"Minimum Wages and Firm Profitability"

With all of the recent discussion about the minimum wage (e.g.), I thought this paper was worth noting. It finds evidence that the minimum wage transfers income from owners to workers, i.e. that it reduces profit and increases wages, but it does not change the probability of a firm going out of business, and it does not reduce employment. Thus, this paper raises the possibility that an increase in the minimum wage reduces inequality without having much of an impact on aggregate activity or employment:

Minimum Wages and Firm Profitability, by Mirko Draca, Stephen Machin, and John Van Reenen, NBER WP 13996, May 2008[Open Link]: I. Introduction In debates on the economic impact of labour market regulation, much work has focused on minimum wages. Although standard economic theory unambiguously implies that wage floors raise the wages of the low paid and have a negative impact on employment (Borjas, 2004; Brown, 1999), the existing empirical literature is not so clear. Whilst many studies have shown that minimum wages significantly affect the structure of wages by increasing the relative wages of the low paid (e.g. DiNardo et al, 1996), empirical evidence on the effect on jobs is considerably more mixed (see the recent comprehensive review by Neumark and Wascher, 2007). Some studies have found the expected negative impact on employment[1], yet others have found no impact or, in occasional cases, a positive effect of minimum wages on jobs.[2]

In the light of this, one may wonder how firms are able to sustain the higher wage costs induced by the minimum wage. One possibility is that firms simply pass on higher wage costs to consumers in the form of price increases. However, there is scant evidence on this score (exceptions are Aaronson, 2001, and Aaronson and French, 2007).[3] An alternative is that the higher wage costs are not fully passed on to consumers and the minimum wage eats directly into profit margins.[4] Since there is a complete absence of any study directly examining the impact of minimum wages on firm profitability, this is the focus of this paper.

Our identification strategy uses variations in wages induced by the introduction of the national minimum wage (NMW) in the UK as a quasi-experiment to examine the impact of wage floors on firm profitability. The introduction occurred in 1999 after the election of the Labour government that ended seventeen years of Conservative administration. There is evidence that the NMW increased wages for the low paid, but had little impact on employment[5] and so this provides a ripe testing ground for looking at whether profitability changed. We use the fact that the intensity (or “bite”) of the NMW is higher for firms with many low paid workers relative to firms with fewer low paid workers in order to construct treatment and comparison groups. We then compare outcomes in terms of wages, profitability and firm exit and entry using difference in differences methods.

Our work does uncover a significant negative association between the minimum wage introduction and firm profitability. This association is robust across two very different panel data sources, namely a specialized UK data source on workers in residential care homes (a very low wage sector) and an economy-wide firm level database FAME (Financial Analysis Made Easy) that covers all registered firms in the UK.[6] In both data sets, firm profit margins fall in relatively low wage firms following the introduction of the minimum wage. These effects correspond to about a fifteen percent fall in profit margins for the average care home and an eight to eleven percent reduction in profit margins for the average affected firms in FAME.  ... Finally, we could not find any evidence that low wage firms were forced out of business by the higher wage costs resulting from the minimum wage. Our analysis of an industry level panel dataset suggested that there was some fall in net entry rates following the minimum wage, hinting at a longer run negative effect on the number of firms. These results were rather imprecise, however, and not significant at conventional levels.

Comments

[Farrar]

We already knew this, but it's useful to have further evidence. If we rely only on the earned income credit or negative income tax, employers take advantage of the situation, pay low wages, and shift the burden to the general public - you and me. This was already happening in rural England in the 18th century. See Trevelyan's english Social History.

[reason]

Farrar...
theory would suggest that EIC and negative income tax have subtly different effects. NIT would allow longer search strategies for prospective employees - it would be easier for them to say no if they felt they were being exploited.

[Farrar]

Reason -
That makes sense. There're now about 1007 reasons I prefer NIT. I suppose some safeguards would be necessary, e.g. job search for non-invalids, etc.

[anne]

Mark Thoma:

"I thought this paper was worth noting. It finds evidence that the minimum wage transfers income from owners to workers, i.e. that it reduces profit and increases wages, but it does not change the probability of a firm going out of business, and it does not reduce employment. Thus, this paper raises the possibility that an increase in the minimum wage reduces inequality without having much of an impact on aggregate activity or employment."

Nice.

[jamzo]

a semantic game:

"transfers income from owners to workers"

increased labor costs migt decrease profits but then the author was doing maths

[anne]

Farrar:

"We already knew this, but it's useful to have further evidence. If we rely only on the earned income credit or negative income tax, employers take advantage of the situation, pay low wages, and shift the burden to the general public - you and me."

Work with dignity.

[Bruce Wilder]

"Although standard economic theory unambiguously implies that wage floors raise the wages of the low paid and have a negative impact on employment . . . "

Which, naturally, raises the question, why is that theory, "standard"? Why is there no feedback from observational studies to "standard" theory?

