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Economics

[2513] Minimum wage and the money illusion

In the short run when (nominal) prices are not so flexible, there will be a trade-off between (nominal) minimum wages and unemployment rate. The mechanics is simple. If businesses cannot change the price they charge their customers, they will optimize their cost. Since a person’s real wage theoretically equals the person’s marginal product of labor (or in English, productivity), businesses will try to maintain workers whom are reasonably productive with respect to the wage paid. In reality, this could mean either tighter selection of workers or even firing of unproductive workers. More often than not, it would likely only lead to tighter worker selection criteria. Regardless, with labor population growth, it would lead to lower hiring compared to pre-minimum wage and then immediate creating  greater unemployment among the labor force, with all else being constant.

In the long run when prices finally adapt, the relationship between minimum wage and unemployment can be rendered impotent. Prices adapting means erosion of minimum wages by inflation. The more prices adapt, the less productivity is required given the equivalent fixed minimum wage level. This thus opens up more space for less productive workers to have a shot at employment in sector which the minimum wage law covers and in turn, applies a downward pressure on the unemployment rate.

Unless, of course, if the minimum wage level is updated in line with some measure of inflation. In that case, the negative relationship within minimum wage and unemployment rate will be sustained.

There is one important point that I wish to highlight if it is not so apparent already. While the negative relationship between minimum wage and unemployment will weaken over time in the face of inflation and non-update of the law, the effect of unemployment is real due to sticky prices in the short run.

With a real minimum wage, the effect is permanent.

By Hafiz Noor Shams

For more about me, please read this.

3 replies on “[2513] Minimum wage and the money illusion”

That depends on what you mean by real wage. I have a feeling, the definition I used for real wage isn’t the same as yours.

As for the free market, well, again, depends on your definition of free. In many cases, implications depends on the definition. And I have found that the other definition of free used mostly by those on the left as utopian.

If you use the left definition of free to assess the right’s definition, and then comes to a conclusion the right’s free does not match the “free” implication of the left, and so declares the right’s scenario as utopian, well, that’s just an inconsistent and unfair declaration.

So, check your premise.

I just came across your blog and your zeal in your oposition minimum wage in your series of articles from year 2006 inwards. To be honest, I do not have the intelectual capacity to challenge your high IQ reasonings.

Until this piece , I quote

Since a person’s real wage theoretically equals the person’s marginal product of labor (or in English, productivity), businesses will try to maintain workers whom are reasonably productive with respect to the wage paid.

so much for theory, for in real life, employers never pay teh real wages in relation to productivity. if they do, we do not need a minimum wage. Net result is that in malaysia real wages has lagged behind productivity growth and wages incease has lagged behind inflation, resulting in negative growth in real wages.

The free market is never free. and those who believe in it live in Utopia

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