Rebirth of Reason


Fallacious Arguments for the Minimum Wage
by William Dwyer

Writing in the Journal of Economic Issues, liberal economist Robert Prasch challenges a basic precept of microeconomics by defending the minimum wage.(1) He claims that there are at least three constructive outcomes of a price floor on labor: First, it increases the level of effective demand; second, it provides an impetus for rapid technical change; and third, it equalizes bargaining power in labor markets. Let us consider each of these alleged benefits in turn.

Does the Minimum Wage Increase Effective Demand?

Prasch argues that the minimum wage increases the level of effective demand by transferring purchasing power “from profits, perks and overheads to those who earn low wages”. He says that post-Keynesian economists have long maintained that when income is more evenly distributed, there is an increase in the total quantity of spending.(2)

Question: What does Prasch think business people do with their “profits and perks”, if not spend them? As Henry Hazlitt observes in his illustrious Economics in One Lesson(3), the capitalist must use his profits in at least one of three ways:

(1) he will use the extra profits to expand his operations,
(2) he will invest the extra profits in some other industry, or
(3) he will spend the extra profits on increasing his own consumption.

Whichever he does, he will be engaged in spending – in “effective demand”. After all, any “transfer of purchasing power” – to use Prasch’s own words – from capitalists to workers is just that – a transfer of purchasing power, which would otherwise be employed in the act of purchasing goods and services and/or financial assets!

More important, as any price floor above the free-market level creates a surplus of the controlled commodity, minimum-wage laws above the equilibrium wage-rate create a surplus of labor, i.e., unemployment. As a result, they necessarily reduce aggregate production. The fewer workers who can be employed, the less will be the output in the economy. The less the output at a given level of nominal spending, the higher will be the average level of prices relative to output. How this is supposed to increase effective demand is anyone’s guess.

Moreover, to the extent that people are unemployed, they must be supported at taxpayers’ expense. Therefore, insofar as the minimum wage increases the burden of supporting the unemployed, the take-home pay of the average worker will fall, even as prices increase in response to a drop in total production. (4)

The result is that, if anything, minimum-wage laws will reduce aggregate purchasing power, and therefore lower effective demand, not raise it, as Prasch would have us believe! If his theory were correct, we would have only to mandate an increase in the minimum wage to $1000 per hour, and the purchasing power of the average worker would skyrocket. But this is clearly a reductio ad absurdum of his argument, which highlights its fallacy. If a minimum wage of $1000 per hour doesn’t raise the level of effective demand, because it would produce massive unemployment, then any law that puts the wage above the equilibrium level will be counter productive, even if only to a lesser degree.

What is astonishing is that nowhere in his article does Prasch address the standard argument of economists that a minimum-wage law above the free-market level would create unemployment. The closest he comes is to argue that even though the real minimum wage fell by approximately 25 percent during the previous decade, there was no significant reduction in structural unemployment among unskilled workers. (Prasch, 390) But this rejoinder does not control for other factors bearing on the unemployment rate during that period. It also ignores a number of studies from previous decades showing a correlation between minimum-wage legislation and increased unemployment for teenagers and minorities.(5)

A study published in Economic Commentary (February 1, 1999), the official journal of the Federal Reserve Bank of Cleveland, also documents the adverse effect of minimum wages on unemployment. In their conclusion, the authors state:

"Minimum wages do, no doubt, help some families escape poverty; but the employment losses associated with a higher minimum also appear to cause some families to fall into poverty. On balance, our estimates suggest that the latter effect outweighs the former, and therefore the net effect of minimum wages is an increase in the proportion of poor families."(6)

Prasch also claims that a transfer of purchasing power from the rich to the poor will increase domestic spending, because the wealthy tend to invest more of their money in “stock market speculation” and to take more European vacations, spending their money abroad, whereas the poor spend more of theirs on domestically produced goods and services.(7)

This argument echoes the standard Keynesian fallacy that saving is not a form of spending. But investment in financial assets still leads to spending on capital goods. Prasch also courts the common protectionist fallacy that spending on foreign goods represents a net loss to American businesses. But if the wealthy spend American dollars abroad, those dollars must eventually come back to the United States. They must ultimately be used by foreigners to buy American goods, which will then make up for any short-term loss in domestic spending.

Prasch also argues that “to the extent that capacity has been idle and workers underemployed at previous levels of effective demand, an increase in the level of demand has the ability to increase measured ‘productivity’. This tendency has come to be known as ‘Verdoon’s Law’.”(8)

This argument assumes a flawed theory advanced by Messrs. Malthus, Veblen and Keynes that in a free market, it is possible to have general overproduction, with corresponding underconsumption or an insufficient level of effective demand. But if prices are free to fall, no such general overproduction and underconsumption is possible, since human wants are never fully satisfied. In the absence of minimum price controls, there can be no long-standing idle capacity or chronic underemployment.