"transfers income from owners to workers" implies a theory, I think. Just not the "standard" theory.

[robertdfeinman]

Perhaps we should stop talking about "owners" of businesses. Small businesses have owners, large firms have managers.

Small businesses have to pay the prevailing wage because there is another small business down the street competing for the same labor pool. Thus, the wages for hairdressers or fry cooks in a region can't differ by much.

Large businesses can avoid paying the prevailing wage by a variety of techniques, such as citing their firm in an area where they are they have monopsonist power (think large farms or meat packing plants). Or think of all the firms that fled the industrialized rust belt for the sunny south. With no other manufacturing plants in the region who established the wage rate?

Owners want to see the firm do well, their livelihood depends upon it. Managers want to see the stock do well. This is the basis of their compensation and they don't stay around long enough, on average, to have to worry about the consequences of their slash and burn polcies.

Until recently there were many large industrial firms where the original owning families still had control, but this number has dwindled. Among public firms we see Walmart, Ford(?), the NY Times and a handful of others. The Rockefeller's own .006% of Exxon which is why their criticism of management was ignored recently. The situation with private firms is slightly different, but most big, private firms are only big compared to the average (Mars, Koch Industries, etc.).

I think any study of wages and how firms fare needs to consider the type of firm before drawing any overall conclusions. Lumping the corner deli and McDonald's together isn't useful.

[Tom]

No adverse impact whatsoever resulting from an increase in the minimum wage, you say. Really? No unemployment or decrease in hours worked, just a transfer of wealth from the producer to the laborer.

Great! Let's raise the minimum wage to $100 per hour and forget these inconsequential increases. We'd all then be wealthy and living in your liberal fantasy land, where we could all have our cake and eat it too, not to mention a puppy dog for each child to hold in his lap.

[ken melvin]

Damned dogmas out chasing cars again.

[reason]

Tom,
strawmen are good for burning, but not much use as arguments. Nobody says that the minimum wage does not affect employment, regardless of its value. The argument is, that at the levels at which it is set, the elasticity of demand for labour is so low that effects on employment aren't significant, so that there are net gains to labour as a whole. Now that is an empirical question. Not that ideologues like looking at evidence.

[OhNoNotAgain]

"No adverse impact whatsoever resulting from an increase in the minimum wage, you say. Really? No unemployment or decrease in hours worked, just a transfer of wealth from the producer to the laborer."

That's what they found. Did you not actually read the post and the linked-to paper ?

"Great! Let's raise the minimum wage to $100 per hour and forget these inconsequential increases. We'd all then be wealthy and living in your liberal fantasy land, where we could all have our cake and eat it too, not to mention a puppy dog for each child to hold in his lap."

Easy now ! I know your head is probably about to explode while thinking about the fact that a higher minimum wage is actually beneficial, but try to keep a lid on it.

[Noni Mausa]

jamzo said: a semantic game: "transfers income from owners to workers" ...increased labor costs mgt decrease profits but then the author was doing maths

jamzo, I hope you will agree with me on the following points:

--that the employees are necessary in order for the business to exist.

---that any profit which the owner/manager acquires is a direct result of the efforts of the workers.

---that the employees give up their time, effort and attention in return for a fraction of the income of the company.

To require of the employees that in addition to allowing the company to exist and taking only a portion of the return of their efforts, the employees should take as tiny a portion of this return as possible, is a bit demanding, don't you think?

At the low end of the income slope, there seems to be an idea that staff should be paid the minimum or less, because they are making the minimum.

At the high end of the income slope, there seems to be an idea that staff should be paid lavishly or more, because they are being paid lavishly.

Neither idea is tied to productivity at all.

Noni

[Denis Drew]

One concept that seems perpetually lost in minimum wage hike v. job loss discussions is inflation: as consumers nominal income grows more dollars become available to chase the same old number of hamburgers -- ergo, there should be no hesitation as far as job loss is concerned to hike flipper wages in step with inflation. IOW, the demand curve has moved already and the price curve is merely catching up. Rudimentary, but seems endlessly ignored when you hear policies debated.

Another factor that makes more dollars available to chase hamburgers is economy wide increases in productivity. As we get richer we may become more willing to pay same-old productivity minimum wage workers to flip burgers for our lazier selves.

Another all important and seemingly always ignored factor is that even if a raise in the minimum wage from $5.15/hr (really a foreign born worker, mostly Mexican, minimum wage -- Americans used to show up for that minimum wage the first time around: in 1939) to $10/hr cuts minimum wage employment in half: labor would still take home the same amount of pay -- albeit for half the hours.

