In Which I Disagree with Paul Krugman about the Minimum Wage

I winced typing that title, since it is not wise to disagree with Paul Krugman and since I am going to argue that cutting the minimum wage can cause increased employment. Before going on, I stress that I oppose cutting the minimum wage as the logic of my argument suggests making the tax code more progressive. I think what we need right now is a more progressive tax code. That’s what I always think.

OK so first Krugman argues that, when in a liquidity trap cutting all wages equally will not cause increased employment. Only here does he respond to the obvious criticism.

1. Why did I go from minimum wages to overall wages? Clearly, a cut in minimum wages –which only apply to some workers — can raise the employment of those workers at the expense of other workers. But the advocates of a cut are claiming that they can raise overall employment. The only way that can happen is if a reduction in average wages raises employment.

I assert it depends on how you measure employment. Krugman is appealing to standard macro models in which employment is measured in “efficiency units” and the wage level (“wage unit” to Keynes) is the wage per efficiency unit.

The standard assumption is that labor is uniform and can be measured by a number. The plain fact that some people are paid more than others is handled by assuming that they are more able in every way so their wage per efficiency unit of labor is the same. Thus consider able Andy who has twice the wage of luckless Larry and of bad Brad so he is paid as much as the two of them. It is assumed that he can do everything just as quickly as the two of them working together.
This is clearly absurd and is not to be taken literally.

As Krugman does.

Worse than that, once you define labor in efficiency units, you define employment as the number of efficiency units of labor employed.

The public policy concern is about how many people are employed. These can’t be the same. Measuring labor in efficiency units might be an OK approximation if we cared about GNP, but if we care about employment and unemployment (as Krugman regularly insists we should) we have to think about people not units of efficient labor.

For the sake of argument let’s stick with the efficient labor assumption. Oh and assume wages are sticky (we need some nominal stickiness to avoid the price level falling a few hundred fold in a second making the real balances effect a real factor). Now assume 2 types of workers able and not so able (90% are able 10% not so able) . An able worker produces just as much as two not so able workers.

Back in 2007 all workers were employed, not so able workers were paid the minimum wag and able workers twice as much. Now the market clearing real wage is lower, able workers are paid 1.99 times the minimum wage. Not so able workers are all unemployed so the unemployment rate is 10%

What happens if the minimum wage is cut 1% ? Suddenly all the not so able workers are hired. For each two that are hired one able worker is fired. Now the unemployment rate is 5%.

See simple. The reduction of the minimum can “raise the employment of those workers at the expense of other workers.” Under standard assumptions such a shift in relative demand for different types of workers “can raise overall employment.” so long as employment is counted you know by counting how many people are employed.

The absurd “efficiency units of labor” assumption implies that this effect is huge. Able and not so able workers are perfect substitutes so the elasticity of substitution of not so able for able workers is infinite.

In the real world the effect would be much smaller. It might be smaller than the damage to employment caused by the reduced expected inflation and therefore increased real interest rates noted by Krugman.

I oppose cutting the minimum wage, because I support cutting payroll taxes on low wage workers and making up the money by raising the FICA ceiling. I think payroll income above a floor should be taxed, not payroll income up to a ceiling.

According to Krugman’s argument this wouldn’t cause increased employment.

To put it another way, he is arguing that the increase in taxes on the rich and of the EITC enacted in 1993 had nothing to do with the huge puzzling increase in employment (without accelerating inflation) of the 90s.

OK now that I have argued with Krugman what about Card and Krueger. Empirical estimates of the effect of the minimum wage on employment suggest that the effect is very small. One famous study by Card and Krueger showed a positive effect of an increase in the minimum wage. The logic used by Card and Krueger to understand how this could happen suggests that things are different now.

Their logic is basically that firms can choose to pay a low wage and have a high quit rate and take a long time to fill vacancies or pay a high wage and have fewer quits and fill vacancies more quickly. If they are forced to pay the higher wage, their desired level of employment will be lower, but that level is the sum of employment plus vacant jobs. A binding minimum wage can reduce the number of vacant jobs by more than it reduces the sum of employment plus vacant jobs. Thus more employment.

I think this is not relevant to the current situation. There are very few vacant jobs. Quit rates are low. According to their logic, the effect of the minimum wage on employment depends on the unemployment rate. The evidence of a small effect is almost all from periods of unemployment far below 10%. I don’t think it is relevant to the current situation.