I’m not an economist, but you knew that, right? In fact, my exposure to the science of economics is one freshman-level econ course, taken almost 20 years ago, plus the minimum due diligence that I think any citizen owes in learning about things that might affect the way they’d vote, plus the random poking about that I do in most subjects because I’m just generally a geek. So you should all take this with a grain of salt.
That said, there’s a theory that’s been bouncing around in my head for years now that I want to get out there. I’ve actually asked a couple of economists about it, but I have a feeling that my economics vocabulary just wasn’t up to communicating the idea properly, because I kind of felt like we were talking past each other. Hopefully in writing, with diagrams, I can communicate this a bit more clearly. What I want to argue is that, contrary to the standard economic line, well-judged price caps can actually reduce shortages, and a well-judged minimum wage can actually stimulate the creation of jobs.
This isn’t, by the way, to say that there might not be independent reasons for institutions like the minimum wage, even if I’m wrong. But most of those reasons are usually phrased as, “even though there would be more jobs without a minimum wage, it’s worth it because…” I actually want to dig in there a little bit; in certain cases, I’m saying, no tradeoff has to be made, because a minimum wage (or a price cap) will actually get the market closer to a market-clearing situation than it otherwise would be.
Basic Supply, Demand, and Deadweight Loss to Price Caps (People Who Know This Should Skip to the Next Section)
OK, first a little background for you fellow non-economists out there. Two of the fundamental concepts of microeconomics are the “market price” and ”market clearing situations.” If you look at potential suppliers of a good or service, in aggregate, they face a generally increasing marginal cost of supplying more of the good or service. The idea here is that, after any initial startup costs are recouped, the first few units are easy to produce because the best resources for producing them are relatively unused, but that as more and more resources are consumed, producing subsequent units becomes more and more difficult. At the same time, they face declining demand for the good or service, because the market becomes saturated.
Supply and Demand Curves
So, if you graph supply as number of units produced (on the X axis) vs. marginal cost to produce each unit (on the Y axis), and demand as number of units sold (X) vs. the amount the public would be willing to pay for a unit given that many units already in existence (Y), you get a graph like the one at right. You’ll notice that there’s a point in the middle there where supply and demand meet–where consumers are willing to pay exactly as much for one more unit of the product/service as it would cost producers to make them. As long as less units than that are in existence, it behooves producers to make more; once there are that number, there’s no reason to produce any more, because people won’t pay more for subsequent units than they cost to produce. The price/cost at which the two lines cross is the market price of the good/service; the situation in which exactly that number of units are made and sold at exactly that price is the market-clearing situation. Free markets are supposed to naturally converge on the market-clearing situation (but more on that later); that’s supposed to be a good thing, since consumers won’t find that there are less units available than they want to buy, and producers won’t be stuck with units they can’t sell.
Supply and Demand Graph with Price Cap and Deadweight Loss
If you’re currently in a market-clearing situation, putting a price cap on the good or service that’s below the market price will cause a shortage, as shown at left. Producers can’t sell at above the price cap, so they won’t have any incentive to make more units than the place where the purple and red lines cross. And because the price has been brought down, consumers will want even more of the product–the place where the green and red lines cross. So consumers are going to want lots more of the product than is being produced, leading to empty shelves.
The units that are not being produced because of the price cap, and the extra money those units would fetch, forms an area called the deadweight loss of the price cap. This is value that could have been produced without the price cap, but isn’t. So, if the market will clear itself otherwise, a price cap is pretty much a bad thing, at least as far as producing as much value as possible goes (again, there might be other considerations that pull the other way, but we’ll ignore them for now.
Price Takers and Price Seekers (Skip This Too if You Know It)
Marginal Cost vs. Demand: Price-Takers
In an “ideal” competative situation, people who are, say, selling a product are what are called price-takers: Each individual seller can, effectively, sell all they want of a product at or below a particular price, called the market price, and can’t sell a single unit above that price (because people will go to their competitors instead). They face a (generally) increasing marginal cost of creating each new unit, and a flat demand for each unit (at the market price)–despite the fact that, in the aggregate, there’s a decreasing demand, the idea is that no single producer can possibly make enough products, or limit the products they make enough, to have any noticeable affect on the market’s saturation level. Where the marginal cost line and the demand line cross, you get the number of units that producer should produce, as shown at right. If all producers produce just that much, a market-clearing situation will be achieved.
The thing is, though, competition isn’t perfect. Suppose you want to buy some lawn-darts. The closest place to you that sells lawn darts is a Wal-Mart (2 miles from where you live), and the second-closest place is, let’s say, a Bed, Bath, and Beyond (100 miles from where you live). Well, Wal-Mart isn’t going to be in the situation above. There’s no one price at which Wal-Mart will be able to sell as many lawn darts as it wants, and above which they won’t be able to sell any. If BB&B is selling lawn darts for, say, $15.99, and Wal-Mart is selling them for $16.00, there’s no guarantee that you’ll go to the BB&B for your lawn dart needs. In fact, if you’re rational, you assurredly won’t, because the cost of getting to the BB&B is going to be way more than the one cent you spent.