Lastly, when the minimum wage (and other low end wages) have dropped so low that they amount to a minuscule fraction of the cost of GDP output (raising the minimum from $5.15/hr to $12.50/hr would add all of 3.5% to the cost of output -- about what we grow every couple or years -- giving 40% of American workers a raise!), then the dollar or half dollar a dose increase that is usually prescribed is liable to be below the sensibility level of such a fantastically productive economy.

When, Illinois recently raised its minimum to $7.50/hr, I and others noticed a definite up tick in business in our local Macs -- all in the third-world segment (Mexicans finally able to afford some of what they make?). At $12.50/hr ($2.50 more than the 1968 minimum) McDonalds profits might really take off -- never know until we try.

[Lafayette]

What goes around ...

MT: Thus, this paper raises the possibility that an increase in the minimum wage reduces inequality without having much of an impact on aggregate activity or employment

This is good news. For too long we've heard delicately woven arguments against the Minimum Wage, such as "That minimum wage hike is gonna cost us one helluva lotta jobs!"

Crocodile tears from the owner-elite class. By hiring at the minimum wage, thereby having just rescued the downtrodden from a life of misery in unemployment, they then complain that it is too expensive.

Not seeing (beyond their noses) that the Minimum Wage is at the bottom of the wage scale and, besides, whatever people spend out of their minimum wage it is likely more than what they would have spent out of no wage or unemployment benefits. It thus serves therefore to sustain economic activity much better than either of the latter two alternatives.

What goes around ... comes around.

PS: Now, if we could only pass a law that states hiring anyone below the Minimum Wage is a penal offense. Which is necessary but not sufficient, cuz then it would have to be enforced as well.

[Alex Tolley]

This would be good news if true, but I am not sure the conclusions are correct.

Firstly, the actual statistics are difficult to interpret (for me at least). Some data, e.g. table 1 for UK care homes suggests that profitability INCREASED (10.2->11.8%)after the introduction of minimum wages, contrary to the more general industry data and the conclusions.

There is no data on the entrants to the market, although the exits are high ~ 23%. One hypothesis could be that higher wage rates increased consolidation in the undustry to achieve scale economies and/or care workers expected to cover more "patients", much like the current oproblem of nursing in US hospitals. Certainly there would be an incentive to "sweat the human assets" to maintain profitability. If I was a manager of a care home, I would certainly be more careful in my choice of hiring and want better workers for the higher wages.

Even if it is true that profit margins were declining, we don't know whether ROI/ROC/ROE was relatively declining (vs high wage firms) as well, which are more important metrics for the owners.

As for employment, the data does not really detect higher unemployment except through the proxy of the same firms' employment data. All we have is data showing that there is no statistically important difference between high vs low wage firm exits over a 6 year period. We don't know if employment growth was slowed, although we do know that average employees stayed fairly constant (slight decline) over the period (table A1).

[anne]

I have never been interested in whether the earned income tax credit is actually more efficient than fair wages and benefits, because there should be an obligation for an employer to treat workers with dignity and that means paying them properly and providing benefits. Fiscal policy can encourage employment other ways than by cheapening and undermining the dignity of labor.

But, analysts often take the position that rather than simply ask for fairness the need is to trick the market to fairness. Rather than employers paying properly, taxes can be used to make up for improper treatment.

[a]

Don't know, doesn't make too much sense to me. In the same industry there is usually a gamut of firms making different profits. If profitability in a general way goes down (or at least, goes down enough), one would think the least profitable firm becomes unprofitable and goes out of business. Or even if the least profitable firm doesn't become immediately unprofitable, surely the probability that it might in the future increases.

I guess the theory would have more chance being true for big firms or firms where wages are less importance as an overall percentage of costs.

[2slugbaits]

Their third concluding possibility seems the most likely; but if it's true, then perhaps the paper isn't really addressing the minimum wage as much as it is unearned income from businesses with monopsony powers. The pre-minimum wage profit margin of 10.4% seems kind of on the high side.

The paper didn't really address the issue of substitutability between low skilled labor and other production inputs. It seems plausible that over the short run the elasticity of substitution might be quite low (i.e., isoquants at near right angles), but over the longer run the elasticities might increase. In that case we might see some substitution towards capital. We see this all the time. For example, captial equipment at airports replacing check-in clerks with self-check-in computer screens. Or Wal-Mart's self check-out aisles. Or gas stations replacing minimum wage clerks with credit cards at the pump. Over a long enough time horizon we would expect some substitution away from labor inputs and towards capital.

The paper only talked about wage rates. I don't know about Britain, but in the US it is common for employers to supplement minimum wage earnings with nonmonetary benefits. For example, in the fast food industry employers will often give employees a free meal, or tolerate flexible working schedules for college kids. That kind of thing. But when there is an increase in the minimum wage sometimes those kinds of supplemental benefits go by the wayside. Still, the paper reported that profits were down significantly, so presumably the minimum wage did bite capital owners pretty hard. But if that's the case, then over the long run wouldn't we expect to see investment move elsewhere...say for example nursing homes in developing countries where labor is cheaper.

