The Minimum Wage is a Critical Reference Point in Wage Setting

20 Oct 2015 8:25 AM | Deleted user

Following the first Democratic presidential debate, one could not help but wonder what exactly is the party’s economic platform. At times it appeared that each candidate was attempting to outdo the other in terms of how much the wealthy should be taxed in order to pay for more programs for the poor and the middle class. Although each candidate professed his or her love for the middle class, it became apparent that nobody was really addressing their needs.

Sure, they all talked about the need for higher minimum wages, but none of them seem to grasp the importance of the minimum wage for the overall health of the economy. The minimum wage is critical because it serves as a reference point for wages in specific industries — what we would term the low-wage industry — with potential spillover effects for others. In other words, if you were setting up a businesses in services, how would you know how much to pay your workers? You would most likely survey other businesses in the same industry to get a sense of what the prevailing wage is. But this is not what neoclassical theory tells us about how wages are set.

In the theory of competitive markets, wage setting is fairly simple: wages are set at the point where the demand for workers intersects the supply of workers. The more workers there are the lower their wages will be because more workers are competing for fewer jobs. Therefore, they will lower their wages until their labor services are consumed, i.e. purchased by employers. The problem, however, is that one would think there is one labor market, when in reality there are multiple labor markets. The labor market where the minimum wage has its greatest influence is in the low-wage labor market, which also happens to be the lowest skilled market.

In this labor market there is also an oversupply of low-skilled workers, which only drives their wages down further. Now for those industries that would like to pay as little as they can, which is also consistent with the basic tenets of micro-economics, these workers precisely because they have no real skill to offer are in no position to bargain for higher wages. A wage floor becomes necessary to ensure them a measure of monopoly power they otherwise would not have.

This is precisely why collective bargaining was so important to the building of the middle class during the Twentieth Century. It gave workers a measure of monopoly power to bargain for higher wages. In other words, it gave workers voice. Moreover, factor worker at the end of the Nineteenth and beginning of the Twentieth centuries were considered to be no more skilled than low-wage service workers are today. The fundamental difference is that they were able unionize, and unions were able to afford them dignity in their work, while low-wage workers are not able to organize.

The neoclassical economist, however, might respond in two ways: First, collective bargaining is no better than a wage floor, rather the effect is to artificially inflate wages where natural market forces would otherwise leave them. And second, a wage floor results in lower employment because workers are unable to accept jobs at lower wage rates. If wages are artificially inflated too much, employers might seek to substitute technology for workers. In other words, we are led to believe that wage setting according to the laws of supply and demand are really natural forces. 

Perhaps the real issue is that there is no such thing as natural forces when it comes to wage determination. The so-called laws of supply and demand work when we have skilled workers, but when our economy is only leaving us with low- skilled workers, then employers need a little push from the state. The purpose of the minimum wage then is to afford workers a measure of monopoly power.

In other words, heterodox economists don't disagree with the neoclassicals; they simply say so what? What heterodox economists realized was that workers and employers are not equal in their bargaining power. The neoclassical model always assumed that they were. Early heterodox economists, like John R. Commons, emphasized that the labor market imperfectly gave employers superior bargaining power relative to individual employees. There is an asymmetrical power imbalance between employers and their workers. Employers are wants traders while workers are needs traders.


The employer has sufficient resources that s/he does not have to hire workers immediately. Rather, s/he can wait it out until the price of labor drops to a more favorable level. The worker, however, is a needs trader who, because s/he needs to eat, does not have the luxury of waiting it out until employers raise their wages. Therefore, they will take whatever job is available. This, of course, gives the employer considerable power over workers.  Because of this inequity in bargaining power, there really was nothing to prevent the economic coercion of workers.

A wage floor, then, increases the bargaining power of those at the bottom rungs of the labor market. But for those employers who might like to obtain more effort from their workers in the general industries where minimum wage workers are found, they can now use the statutory minimum wage as a reference point for the wages they will pay. An increase in the minimum wage will no doubt affect the wage rates of those earning between $8-10 an hour or even more. Moreover, there is no reason to believe that there aren’t spillover effects into those industries paying more. After all, if the wages of low-skilled workers rise, is it unreasonable to expect that more skilled workers will similarly demand higher wages?

Now we can cut to the chase. The minimum wage does not really refute the laws of supply and demand, but the idea that it is a reference point does expose as hollow the idea that wage setting is really a natural process. It then becomes even more curious why those politicians who talk about the power of corporations don’t seek to explain the operations of the market place in these terms. Those who really want to help the middle class should seize on this idea of the minimum wage as a reference point, whose increase can help many more. As wages increase, so too does purchasing power, which in turn leads to more demand for goods and services in the aggregate. This is ultimately what drives the economy; not more programs paid for by more taxes on the wealthy.

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