Minimum wage vs inflation: A TVHE discussion

We are sadly too busy to really post anything at the moment.

As a result, to fill in time we will put up a recent discussion between TVHE writers.  The one thing this conversation shows:  we all agree that arbitrary policies that are introduced to indirectly target a problem (eg changing the minimum wage to target inflation) tend to do more harm than good.

Am I missing something? Cost push anyone?

http://www.newsobserver.com/340/story/287265.html


Increasing the minimum wage is a one off increase in the wages for one part of the labour market right, and it would reduce employment, which would reduce “demand”, which would reduce growth in prices (which is inflation).

Any increase in inflation would have to come from inflation expectations – where the increase in cost passes into prices and then the higher price level is “confused” for inflation.

As a result, if we can say that an increase in the minimum wage will:

  1. Be in industries where demand for the product is relatively elastic so the change in price is minimal,
  2. Be in industries where demand for labour is relatively elastic so that employment falls reducing demand

Then we can say a higher minimum wage will reduce inflationary pressures.

Of course, this seems like a fairly suboptimal way to reduce inflationary pressures – as when demand is elastic (as it would be in the labour and goods markets here) the direct welfare cost of the minimum wage is very high …


how likely is it that the set of circumstances you outline will eventuate? It seems quite far fetched to think that it will hold across all industries that heavily utilise minimum wage labour.


Well then there is a trade-off – its impact on inflationary pressure vs its impact on economic efficiency and direct impact on welfare.


I’m suggesting that the trade-off might not even exist:  it may hurt efficiency and thereby exacerbate the inflation problem.


True.

However, they only way I can think of really getting that result is:

  1. Using a capacity model of inflation,
  2. Saying that the corresponding lift in the price level for a negative supply shock will feed into inflation expectations.

Although this will limit the inflation vs efficiency trade-off I’m not sure it will make it reverse direction, although it could.

  • steve

    I heard a recent argument which explained Australia’s wealth is because of our employment contracts act, as well as their compulsory saving for superannuation. In NZ, wages stayed low so when firms expanded they simply employed more people at a relatively low wage. In Australia, a higher minimum wage and stronger unions meant that firms had to look for alternatives such as innovating and employing more capital, rather than labour. capital was also relatively cheap because of compulsory savings, and comparatively cheaper than labour in the production function. The additional capital in the market has now resulted in higher wages being passed on to the labour market.

    I don’t think increasing the min wage would help us though because of factor mobility. firms would continue producing in Australia if we increased wages here and there would be an outflow of capital as firms continued shifting production to Australia.

  • How would changing one relative price cause inflation? Inflation is about the price level, not relative prices.

  • @Paul Walker
    1) Labour is an input to pretty much everything so the price level is affected.
    2) Changing the minimum wage can affect national incomes and aggregate demand.

  • @rauparaha
    1) Labour is an input to pretty much everything but the labour affected by the minimum wage isn’t. Also even if labour is an input to everything, a change in its price should affect unemployment – labour demand curves slope downwards – not inflation.
    2) The minimum wage increase would increase C for some groups but only by reducing C or I for other groups. The money to pay for the increase in wages has to come from somewhere. Also if output Y doesn’t change then the effects of the increase in the wage have to be cancelled out by a reduction in something else.

  • @Paul Walker

    @Paul Walker

    To quote the blog post:

    “Increasing the minimum wage is a one off increase in the wages for one part of the labour market right, and it would reduce employment, which would reduce “demand”, which would reduce growth in prices (which is inflation).

    Any increase in inflation would have to come from inflation expectations – where the increase in cost passes into prices and then the higher price level is “confused” for inflation.”

    So higher minimum wages are a cost shock, which would feed into a higher aggregate price level, which could increase inflation expectations and thereby inflation.

    However, higher minimum wages also reduce employment. This should reduce inflationary pressure by weakening the bargaining position of labour for future wage growth.

    Because the money supply is endogenous, inflation stems from inflation expectations and the relative strength of the labour market (compared to its natural level). A relative price shock does influence these two macro variables, so we can say that there is some relationship.

  • “Any increase in inflation would have to come from inflation expectations – where the increase in cost passes into prices and then the higher price level is “confused” for inflation.””