This is probably more appropriate for the technical comments, but I thought the simple OLS regressions in Figures 1a and 1b looked like they may have been mispecified.

[TDM]

One data point in 1999 is probably not significant. As a control, the U.S., without any major change in labor policy, was in the middle of a bubble where employment and wages were increasing, profits were decreasing, but firms were not being forced out of business ("Earnings don't matter"). Examining U.K. data without accounting for global trends is probably meaningless.

[dbr]

I approach this topic from a different frame of reference. My parents owned 2 ice cream stores. They both worked 60+ hours a week and I think took 3 vacations in 25 years. Outside of my family, most of the employees were high school students working their first job 10-20 hrs / week for spending money and I would guess that 90% of them had higher family incomes than mine. I went to college and got an engineering degree so I could be an employee - being an owner is way to much work.

I don't think its universally true that the transfer of profits from owners to employees is automatically a good thing...

[Me]

"Easy now ! I know your head is probably about to explode while thinking about the fact that a higher minimum wage is actually beneficial, but try to keep a lid on it."

Wow! How condescending.

Look, I can manipulate this same data to obtain any outcome I desire. There are far too many variables to control for, thus making much empirical evidence irrelevant. This study did not look at long-term consequences, such as the businesses that did not start-up in a given sector because (if the results were actually relevant) capital shifted to more profitable endeavors.

Two points:
First, how is a higher minimum wage beneficial? Do you mean to the payer or the recipient? How is it not beneficial that two parties who voluntarily agree to an employment contract both honor their agreements sans manipulation by the state?

Second, why is it that if we desire to help the least skilled we foist the cost of doing so on those most willing to help in the first place - the person willing to offer the low-skilled worker his best employment offer? Why do liberals get so irate at firms that pay low wages when they should really be irate at other higher paying institutions such as Professor Thoma's university for not offering these low-skilled people better employment opportunities?

[CasualObserver]

Me,

The answer to your questions are easy. How many active blog posters on left leaning blogs own their own business? I am not talking about one person "consultants" or those doing "contract" work, but rather those that actually have numerous employees?

I have asked around on various blogs....you can hear the crickets chirping.

I am sure there are some lurking. It would interesting to see what they pay their employees and what benefits they offer.

[Casual response]

It's a silly assertion, but even if it's true, so?

Why would people who have been getting more than their share volutarily give it up? They wouldn't, so hearing from them isn't all that helpful - unless you want to hear self-interested, biased arguments. That's why actual evidence is important, and the evidence here is that there is market power that distorts rewards (otherwise profit couldn't fall without causing increased exit).

But of course, it's easier to simply portray people on the left as a bunch of barefoot hippies without jobs than to actually deal with issues. That's how peole with no ideas behave, they play the games you are trying to play by creating false images that try to impugn motives and character.

But the times they are a changin'

[DRR]

Things one should learn following the "minimum wage' debates.

1. That the classic theoretical economic argument about minimum wages or any other price floor is that they decrease employment; ceteris paribus and all that.

2. That because of the sheer variety of different industries out there, which range from almost perfect competition to monopsony, and because of variiations in labor markets between and across industries, for different regions, countries etc, the standard theoretical economic argument about the effect of price floors is only the first step and sometimes a pretty small one in determining what the effect of a minimum wage would be in any given situation.

3. Because of #2, combined with some other things like the current macroeconomic situation and other unaccounted variables, any empirical study of the effects of the minimum wage, what it does and doesn't do is going to be neccessarily limited and is unlikely to even be a definite bench mark for that industry, in that region, at that level of wage hike, in that given time, in that labor market, in that particular macroeconomic situation...much less something you can wave in another person's face and proclaim that the minimum wage does or doesn't do in general. Until all these things are accounted for, and empirical studies (lots of them) produce the same results repeatedly, the answer is still & always "it depends".

I say, out with the ideological cheerleaders on both sides and a return of the two-handed economist.

[Lafayette]

2slug: The paper didn't really address the issue of substitutability between low skilled labor and other production inputs.

This IS indeed an issue.

After all, what is the most competitive element of a minimum-wage earner (aside from replacement by a lower than minimum-wage earner)? Replacement by robotics.

Given any particular manufacturing application, then robots can effectively replace humans at a much lower cost. This apparently is no moving upwards in technical nature. Some companies are using robots to range about collecting mail. And, other "robots" are replacing hard-copy documents all together.

Where they cannot, the minimum-wage labor becomes the most durable -- unless there is widespread usage of illegal migrants. (Making such migratory work legal means applying the minimum-wage to their jobs and assuring that the labor-spigot is opened and closed according to the need.)