And what if Wal-Mart decides to raise their price to $50? Well, and this is the important part, it depends. You might think that even the $34.01 you’d save at BB&B is not worth the expense and inconvenience of going 100 miles, and so might just go ahead and buy from Wal-Mart anyway. Or, you might decide that it is, and drive to BB&B. Or, you might decide that between the option of going 100 miles and paying 50 bucks, lawn darts just aren’t worth it to you, and go without. Different people will have different thresholds here, so Wal-Mart doesn’t face a flat demand curve. They face a declining demand curve, much like the case of the sellers in aggregate discussed above. But there is a crucial difference: Unlike the aggregate, which doesn’t really have the ability to choose prices to sell at (because it’s just an aggregate of independent entities, which are actually competing with each other), Wal-Mart actually faces a decision about where to set its prices.
There’s something else about Wal-Mart, which interacts with the above. Wal-Mart, for reasons of prohibitive administrative costs, can’t really haggle over the price of their lawn darts. They can sell lawn darts at $10 or $16 or $50, but they really can’t appraise each customer as he or she comes in and decide how much to charge that customer for a lawn dart. This is different from, say, the way my company charges for an hour of my consulting time–they work it out with each individual customer, though a process of bargaining. They don’t just have to set a price and stick with it for everyone.
Producers in both of these situations are known as price seekers. To be explicit, I’m going to define a price-seeker (and I don’t think this is too far off the standard definition) in the following way: A price-seeker is a producer who:
- Faces a declining demand–the more they charge, the less people want their good, as opposed to there simply being a fixed price at which they can sell effectively arbitrary amounts and above which they can’t sell anything
- Has to offer a fixed price for a particular good or service–they can’t charge different potential customers different amounts based on the customer’s personal price thresholds.
People often think of price-seeking as a synonym for “monopolistic,” but you don’t really have to have a monopoly to be a price-seeker. You just have to have some sort of non-price-based competitive advantage over all competitors selling equivalent goods/services (in the Wal-Mart case, it’s geographic convenience, but it could be almost anything; and let’s not even get in to the complexities introduced by the fact that, except for a handful of goods/services called “commodities”, no two products or services are ever really equivalent to everybody), which different people may value differently. It’s also completely separate from some sorts of monopolistic practices like platform-control leveraging.
Price-Seeking Behavior, with Deadweight Loss
Having price-seekers in your market is a bad thing, and here’s why. Price-seekers, in addition to facing a declining demand curve, also face a curve that declines faster, called the marginal revenue. For example, suppose Wal-Mart can sell 10 lawn darts at $50, but to sell 11, they can only charge $49.75. The demand for that 11th lawn dart only goes down by 25 cents. But if they lower the price by 25 cents to sell lawn dart #11, they don’t just lose that quarter on that particular lawn dart. They also lose a quarter on each of the 10 lawn darts they were already counting on selling. Their marginal revenue for that last lawn dart goes down by $2.75–much more quickly than the demand. An example of this is shown at left.
Now, market-clearing behavior would be to make as many units, and sell them at the price, represented by the point where the demand and marginal cost (the green and purple lines on the graph) cross. But that’s not actually what’s in the best interest of a price-seeker. For a price-seeker, the break-even point is only to make enough items so that marginal revenue and marginal cost (the blue and purple lines on the graph) cross. After all, there’s no point in making units that cost more to produce than they would add to revenue–even if they still cost less to produce than they could be sold for. A price-seeker has an incentive to create an artificial shortage to keep prices high; they certainly could make more items, and sell them (at more than cost) to eager customers, but that would actually make their bottom line smaller. So less units are produced than should be (the left edge of the gray triangle), and they’re sold at a higher price than they should be (the upper point of that triangle)–and their lost value is called the deadweight loss of price-seeking behavior.
How a Price Cap Can Cut Shortages (This Bit is Original)
What I claim (we’ll get to how this relates to wages later) is that a judiciously placed price cap, far from causing a shortage (and deadweight loss), can actually cut the shortage and deadweight loss caused by price-seeking. A price cap can actually remove, or at least reduce, the incentive to create an artificial shortage, making a price-seeker behave more like a price-taker.
Price-Seeking with a Price Cap
How is this possible? Well, suppose a price cap is set that is higher than the market value, but still lower than the top point of the deadweight loss triangle shown in the “Price-Seeking Behavior, with Deadweight Loss” picture above (that is, lower than what Wal-Mart is currently charging for lawn darts, if they’re smart). As shown at right, the price cap artificially creates a flat demand, at least until it crosses the demand line. So suppose the price cap on lawn darts is set at, say, $40.00. If Wal-Mart can sell 10 lawn darts at $50, they can certainly sell them at $40. And they can sell 11 lawn darts at $40 too, so selling that 11th lawn dart has a marginal revenue exactly the same as selling the 10th one did–marginal revenue doesn’t go down at all. Wal-Mart has more incentive to make more lawn darts (so long as their cost is below $40), because they can’t raise the price above the cap by creating an artificial shortage.
