Economics Tuesday: The Theory of Labor Markets

My family, the long haired, slack jawed, mouth breathing, hippie, liberal, commie, pinko, leftists that they are; are always trying to ply me with their socialist ideas. The ideas usually sound good, and, quite honestly, they make us feel good initially. The problem is this, most do not hold up when the rubber meets the road. (A.k.a. reality)

I am going to talk about one my brother brought up on his blog: the living wage. The living wage (minimum wage) is a bad idea because it creates a price floor for labor. This becomes a bad idea in that there is a loss of Social Surplus when the Demand Supply Curve (that’s right, it is really called the Demand Supply Curve, but it doesn’t roll of the tongue so well, so most refer to it as the supply demand curve) isn’t at an efficient market Equilibrium.

I am going to explain this in an example: There are companies that are willing to pay workers build widgets. The companies have a demand for labor D that is represented by the downward sloping line D in the graphs. The workers are willing to supply labor S represented by the supply line S on the graphs. For the demand curve, there is one company that is so desperate to make a widget, they are willing to pay workers $100 to make widgets; and there is one company that is so cheap, they are only willing to pay workers $1 to make widgets. Conversely; there is a worker who is so hard up for money (must be married) that he is willing to build widgets for $1; and there is some rich kid, entitled worker that will only make widgets if he is paid $100. The efficient market equilibrium for this example is $50 for making widgets.

The concept of Social Surplus is defined as the sum of Consumer’s Surplus and Supplier’s Surplus. The Consumers in this example are the companies, and their surplus is the difference between what the hard up companies were willing to pay ($100, $99, $98, etc) to build widgets and what the market price is ($50); it is represented by the pink shading on the graphs. The Suppliers in this example are the workers, and their surplus is the difference between the hard up workers were willing to build widgets for ($1, $2, $3, etc) and the market price is ($50); it is represented by the blue shading on the graphs.

The second and third graphs are what happen when you screw with the prices. The new horizontal lines represent either a price floor (minimum wage) or a price ceiling (I don’t know of a good example of a legal price ceiling). When you have a price floor, the Supplier’s (Workers) Surplus goes up, but the Consumer’s (Companies) Surplus falls by more than was gained but the Supplier. This loss of Surplus is represented by the black shaded areas on graphs two and three. When there is a price ceiling put in place, the positions flip-flop (Romney, anyone?) and you get graph three.

Why does the loss of Social Surplus happen? Simple, by changing the price of labor to the new mandate, the quantity of work that the companies demand, or that the workers are willing to supply changes. A minimum wage reduces the amount demanded, and a wage ceiling reduces the amount supplied: any move away from the market efficient price lowers the quantity consumed.

So, the next time someone starts talking to you about the benefit of a minimum wage/living wage you can chuckle, shake your head and say, “Brian Reschly is right, and Luke Reschly is wrong, er left, er wrong, hell, he’s both; but he is much taller than Brian, so he wins.”