Sunday, 19 October 2014

Predistribution vs hourly averaging

Following on from my previous blog, I will now argue that earning subsidies, such as my hourly averaging proposal, are preferable to Predistribution. I will begin by setting out the mainstream economic view of the minimum wage and then consider this. My argument is that a minimum wage, if effective at raising hourly earnings will have much more serious economic effects than an hourly earnings subsidy. 

I will mostly focus my arguments on the aspects of Predistribution which would seek to raise wages either by imposing high minimum wages, by imposing collective wage bargaining, or by training workers so that employers can employee higher skilled (and therefore higher paid) workers. According to mainstream economic theory, policies of the above types will cause a mixture of price and unemployment increases. I will explain the logic of this.

In the absence of any government intervention workers and employers will make agreements whereby workers get paid at least their reserve price for labour—the point at which they would rather not do the job. Similarly, employers will demand labour up until the point that the price (wage) is equal to their willingness to pay. This willingness to pay valuation will reflect the relative price and productivity of labour compared to substitute inputs such as capital.

A minimum wage acts as a price floor in the market for low-skilled labour (as illustrated in Figure 1 below, assuming that the floor is set above the equilibrium market price i.e. that the minimum wage is binding).

At price pmin the wage is greater than employers’ marginal value of labour at the market equilibrium level. This will cause employers to substitute their demand towards capital inputs and higher-skilled labour for which the relative price has now reduced. As such only quantity QD is demanded at the minimum wage rate.

Figure 1 Illustration of Welfare Loss from Price Floor

At the same time, the minimum wage rate has induced the entry of workers whose reservation wage was below the prevailing market rate, such that quantity Qs is now supplied. The minimum wage has therefore created a labour surplus equal to distance Qs minus QD. This represents the induced involuntary unemployment that results from the imposition of the minimum wage.

The social welfare loss of the imposition of the minimum wage is represented by the shaded triangle. This is welfare loss is equal to i) the surplus foregone by employers who would previously have been able to employ quantity Q’ minus QD of labour at a price above its marginal value (area A) and ii) the surplus foregone by workers Q’ minus QD who would previously have earned a wage above their reservation rate.

Some workers are worse off as they will become involuntarily unemployed. Meanwhile firms will have greater costs. Affected firms which cannot change their production processes will have to pay higher wages yet their output will remain the same. Some firms will be able to alter their processes to get more from each worker by increasing their capital inputs. This will enable them to make better use of the more expensive workers they now employ, but will cost more than employing workers at the lower rate would have done. Where firms can pass on the higher production costs they will do so, usually because all firms in the same sector are affected similarly. However, where firms cannot charge higher prices then they will lose market share to their competitors (either firms in the same sector which operate with lower wages or sectors of the economy will lose out to other sectors).

Caution about textbook models

Of course, the real economy does not work exactly like a textbook or a model. Minimum wages do not always immediately produce the above effects, a point well-made by economists such as Card and Krueger. Indeed, the minimum wage in the UK did not have any obvious unemployment and price effects. However, there are many reasons why this does not disprove the mainstream picture. For example, it was introduced gradually during a period of economic growth, and at a level that was unlikely to be biting.

A second type of caution about textbook models is that they assume that firms are already maximally efficient and will therefore pass on any costs to customers rather than increase efficiency. This may muddy the textbook response further, though in an abstract discussion between broad policy options such as this one there is little to make of this point. It does mean, however, that in some cases the price rises resulting from Predistributive policies may be avoided to the extent that efficiencies can be found elsewhere.

If the minimum wage were raised from the current £6.50 to “living wage” levels (living wage advocates argue for £8.80 in London) or the Green Party proposal for a £10 minimum wage by 2020, then it would be much more likely to bite. The more the bite the more reasonable the expectation that the above described effects will occur.

The extent of the unemployment or price rise effect will depend upon the sector in question, and whether a) the cost can be passed on to consumers (increasing prices), b) whether it is possible to substitute capital instead of workers (increasing unemployment) and c) whether the work can be done elsewhere—either directly by the same employer or indirectly where an industry declines in one country and increases in another.

Predistributive policies like the minimum wage may not end up causing mass unemployment. However, this would be because they would cause major shifts in the direction of economy. Employers who can pass on their costs to customers will largely continue as before, while those which cannot will decline. For example, retail spending would be maintained. However, the difference is that industries with competitors or sites with less onerous minimum wage regulations would switch production to those cheaper locations.

Supporters of Predistribution might respond that ideally the minimum wage would apply to all the employers in the world. However, even this would mean that employers would have to provide work that was worth doing at that minimum wage. Employers would have to alter their production methods in order to make sure it is worthwhile employing all their staff at a higher rate. The new methods of production would, by definition, be different from that undertaken in the absence of the minimum wage, and these methods are clearly less efficient than the alternative. Employers will pass this loss in efficiency on to consumers in higher prices for their products (assuming they are unable to make efficiencies elsewhere). Even those who do not purchase these products will be affected as those who pay more for the affected products will have fewer resources to expend elsewhere (or invest) than they would have done without the minimum wage.