    But given people know its a relative price change why do inflationary expectations change?

  • @Paul Walker

    We are allowing for the possibility that, seeing a one off increase in the general price level, people increase inflation expectations. This is EXACTLY the same thing as the petrol price crisis – when inflation expectations obviously and measurably rose in the face of an obvious relative price shock …

    The reason we accept this as a possibility is because peoples expectations aren’t formed in a manner that is compatible with “transaction costless” rationality – people do appear to allow for some degree of adaptive expectations, and the impact that has needs to be mentioned as a possibility when framing a general situation.

    Furthermore, we are only saying how the minimum wage COULD influence inflationary pressure – we are not saying that it WOULD. Infact, we spend most of the time stating how a higher minimum wage could potentially REDUCE inflation, not increase it.

    The entire post only says what channel the minimum wage change would have to move through in order to influence inflation, it doesn’t state:

    1) that it will happen that way (especially since the change in price growth was ambiguous – as it always is with a relative price shock)
    2) that it would be a good state of affairs

  • @steve

    “In Australia, a higher minimum wage and stronger unions meant that firms had to look for alternatives such as innovating and employing more capital, rather than labour. capital was also relatively cheap because of compulsory savings, and comparatively cheaper than labour in the production function.”

    So there were two things there.

    They increased the relative price of labour – which merely implies that there “budget constraint” was more sharply binding. So this wouldn’t promote growth, but it would likely lead to an increase in the capital-labour ratio.

    The second bit is compulsory saving. Now I am sure that this did reduce the cost of capital for firms, and lead to greater investment. After all there is a “home-bias” for capital.

    But I can’t get past the fact that the saving is compulsory. We could also increase measured output by making people work 20hrs extra a week for free. Anything that forces people to do something which they wouldn’t otherwise choose, and with which there is no direct social benefit, is unlikely to maximise social welfare.

  • steve

    @Matt Nolan
    Typically I would agree. people choose to save based on the discounted long-run returns or they choose to consume. However there is a societal benefit to saving, that is not captured in these individual returns.

    In the longer run, with higher capital per worker, workers benefit because they end up being paid the marginal value per worker. Because individuals percieve the savings as only the return on their investment (in a bank or shares etc) and not the additional wages provided to workers, they will tend to save less than is optimal if everyone were saving together (people do not include the public benefit and would prefer to free-ride on others; savings)- hence a reason for government intervention to encourage savings (even if it is different to the reason given when compulsory savings was introduced).

  • @steve

    But those aren’t “social returns” in the sense that we should subsidise them. Why? There are a bunch of markets which price the return on investment, and price of capital, and the return to labour from different choices – so everything is internalised.

  • steve

    I don’t mean we should subsidise them I mean there is a slight market failure in the market for savings. People don’t price in the return on investment in terms of increased wages to society (due to increased capital). there is an incentive to free ride on others savings.

    Therefore there is some justification for intervention to encourage higher savings so that the savings level reflects all the return on investment of both investment return and increased wages. whether this is by subsidy or compulsory savings would have to be evaluated as to which has the best outcome; I suspect there is a case for a combination of both measures.

  • @steve

    This isn’t a market failure, as there is a price in the capital market and a price in the labour market. To have a market failure we need an area where there is no price. In general equilibrium there is no mis-allocation here.

    The only way we could justify intervention is if:

    1) We think there is some persistent cognitative bias,
    2) We think there are multiple pareto-ranked equilibrium for the economy and that the “high capital” one is superior.

    However, there is no market failure persee.

  • steve

    A market failure is not where there is no price. It is where the equilibrium is not the most efficient. i.e. there is another outcome that is a pareto improvement. In this case there are positive externalities to savings which are not captured by the market.

    whether you call it market failure or not, I was simply pointing out this as a possible reason for government intervention, and a large part of the reason Australia is better off than NZ.

  • @steve

    “A market failure is not where there is no price. It is where the equilibrium is not the most efficient.”

    A market failure is where we:

    1) Have market power,
    2) Have an externality,
    3) Have a co-ordination problem/public good or some such

    There is none of that here.

