Reprinted from International Man
Are things really topsy-turvy down-under? Since people in Australia are already walking upside down on the bottom of the Earth, do the laws of economics operate upside down also? Does the minimum wage in Australia lead to more employment, instead of less?
In light of recent debate over minimum wages, referring to the situation in Australia, one might be tempted to believe that the answer is “yes.”
Some commentators have argued, contrary to prevailing economic theory, that the minimum wage can actually increase employment, owing to additional “money in the pockets” of workers flowing on to greater spending in the economy, which in turn causes greater demand for goods and services, and more employment for workers.
Some have attempted to bolster this argument by pointing to the high minimum wage and low unemployment rate in Australia as evidence that the policy either does not cause unemployment, or possibly even increases employment. If only other countries could be more like Australia, where the beer is cold, the women run around in bikinis, and the minimum wage and employment levels are both high!
Australia and the USA: A Simple Comparison
A simple comparison of the reported minimum wage rates and unemployment rates in Australia and the USA show that, prima facie (at first glance), Australia has a higher minimum wage and lower unemployment.
Even after conversion of the minimum wage into equivalent currencies, or equivalent purchasing power, the higher minimum wage in Australia still holds. This simple comparison tells the story of an Australian economy with greater employment and higher minimum wages than in the US.
However, as with many superficial comparisons of this kind, there is a lot more to the story that must be understood.
First of all, the rosy picture of employment in Australia ignores a great many statistical issues that take certain kinds of unemployment and underemployment out of the official figure.
Second, the minimum wage in Australia is exaggerated somewhat by the above figure, since its application to low-skilled groups is tempered substantially, using a sliding scale of rates that reduces the hallmark figure for the main groups affected by the policy.
Finally, there is the simple fact that basic comparisons of this kind do not get to the root of the causal effects of a policy like minimum wages—economic comparisons must occur ceteris paribus (all other things being equal).
When one takes account of these various issues, the reality of economic law is brought back into focus, and the situation in Australia is neither unusual nor inspirational.
What the Minimum Wage Actually Does
Understanding the effects of minimum wage laws requires a proper appreciation of what these laws actually do. Since a minimum wage law does not create any new resources, it does not create new jobs. All a minimum wage law does is to prohibit employment relationships that offer wages within a certain proscribed range.
For adults working in Australia, it is presently unlawful to employ an able-bodied person (over 21 years of age) to work for more than $0 an hour but less than $16.37 an hour. It is still legal to employ someone without giving them any wages at all, and it is also legal to employ someone for any amount at least as large as the minimum wage, but everything in between is forbidden.
This has two main effects, one pertaining to existing workers earning less than the minimum wage, and the other pertaining to potential workers that are not yet employed.
With respect to existing workers who are paid less than minimum wage (but more than zero) the employer must make a decision either to raise the employee’s wage to the minimum, or terminate their employment. Since the latter is costly, and there is also a certain degree of inertia in employment relations, the former option may be preferable and this may result in higher wages for some existing employees.
With respect to people who are not working, the minimum wage law creates a productivity bar that the would-be employee must now jump over before being offered paid work. If a person has low productivity (estimated by a potential employer to be below the minimum wage), then that person is unlikely to get a paid offer of employment—they can either choose to work for free, or they can look for alternative opportunities instead of employment.
Economic theory tells us that the minimum wage will cause unemployment, by virtue of the fact that it prohibits some employment relationships that would otherwise have been mutually beneficial to employer and employee —i.e., employment relationships that would have existed at a wage rate that is in the proscribed range.
This conclusion follows directly from the fact that, when labour is at a higher price, employers will generally want to use less of it, and workers (or prospective workers) will generally want to supply more of it, leading to a gap between offers of work and opportunities for work.
The long-run effects of the minimum wage are even more pronounced. Over longer periods of time, businesses have an opportunity to substitute away from labour towards capital-intensive modes of production. Labour-saving capital investment becomes more attractive when low-skilled workers are made more expensive by minimum wage laws.
As a result, there is a tendency for minimum wage laws to result in a shift to capital-intensive production, with a long-term reduction in the demand for low-skilled labour. Since this involves capital investment, it will generally persist even if the minimum wage laws are later removed.
Where the Minimum Wage Has Its Effects
This unemployment effect from the minimum wage does not occur across the entire labour market, and indeed, it affects only those areas where the designated minimum wage actually impacts the prevailing wage rates.
Economists sometimes say that the minimum wage will have effects only in cases where it is ‘binding,’ meaning that it operates on fields of employment where the designated minimum is enough to affect existing wages.
For example, if a minimum wage of $20 per hour was imposed on neurosurgeons or movie stars this would not do anything, save for wasting some administrative resources to impose the rules. Such a policy would not affect wages in these areas, since wages are already far above the minimum, and it would not cause any unemployment.
