Why Do Wages Rise? Not Because of Minimum Wage Laws, New Data Show

In 2023, more than half of states will be raising their minimum wage.

While this may sound like a recipe for disaster, recent reporting has demonstrated that it is not expected to have a significant impact on employment or wages. The reason is straightforward: wages for low-skilled jobs have risen in recent months amid strong labor demand, which has caused a labor shortage. Thus, the equilibrium wage for low-skilled jobs—precisely those jobs that would regularly be impacted by a minimum wage hike—is already above what the wage floor will be moved to in many cases.

A Wall Street Journal analysis of data compiled by MIT professor Nathan Wilmers found that “Through September, the lowest 10% of workers by income in each state earned hourly wages that were on average one-third higher than their state’s minimum wages.” The “one-third margin was the highest in at least a decade,” the Journal notes.

In some states, the difference is even more pronounced. In Minnesota, for example, the Journal found that the bottom 10 percent of earners are making about 40 percent more per hour than the state’s minimum wage would dictate. Additionally, a local paper in Michigan explained that even though their minimum wage is scheduled to rise to $10.10 per hour this year, most business owners are already paying $1 – $4 more than that for low-skilled jobs. Just one percent of Michigan workers are making minimum wage today, as opposed to 10% less than a decade ago.

Why Do Wages Rise?

It should be noted that while these gains would normally be cause for celebration, recent inflation has outpaced wage growth. This means that, in real terms, peoples’ wages have not necessarily risen. However, this is a separate issue that deserves an analysis of its own.

What is relevant to our discussion is that the phenomenon explained above demonstrates that wages are not driven higher by minimum wage hikes but rather by market forces, specifically investment and competition.

We can see how this works by considering a simplified scenario. Firm A is successful and makes a profit, which means that they have earned more revenue than is needed to cover their current costs. So, in order to grow their business further, they will invest some portion of their profit into such things as training workers in new skills or implementing new technology. These investments will likely make existing workers more productive, empowering them to generate more revenue for the firm than they could before. The competition from other firms for this increasingly-productive labor creates upward pressure on wages.

This is not some sort of free-market fantasy, but rather has been borne out empirically. Recently, such competition for labor led to wage increases for hundreds of thousands of workers at companies ranging from Walmart to Costco to Amazon.

Wages have risen even further now due to the labor shortage, as there are many firms trying to outbid one another for a limited number of workers. But employers aren’t only competing with each other; they are also competing with the factors that are keeping people out of the labor market altogether, such as unemployment benefits. Firms must convince workers that they are providing them more value than all alternatives.

In this way, we can see that wages rise for two reasons that are often, but not always, interrelated: 1) investment that increases productivity and 2) competition.

In most cases, what a minimum wage attempts to do is raise wages without changing the underlying dynamics of the market. While this can artificially raise wages for some—although not without significant tradeoffs in the form of lost jobs—it is not reflective of real market conditions.

Two Types of Minimum Wages

A cynic could argue that the fact some minimum wage hikes will be inconsequential is evidence that “raising the minimum wage does not cause unemployment.” But this would be mistaken. It is common sense that people or firms will purchase less of a good as it becomes more expensive. That is true whether we are talking about buying slices of pizza or we are talking about hiring employees. Rather, what this story demonstrates is the difference between binding and non-binding minimum wages.

When discussing minimum wages in politics, we are almost always talking about binding minimum wages. This simply means that the proposed minimum wage is higher than the equilibrium wage, thus binding employers to pay above what they would have otherwise paid. This leads to firms hiring fewer employees, all else equal.

However, in some cases, the proposed minimum wage is lower than the equilibrium wage, which means that the firm was already going to pay prospective employees more than the minimum wage would dictate. This is called a non-binding minimum wage because the new wage floor would have no impact on the employer’s incentives or behavior. It would also have no impact on the wage of the employee.

Many of the minimum wage hikes that will be going into effect in 2023 appear to be non-binding: the equilibrium wage is already higher than the new minimum wage. Thus, we will not be seeing large impacts on employment. Understanding the distinction between binding and non-binding minimum wages is crucial to remaining clear-sighted when reading headlines about how new minimum wage hikes will have little to no effect on key economic variables.

Even so, this will likely not be the case everywhere. We know that different locations have vastly different costs of living and equilibrium wages. This is the reason why, as a FEE analysis demonstrated last year, “A $15/hour minimum wage in Puerto Rico is [equivalent to] a $68/hour minimum wage in DC.”

We must keep in mind that no two jurisdictions are the same.

Wage Floors Are Not An Anti-Poverty Tool

It is a common myth that it is minimum wage hikes, not the shifting landscape of supply and demand, that lead wages to rise. Those making this argument implicitly suggest that the minimum wage is, in fact, an anti-poverty tool.

But this line of thinking is severely mistaken.

The late economist and professor Walter Williams wrote on this in The Freeman in 2007.

This assertion [that minimum wage is an anti-poverty tool] does not even pass the smell test. There are miserably poor people in the Sudan, Bangladesh, Ethiopia, and many other places around the globe. Would any of these economists propose that the solution to world poverty is a high-enough minimum wage? Whether it is Ethiopia or the United States, poverty is not so much a result of being underpaid as being underproductive.

This is absolutely true. By the logic of minimum wage advocates, there is no reason why we should not, and could not, simply raise the minimum wage to $100/hour. The issue, of course, is that a firm’s behavior is significantly determined by supply, demand, and productivity—not abstract notions of what people may “deserve.”

If we wish to pull people out of poverty—a worthy goal—then we must focus on ways to equip people to become more productive, and therefore provide more value for an employer. This is done primarily through education, skills training, and investment in capital.

Minimum wage advocates and opponents are not necessarily in disagreement about what a proper outcome looks like: fewer people in poverty. The disagreement is whether or not this can be achieved through artificial top-down schemes or must be achieved through organic investment and improving skills through education (including self education), all with an understanding that wages are determined by real market dynamics.

The latter has been demonstrated both theoretically and empirically, but the former is unfortunately far more in vogue among political elites. It is our job to work to change that.

The post Why Do Wages Rise? Not Because of Minimum Wage Laws, New Data Show was first published by the Foundation for Economic Education, and is republished here with permission. Please support their efforts.