilliant economist Murray Rothbard in his analysis of marginal utility.

What I will use here to make the connection to the minimum wage is the web that Murray Rothbard constructs, combining the marginal utility of various resources with the value of the particular products produced with them. For me, Rothbard's main point here is to show the fine-tuning upon which the survival and prosperity of business and the economy as a whole depend.

Rothbard shows us how important it is to combine:

• Marginal product of resource X
• Marginal product of resource Y
• Evaluation of the final product from resource X
• Evaluation of the final product from resource Y

It is important to find the right combination because the marginal product (the additional product from an additional resource used) is limited and decreases with each subsequent use.

So it is important, before making a decision, to assess how much additional product we will get from the given decision, how valuable this product is, and how the change fits into our entire situation.

Rothbard gives an example of a situation in which there are products in the ratio of 2Y to 4X and the goal is to decide what additional unit to buy – for example, what worker to hire. The capitalist will decide the case by hiring a worker, according to the additional product that he will produce and the value of this product in the context of the entire business. The law of marginal utility shows that in the 5X option, the additional worker would have a lower marginal utility, because there are 4 more like him. However, in the specific situation and with the specific combination of factors, his additional overall utility may be higher. Imagine, for example, that X is a web designer and Y is, say, an accountant, and the company is a digital marketing agency that advertises itself with its creative concepts and, in particular, with its creative visions for the web. This might mean that not only will the additional X worker be preferred – despite the fact that there are 4 more like him – but that he will also be given a higher salary.

The example is elementary and crude. Yes, in real business it is much more complicated, but that is the nature of economic decisions. That is precisely why, because of this complexity and economic nature, effective economic decisions must be made in the specific market situation.

However, the increase in the minimum wage to 560 leva is accepted outside of this situation. And since it is a minimum wage, the marginal product and utility will definitely be lower than this wage in many places. How can they be increased for a cleaner of an office of a software company, for example? From January 1, 2019, neither this cleaner will wash a larger area, nor will the cleanliness increase, nor will the rating of the service "Cleaning in the office of this company" increase suddenly and out of nowhere. However, she must be paid more! Because politicians say so!

Law of Returns

Murray Rothbard formulated this law as follows: "When other circumstances/factors are relatively unchanged, there is always an optimal amount of specific variable factors. If their amount approaches the optimum, the average product increases. If it falls below or above the optimum, the average product decreases." That is, there is a specific range of quantities and costs for factors/resources for each economic situation in which they bring profit. Below or above it, losses are already registered, and the size of these losses depends on the magnitude of the deviation.

This means that for each company and for each type of employee there is a certain amount of resources used, at which work brings him a satisfactory level of average profit under the given circumstances. For example, a certain number of cashiers, drivers, accountants, marketers, copywriters. Below this amount, the company does not have enough human resources to serve customers effectively and make a profit, justifying salaries - that is, the average profit decreases. Above this amount, certain employees simply do not have enough in quantity and sufficiently valuable work, so their salaries do not justify their contributions to the company - and the average profit decreases again.

And all optimal quantities and wages are determined continuously and for each individual company, according to each specific situation - number and type of customers, number and type of orders, volume of each order, speed and volume of cash flow, competition, etc.

It's about constant adaptation to changing circumstances. An adaptation that is seriously disrupted by any government measures.

Specifically, the minimum wage causes a serious shake-up in the optimal ratios in the quantities of low-skilled employees. The main reason for this is that the marginal product of these employees is initially low and there are not many options for it to increase in response to the increase in the minimum wage. Cleaning the office by a cleaner has no way to change its value for the business of an IT company, for example. This lack of possibility for an increase in the marginal product, as a possible response to the additional cost, significantly increases the average cost. That is, each cleaning /as well as other low-skilled work/, although it remains unchanged in value for the IT company, now costs more money than before.

And when the cost exceeds the optimal allowable amount, the cleaner/or any other low-skilled worker/ becomes redundant or at least a serious burden. She is either laid off or will have to work illegally. Low-skilled employees are the most vulnerable to increases in the minimum wage. Contrary to many beliefs, it is the minimum wage that can reduce their ability to earn a satisfactory income. The main reason is that their work is in most cases quite elementary and there are not many options for modification and optimization through which its value could increase sufficiently. Cleaning an office is generally not a very valuable activity in an IT company, for example, and there is nothing that workers can do to increase their productivity sufficiently. Cleaning is just cleaning and that's it. Therefore, an increase in the minimum wage instantly and irreversibly makes it more expensive - and given its elementary contribution, the increase in price is significant.

Which incentivizes employers to minimize the number of low-skilled employees.

For this reason, although they are advertised as supporting the standard of low-skilled employees, the minimum wage and its increase actually shake it. Since January 1, 2019, the average product of low-skilled workers has become significantly more expensive – or in other words, the average product of these workers has decreased relatively – and this cannot be compensated for to a satisfactory extent, due to the impossibility of using low-skilled workers for other purposes. This can cause many companies to lay off workers and refrain from hiring. And where a given optimal number of workers is mandatory, the increase in the minimum wage will cause an increase in costs, respectively a decrease in business productivity, a slowdown in investments – in general, damage to economic growth.

Why then do politicians maintain and often increase the minimum wage?

This is a perfectly logical question, especially given the defects it creates. My answer is simple: for PR.

Every politician wants people to notice and remember that during his time, wages are going up. And the minimum wage is going up the easiest and fastest. All it takes is one vote and that's it. But aren't some economic calculations being made anyway?

Here is the other PR trump card of the politicians. Because they have realized that an economic justification for policies is necessary, they use the increase in the minimum wage as an argument for good governance.

For example, Boyko Borisov recently boasted that “pensions and salaries are being raised” during his time. Indeed, once again under GERB rule, we have an increase in the minimum wage. The trump card in this case is the statement: “We are right-wing and we increase the minimum wage only in line with economic growth, and since we are doing it now, it means our policy leads to growth and is successful.”

However, how is this growth determined?

Mostly, through GDP growth. I won't go into details, but I will say that:

• GDP is more of a statistical than an economic indicator. It reports current quantities and average prices of selected products, perceived as “representative”. Given that the economy is dynamically driven by many and diverse specific factors, GDP is a rather irrelevant measure of economic development. Yes, its reporting is important, but it cannot be a critical factor giving carte blanche for interference in a given private business. Even if there is indeed an increase in some aggregate quantities and prices of “representative” products, this does not at all mean sustainable economic growth, accumulated savings and productive investments. Even less does it give reason to confuse the accounts in a particular company, forcibly increasing its average and marginal costs for labor products.
• GDP is a manipulated indicator. I cannot be convinced that GDP shows any real state of the economy, given that the abundant liquidity created by the unbridled financial policy of banks and governments artificially changes its magnitude. Economies are filled with wrong investments, ballooning spending, inflationary incentives. This completely knocks out the possibility of GDP adequately indicating the real economic state, let alone being a justification for artificially and forcefully increasing human resource costs in a particular company.

So, in reality, behind the increase in the minimum wage is mostly political PR. Political PR, which may succeed if business achieves productivity that hides the damage from the minimum wage.

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