My TCS column Minimum Behavior:
California is considering raising its state minimum wage. Bills under consideration would raise the wage by as much as a dollar and call for subsequent indexing of the wage, so that it will increase automatically along with inflation. According to press reports, Governor Schwarzenegger will not oppose a hike in the minimum wage, but is resisting indexing.
Assuming California ought to have a statutory minimum wage, which admittedly is a contested proposition, Schwarzenegger has it exactly backwards -- at least as far as an important segment of the relevant population is concerned.
The standard arguments over increasing the minimum wage are all focused on the effect of such a hike on the supply of jobs by employers. Basic price theory from Econ 101 tells us that employers faced with higher wage bills will hire fewer workers. Proponents of higher minimum wages counter with various empirical studies purporting to find no loss of jobs and various theoretical explanations for why standard price theory might not apply to this market. Opponents of wage hikes counter with their own studies and theories. And so the weary day wears on.
To be sure, the argument over job supply is an important one. Yet, in focusing on that issue, we overlook an equally important question; namely, what effect does a minimum wage hike have on the demand for jobs by potential employees?
At the outset, it is critical to recognize that the minimum wage debate is mainly a debate about how much working teenagers and twenty-somethings in their first job ought to make. The federal Bureau of Labor Statistics reports that (in 2002):
"Minimum wage workers tend to be young. About half of workers earning $5.15 or less were under age 25, and slightly more than one-fourth were age 16-19."
Let's focus specifically on the latter group. Imagine you're a 17 year-old junior in high school with a part-time job paying the minimum wage. You're eager to get started with life. You want to get a car, a place of your own, and maybe even get married. You're bored with high school and don't expect to go to college.
If you stay in school, you sacrifice current wages for higher future income. If you drop out, you likely will have a lower lifetime income, but start making money immediately.
Although you likely wouldn't articulate the problem in these terms, you're faced with a capital budgeting problem. Should you invest in your human capital by staying in school or should you drop out and go to work full time?
Although there are several ways for a business to make capital budgeting decisions, the simplest and most relevant to our hypothetical teenager is net present value. You therefore should discount to present value the net stream of income that would be generated by each of your choices.
The problem is that research in behavioral economics suggests that young people tend systematically to err in assigning discount rates; specifically, because they tend to be systematically biased in favor of current consumption, they tend to use too high a discount rate in making such calculations. As a result, the prospect of an immediate income will be given too much weight in their calculus and the prospect of higher lifetime earnings in the future too little weight and, when deciding between work and a present paycheck versus staying in school and deferral of income, they will tend to err towards the former.
Although relatively little empirical research has been done on the effect of a minimum wage hike on the demand for work by teenagers, one study does find results consistent with the foregoing analysis:
"Minimum wages increase the probability that teenagers leave school to become employed or work more hours, and increase the probability that they leave school and become non-enrolled and non-employed. Minimum wages also increase the probability that lower-wage employed teenagers become non-enrolled and non-employed." (Link)
Increasing the minimum wage is thus problematic because it makes the choice of work over school marginally more attractive.
For America to be competitive in a global marketplace, it needs an educated workforce. Minimum wage policy therefore must take into account the impact of changes in the minimum wage on the choice the youngest workers make between school and work.
The foregoing analysis has two specific implications for minimum wage policy. First, a differential lower minimum wage for those who have not completed a high school degree should result in a lower dropout rate.
Second, and here is where I think Schwarzenegger is wrong, the minimum wage ought to be indexed. Under current law, we get episodic large hikes in the minimum wage. In the interim between hikes, inflation tends to erode the value of the minimum wage, which will encourage teenagers to stay in school. In the year that a large hike occurs, however, the growth in the minimum wage far outstrips inflation, which tips the balance in favor of work. An indexed minimum wage, which grew steadily and no faster than inflation, would avoid the potential for biasing the choice between work and school.