This means that when one is looking at the effects of the minimum wage, one must concentrate on the areas of employment where these laws are ‘binding’ in the sense of affecting existing wages and employment relationships.
It is quite misleading to look at the entire labour market, since much of this is composed of employment relationships where the minimum wage does not come close to affecting things. Where the minimum wage does tend to affect things is for low-skilled workers, mostly young people, and people with disabilities. We can therefore gain a reasonable comparison of minimum wage effects by looking at the minimum wages prevailing among these groups.
In the USA, the federally mandated minimum wage is an across-the-board minimum applying to all age groups. There is a temporary lower rate for younger people for their first 90 days of training, but after this they revert to the headline minimum wage, regardless of their age.
In Australia, there is a graduated system in which the minimum wage operates on a sliding scale according to age. The headline minimum wage that is reported in discussions of the topic applies only to people who are at least 21 years old, with the minimum wage for younger workers being substantially below this.
A comparison of the US and Australian minimum wages by age group (with the US minimum being a flat rate) shows that the minimum wage is actually lower in Australia for workers under 18 years of age. (All the present comparisons are for minimum wages adjusted for purchasing power parity.)
For disabled workers, both the Australian system and the US system allow an employer to pay below the minimum wage subject to various certification requirements. Broadly speaking, the laws allow for a reduction in the minimum wage commensurate with lower productivity, with disabled workers mandated to be paid a proportion of the minimum wage proportionate to their relative productivity in comparison to a non-disabled worker experienced in the relevant area of work.
Regarding the various complications of the minimum wage systems in Australia and the US, the one that is of most importance for comparative purposes is the fact that Australia uses a sliding scale of minimum wages according to age.
The reason that this difference is important is that it is the youngest workers in the economy that tend to be the lowest-skilled workers and therefore the ones for which a flat rate minimum wage most likely would be ‘binding.’
In the USA, the youngest workers have a higher minimum wage than in Australia, but the wage then crosses over to a higher minimum in Australia once a worker reaches 18 years of age. By the age of 21 the minimum wage in Australia is substantially higher, but by then work skills have also grown substantially.
The simple comparison of the minimum wage in Australia with minimum wage in the USA tends to use the headline rate for adults over 21 years of age. This is quite misleading, because there is a large class of younger workers where the minimum wage in Australia is much lower, and these tend to be the workers most affected by minimum wage laws.
In addition to its importance in making a proper comparison of minimum wage laws, the graduated minimum wage system prevailing in Australia is a tacit admission by the government that minimum wages are known to cause unemployment, especially among low-skilled workers.
The same is true of the exemptions for disabled workers in both countries. In the latter case, the adjustment is tied directly to an assessment of worker productivity, albeit with the intervention of a third-party. This occurs precisely because of the awareness that a low-productivity worker can be priced out of the labour market by the minimum wage.
The Effects of the Minimum Wage in Australia
A superficial reading of the minimum wage and employment statistics in Australia has led various commentators to believe that the minimum wage does not have any negative effects in Australia, and that a similarly high minimum wage could be adopted in other countries without negative consequences.
The foregoing analysis shows that the minimum wage in Australia actually is high only for adult workers, and it is relatively low for very young workers. Moreover, the minimum wage in Australia has already been the subject of empirical study, and its effects are just as suggested by the economic theory posited herein.
Research by economist Andrew Leigh used historical employment data to examine the effects of various increases in the minimum wage in Western Australia, relative to employment in the rest of Australia.
This research found that increases in the minimum wage in Western Australia were followed by reductions in employment relative to other jurisdictions where corresponding increases in the minimum wage did not occur.
As expected, this was most pronounced among young people, where the minimum wage had a large effect on labour demand. The results of this research found a consistent negative relationship between the minimum wage and labour demand (i.e., when the former is increased, the latter decreases).
In fact, the degree to which changes in the minimum wage affect labour demand was estimated as having a higher overall magnitude than in similar studies in the US and Europe. In short, the minimum wage in Australia causes unemployment among low-skilled workers in just the same way as in other countries—if anything, the magnitude of this effect, when taken across the entire labour force, is estimated to be higher in Australia than elsewhere.
Some of the negative employment effects of the minimum wage in Australia are lessened by the fact that the system uses a sliding scale of wages using age as a proxy for productivity.
Because the minimum wage is lowered for younger workers, this means that some of its damaging effects are reduced, relative to the case that would prevail if the headline rate applied to all age groups.
This sliding scale is less damaging than a single high flat-rate, and indeed, this policy is used precisely because it is understood that the minimum wage causes unemployment among low-productivity people. Notwithstanding this fact, the effects of the minimum wage are harmful for low-skilled workers, since they are prohibited from entering into various forms of employment that would be beneficial for them, both in terms of earnings and in terms of gaining job skills.