Compare the pictures with and without the price cap. With the price cap in place, Wal-Mart is making more lawn darts and selling them for less. And look at the difference in size of those deadweight loss triangles! Far less value is being lost to price-seeking behavior than without the price cap.
If, by some miracle, the government were able to perfectly pinpoint the true market value of lawn darts, and set the price cap there, it would effectively turn Wal-Mart into a price taker. Wal-Mart would sell lawn darts at the market price, in exactly the quantities that would clear the market. Sussing out the exact market price, of course, is rather too much to expect–it probably changes from day to day, and there’s no way to be exactly sure of it short of actually having a market-clearing situation. But of course, the government doesn’t need to do that–as long as they get somewhere between the market price and the price-seeker’s artificially inflated price, they’re improving matters. For that matter, even if they’re slightly below the market price, although they will create their own shortage that way, it will be smaller–and be associated with less deadweight loss–than the price-seeking shortage it will replace. It’s only if they set the price cap a good ways below the market price that they’ll create a worse shortage than the shortage they’ve fixed.
How a Minimum Wage Can Create Jobs (This Bit is Original Too)
So, what does all this have to do with wages? Well, the process of deciding what wages to hire at is actually kind of similar to the process of deciding what price to sell at. Many employers are essentially wage-takers: There’s a going rate for the kind of work they need done. If they pay that rate, they can hire all the people they need; if they pay less than that rate, they can’t hire anybody (because their competitors snap them all up).
Again, though, this sort of competition isn’t perfect. Let’s suppose that, instead of buying lawn-darts, you want to find work as a store greeter. Let’s suppose (this is a scenario before minimum wages) that Wal-Mart is offering $2.99/hour for store greeting, and BB&B is offering $3.00. Should you take the BB&B job? Not unless you really think that that extra penny an hour is worth the hundred-mile commute. But what if Wal-Mart cuts their wages to $1/day? Well, again, it depends. You might think that it still beats a 100 mile commute, even for a substantially better salary. Or you might think that the salary difference really is worth the commute. Or you might decide that the choice just isn’t worth it and instead consider a career as a medical guinea pig.
Another consideration that applies to Wal-Mart and is similar to a pricing consideration we talked about before is this: It’s really not worth Wal-Mart’s while to try to negotiate salaries with each individual greeter. Store greeting is not a highly-skilled job; it’s much easier for Wal-Mart to just post an add saying “Store Greeter $2.99/hr no bnfts” then to actually train their hiring managers in the fine art of greeter salary negotiation. Let’s call employers in both of these positions (don’t know if this is the right term or not) wage-seekers. In particular, a wage-seeker is an employer who:
- Faces an increasing supply–the more they pay, the more employees they can hire, as opposed to simply having a particular wage at which they can hire arbitrary numbers of employees but below which they’ll lose all of them to competitors
- Has to offer a fixed wage for a particular job–they can’t offer different applicants for similar positions different amounts based on the applicants’ particular wage thresholds.
Wage-Seeking Behavior
Having a wage-seeker in your market is just as bad as having a price-seeker, as shown at left. Just as price seekers face a marginal revenue curve that decreases more quickly than demand, wage-seekers face a marginal labor cost curve that increases faster than wages. Suppose Wal-Mart can hire 10 greeters at $1/hour, but to hire an 11th, they need to raise the wage for greeters to $1.25. That’s only a 25-cent increase in wage, but since you have to offer the wage to the other 10 people too, it’s actually a $2.75 increase in marginal labor cost.
And just as a price-seeker is more interested in marginal revenue than demand, a wage-seeker is more interested in marginal labor cost than wage. There’s no point in hiring someone if the addition they will make to total labor cost is greater than the value they’ll produced for the company; even if they’re still being paid less than that value. In other words, although a market-clearing situation would involve Wal-Mart hiring enough people, at a high-enough wage, to make the green and purple lines meet, it’s actually in Wal-Mart’s interest to only hire enough people at a high enough wage to represent the lowest corner of the gray triangle. It’s actually in Wal-Mart’s interest to create an artificial job shortage to keep wages down. The gray triangle itself represents a deadweight loss–those are all people that should have been hired, and additional value those people would have produced (beyond their wages).
Wage-Seeking Behavior with a Minimum Wage
Now (does this all sound familiar?) suppose the government sets a minimum wage for store greeters, which is below the market wage, but above the bottom corner of the gray triangle in the picture “Wage-Seeking Behavior” above. Something like this is shown at right. Basically, creating an artificial job shortage won’t help Wal-Mart as much now, because they’re not going to be able to depress wages below the minimum wage anyway. They act more like a wage-taker, hiring more people at closer to the market wage, coming closer to a labor-market-clearing situation.
The same accuracy stuff applies as with price caps: Obviously, setting the minimum wage at exactly the market wage is ideal (and completely eliminates deadweight loss), but setting the minimum wage anywhere between the artificially lowered wage and the market wage, or even a little higher than the market wage, will make matters better than no minimum wage at all.
So: Price caps can make producers make more stuff, and a minimum wage can convince employers to hire more people. This should make government intervention in the markets seem rather more attractive, at least to people who are interested in clearing the markets.
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