A final important point is that price rises are not only going to occur in industries heavily affected by the minimum wage. The rises in prices will filter through the rest of the economy as other sectors will make use of goods or services provided by these industries. If the latter industries have more expensive inputs then they will often pass these on in price rises as well. For example, if it becomes more expensive to run a transport distribution company then these costs will be passed on to all businesses using this service. These increased costs will be passed on to the consumers who buy items that have been transported—which is pretty much everyone.

Market interference is acceptable

Now, I am fully in favour of interfering in markets to assist the less fortunate, and also to respond to market failures. I’m not a free-market ideologue. My disagreement with Predistribution therefore arises where policies to raise wages or productivity interfere with the market in a counterproductive fashion.

Earning subsidies such as those I propose would also interfere with markets. However, if they are well-designed they will do little to alter the overall pattern of employment. The primary outcome is that most people receive more income for doing similar work to that which they would have done otherwise. Predistributive interventions, on the other hand, will interfere in a much more profound manner.

Essentially my argument is that Predistributive policies may help some people, but will often make a lot of other people worse-off. My tax proposals are highly progressive and so I am happy to make some people worse-off if it makes society as a whole more just. However, Predistributive policies are likely to make some less well-off members of society worse-off as well as many of the better-off.

The distributive effects of Predistributive policies may not be as consistently progressive as its advocates assume. If economic growth is reduced as a result of the economic inefficiencies generated by the policies then this could make everyone economically worse off, potentially reducing tax revenues as well. Price rises would also impact on everyone’s spending power, as their income would not go as far as it would have otherwise.

The main way in which some of the least economically fortunate will definitely end up much worse off is if they are rendered unemployed. This would not only occur because the unemployment rate would be expected to increase, but also because those most desperate for work (and therefore have a reservation wage) are the most likely to miss out on work. The change in the job market may induce other workers to take jobs or work longer and they would take the place of those who want the work more.

All of these points mean Predistribution can create a group of people who are rendered worse off than they would have been otherwise.

Predistribution vs. Hourly Averaging

As I have explained, Predistribution will produce at least one (and possibly all) of several deleterious effects; increasing prices, increasing involuntary unemployment, and shifting economic activity in unwanted directions.

For the above reasons, the overall distributive effects of Predistributive policies may not be as universally progressive as its advocates may assume. Some unfortunate people may end up worse off than they would with much less intervention. Even for those who would earn more, countervailing factors—such as lower levels of economic efficiency and higher prices—would eat into their gains.

The international nature of the economy adds further problems. If one state adopts wage-increasing policies it may make some of their industries less competitive, which will worsen the balance of trade and the ensuing impacts of this further down the line. If all countries adopt the Predistributive policies then this is likely to cause mass involuntary unemployment and harm global economic growth.

I think Predistributive policies are preferable to leaving everything to the market. However, they interfere with market-led efficiency much more intensely than hourly averaging would. As long as it is possible to generate the tax revenues necessary to provide earning subsidies then this is clearly the way to go.


dougbamford said...

Thanks to my lovely fiancée Katy for reading through several drafts of this blog, and for providing a lot of the economics terminology and the illustrative figure.

dougbamford said...

What about training?

In my discussion above I have mostly considered what happens when pay rates are artificially raised. An alternative is for government to provide an industry with higher skilled workers than would have otherwise occurred. The industry in question might switch to the higher skilled workers and pay them more.

I am happy for governments to provide education and training. There are many reasons for governments to provide these to give people more options in life, to correct market failures (where people will not make enough investment in their skills if they bear all the upfront cost), to encourage the public good of a higher skilled and better education populous, and as a way to assist those who are involuntarily unemployed.

However, the Predistribution policy seeks to do this in order to create higher wages. I am more sceptical of whether this will in fact occur, since it might just mean that the people doing each job are more highly skilled even though the job itself is not very much different. However, if some jobs do change because the workers are more highly skilled then this too could cause involuntary unemployment further down the line.

If a firm will find it hard to sell more of their product then their now more productive industry will need fewer workers to achieve the same output. If these firms could now export more of their produce as they are now more productive than their international competitors then this may be one way to increase output and maintain employment levels. However, if all states were to provide the higher skilled workers and industries became more productive then this could produce greater involuntary unemployment.

As I say, I think government training schemes are much easier to justify than other Predistributive policies…I just think they are better justified for other reasons (such as correcting market failures or for reasons of international industrial competitiveness) rather than because they are an effective way to improve the position of the economically worst off members of society.

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