    Because the equilibrium wage is higher with greater capital accumulation isn’t a positive externality. The wage is a market price, the interest rate is a market “price”, these adjust to meet supply and demand in each of the respective markets. There is no externality here – it is all part of the general equilibrium in the economy.

    “In this case there are positive externalities to savings which are not captured by the market.”

    We have an externality if the voluntary trade of agents has a positive impact on an agent OUTSIDE of the market. We have a market for labour and a market for capital.

    Here the efficient ratio of labour to capital is determined by technology, and the prices in the relative markets represent that. Fiddling a price in one market (enforced savings) will change this ratio and lead to an inefficient allocation of resources.

    “I was simply pointing out this as a possible reason for government intervention, and a large part of the reason Australia is better off than NZ.”

    Forcing people to save more does lead to higher levels of economic activity in the future, yes.

    Does it lead to higher inter-temporal welfare? Only if we believe there is some sort of market failure in capital markets (in this case we could appeal to time inconsistency in the savings decision for example). Personally I believe the burden of proof is on those trying to force compulsory saving, both to show:

    1) That it does increase welfare,
    2) That we can’t solve any identified market failure through voluntary mechanisms (which have the advantage of revealing actual preferences in society – rather than assuming them).

    Also I think a larger reason that Aussie is better off then NZ is their closer location to market, greater scale for production, and their greater endowment of resources – it would be interesting to see a full empirical study on that though.

  • steve

    you don’t understand my argument. the wage rates of others is outside the market for my savings, yet they recieve some of the benefit as the marginal value of their labour increases with my capital. This particularly fits 3, but could also be considered 2.

    think of a model over time and include increasing returns, you might see what I mean.

    voluntary mechanisms won’t work because when I invest, I don’t include these wage returns on my savings because the returns are to others. in fact, I free ride on other’s savings when capital is invested and my marginal value of labour increases. therefore we all free ride on eachother and don’t save as much as is optimal.

    I agree that the closer to the market thing in Australia is why they are better off. I saw a study which said Australia’s location makes it 10% worse off than expected, and the location of central/western european countries makes them 7% better off. Therefore Australia is naturally 18% disadvantaged on Europe, NZ is even more. Plus Australia has a greater home market effect, particularly now that it is significantly more capital intensive.

  • @steve

    “you don’t understand my argument. the wage rates of others is outside the market for my savings, yet they recieve some of the benefit as the marginal value of their labour increases with my capital”

    Ok, here is how I see it.

    Both labour and capital are inputs to the production process. The efficient allocation of labour and capital is such that the marginal rate of technical substitution is equal to the ratio of the marginal costs. The MRTS is determined by technology.

    Arbitrarily increasing savings to lower the interest rate to increase the level of capital will lead to an inefficient allocation of resources relative to fundamentals.

    Now, if capital and labour are strategic complements then yes there is a “positive externality” and the efficient allocation of capital will be greater – but in cases where the inputs are strategic complements we should be looking at policies that promote co-ordinated activity directly, rather than messing around in the macroeconomy.

    Lets fill this out a bit. Looking at this in a strictly GE sense, as you say, under your assumptions a higher level of capital increases wages. So we know that, in this model where forced savings has pushed down interest rates – wages are higher and the cost of capital is lower. As a result, the allocation of resources will be more relatively more capital intensive then in the free market case.

    As a result, this differs from the pareto efficient allocation – which according to the first welfare theorem is the free market one.

    Now if we accept some type of strategic complementarity there will be multiple parteo ranked eqm, sure – and this implies that a higher capital eqm could be pareto superior.

    BUT, where is the strategic complementarity? A firm investing in capital and thereby increasing the marginal product of their own labour isn’t strategic complementarity, as they are choosing their own labour and capital on the basis of this fundamental relationship. Furthermore, doing this increases the wage rate this actually leads to a negative pecunary externality on other firms!

    For strategic complementarity to hold in this sense we need to say that an increase in one firms capital directly increase the marginal benefit associated with other firms hiring labour right – which seems like a stretch.

    I’d buy it for capital influencing capital – which is the case of increasing returns to scale and spillovers. I would not buy it for capital influences other firms labour through spillovers.