The Reality of Unemployment in Australia
The official reported unemployment rate of 5.6% in Australia is calculated by the Australian Bureau of Statistics (ABS) under its monthly labour force surveys.
This figure includes only those people who are classified as being in the ‘labour force’—defined very strictly as people who are actively looking for work and able to start work immediately.
However, the ABS also releases occasional but more-detailed reports that include other unemployed people who are not classified as being in the ‘labour force’ since they do not meet these conditions. This includes a large number of people who are classified as ‘wanting to work’ and meeting some but not all of the requirements to be classified as being in the ‘labour force.’ For example, this latter category would include a person who wants to work and is actively looking for work, but is not available to start work immediately.
Even taking a wider view of the available labour force than is accounted for in the official figure, using people who want to work, there is still a large understatement in unemployment in Australia, since this refers only to people who are unable to obtainany work.
The headline measure for unemployment uses a very broad view of employment, including anyone who works for any number of hours per week. Broader statistics on underemployment, including people who want to work more hours, more than double the official unemployment figure.
The ‘official’ unemployment figure tells us the number of people who do no paid work at all, out of a narrow pool of people who are classified as being part of the ‘labour force.’
Broader measures for unemployment can be calculated from the ABS statistics. There are also some reported alternative measures such as the ‘underutilisation rate,’ which measures unemployment and underemployment in the labour force. This measure was 13.7% in August 2013, including only people in the ‘labour force.’
If people wanting to work are included in the unemployment rate, then it increases substantially, to 14.3%, and if underemployed people are also included to get an underutilisation measure, then the rate increases further to 19.9%. This is a far less rosy picture than the one obtained merely by looking at the headline unemployment rate.
One reason unemployment and the effects of the minimum wage are sometimes underrated is that potential workers are shifted into alternative activities due to the absence of job prospects.
Rather than remaining idle, some would-be workers will undertake education or vocational training as their next-best opportunity. Many people are classified in the labour figures as not wanting to work (and therefore do not show up in unemployment figures), because they are in these alternative avenues of activity.
This educational activity is non-productive in its own right (other than as a means of obtaining human capital), and even its preparatory value may be dubious in cases where it is conducted as a means of receiving welfare payments.
There has even been some suggestion that the Australian government has pushed to get unemployed welfare recipients off the ‘jobseekers’ roll and into vocational training and education.
The minimum wage is usually compared to the alternative of zero income, but in fact, the prevailing welfare system in Australia means that the alternative to the minimum wage is a generous welfare payment, often without any requirement to search for work.
This means that welfare recipients face a high effective marginal tax rate when they enter the workforce. The effective gain in income from progressing from the welfare system to the minimum wage is not large, in view of the fact that the earned income reduces welfare benefits.
This exacerbates the degree to which people eschew low-paid work in favour of alternative avenues of activity, such as education and training.
Of course, all of these various statistical issues occur in other countries also, but they do not operate equally across all relevant age groups and categories. In particular, the costs of education and training are more heavily subsidised in Australia than in the US, meaning that alternatives to low-paid work are more attractive.
Accounting for these various issues means that the picture of the minimum wage and unemployment is far more subtle than a headline comparison would suggest, and it belies the suggestion that Australia is almost at full employment.
Australia Is Not Topsy-Turvy After All
We have already noted that the minimum wage is nothing more than a prohibition on certain kinds of employment relationships.
The policy creates no additional capital or job opportunities, and so its effect is simply to outlaw certain mutually beneficial exchanges that would otherwise have occurred in a free labour market.
Things are no different in Australia—minimum wage laws operate to reduce labour demand for low-skilled workers, along with the employment opportunities for low-skilled people.
At the root of confusion over minimum wage laws is the false view that employers can arbitrarily pay workers whatever they want, without any economic incentives constraining this choice.
This attitude is exhibited in the views of people who imagine that present working conditions in industrialised economies are the result of union bargaining, rather than increases in capital and productivity.
Such a view ignores the fact that there are laws of economics that impose themselves on employment relationships, including the laws of supply and demand.
Regardless of the time or place, so long as labour payment of wages is an incentive to workers and a disutility to employers, the price of labour will be determined by supply and demand.
Political interference in that process does not change the underlying economic reality—it only creates distortion and prevents mutually beneficial exchanges from taking place.
Australia is no different from other countries in this regard, and the minimum wage laws prevailing in Australia cause the same kind of economic damage as elsewhere.
Nothing is topsy-turvy down here in Australia.
We walk upright just like everywhere else, and just like everywhere else, the minimum wage causes unemployment among the low-skilled.
Prohibiting free exchange in the labour market does nothing but extinguish mutually beneficial employment relationships that would otherwise exist and cut off an avenue of advancement to those who have the lowest work prospects.