It is precisely the existence of such impediments as minimum-wage laws that prevent prices from falling and underemployed workers from being hired in the first place. Far from being the solution to unused productive capacity, minimum-wage laws are in fact one of its causes. According to Say’s Law, an increase in effective demand depends on an increase in the productivity of labor, not on a forced increase in the nominal wage rate, which can only exacerbate the problem of unemployed resources.

Do High Wage Rates Increase Productivity?

Prasch invokes the so-called “Webb Effect”, after Fabian “economist” Sidney Webb, according to which high wage rates are alleged to contribute to overall economic growth. This “effect” is supposed to be due to:

1) the elimination of marginal, low-productivity firms, and
2) the enhanced productivity of surviving firms.(9)

To be sure, if wage rates are forced above market levels, marginal firms will be forced out of business, and the surviving firms will gain some of the previous firms’ business. But this can take place only at higher costs, since the surviving firms will be saddled with higher wage rates as well. How this is supposed to enhance overall productivity is difficult to see. The higher wage rates will have reduced aggregate employment, and those firms who do manage to survive will be operating at reduced profit margins and lower marginal productivity.

Prasch says that at higher wages, the surviving firms will be forced to pursue new productivity-enhancing technologies, and that these new technologies, once adopted, will make existing businesses more efficient – as if competition and the profit motive were themselves an insufficient inducement to optimal efficiency.(10) One has to wonder at the kind of reasoning which says that if you make it costlier for people to do business, you will make them more efficient and productive.

It is true that if it becomes more economic for businesses to automate, they will do so, displacing low- and un-skilled workers in the process – the very workers that Prasch is so concerned about helping (see below). But it cannot be good economic policy to make it so costly for businesses to employ unskilled workers that employers are forced to consider other alternatives including automation.

Granted, new labor-saving technologies can be economically advantageous, but not if businesses are compelled to adopt them because cheaper alternatives are forcibly prohibited. New technologies become desirable only when they are adopted voluntarily as their costs fall sufficiently to make them economically feasible.

Does a Minimum-Wage Law Increase Bargaining Power?

Following in the footsteps of the institutionalists, Prasch argues that labor is at a disadvantage, when bargaining with employers. He cites Justice John Harlan’s dissenting opinion in the “Bakers’ Case” (Lockner v. New York, 1905), in which Harlan opined in favor of a law that limited the working day of bakery employees to 10 hours. Harlan endorsed the law on the grounds that the employees “were not upon an equal footing” with their employers. (How a maximum-hours law would remedy that alleged inequality is difficult to understand, since it prevents workers from choosing in their own interest to work longer hours.)(11)

At any rate, Prasch states: “When all parties have their needs met, they can they freely enter into contracts.”(12) Otherwise, he says, an element of coercion is present in the exchange. This is a very strange notion of “coercion”, however, especially when the employer is not a monopsony, i.e., when the employee has other employment alternatives. As John Bates Clark observed, competition among employers for workers virtually guarantees that the employer must offer a wage corresponding to the worker’s marginal productivity.(13)

Moreover, if a worker is in a position of unequal bargaining power vis-à-vis the employer, then so is the employer vis-à-vis the consumer. The employer is selling his products to the consumer, just as the worker is selling his labor to the employer. The consumer does not have to purchase the products of any particular business (with other businesses offering the same or similar products), any more than the employer has to purchase the services of any particular worker (with other workers offering the same or similar services). The needs of business are as vitally dependent on the patronage of consumers as the needs of workers are on the patronage of employers.

Therefore, since prior to selling its products, no business can be said to have its needs met, does that mean that it cannot freely enter into contracts? That would appear to be the implication of Prasch’s reasoning. If an employee cannot be said to bargain equally and freely with an employer, because he has “unmet needs” – needs that depend for their fulfillment on his being able to sell his labor -- then neither can a business owner be said to bargain equally and freely with consumers, because he too has “unmet needs” – needs that depend for their fulfillment on his being able to sell his products.

Nevertheless, Prasch declares: “Remarkably, … few modern theorists understand or appreciate the importance of the premise that all exchanges are presumed to take place between persons whose needs are met.”(14) Tell that to all the companies that were forced out of business by their competitors! Over 50,000 businesses fail every year. Were their needs met prior to selling their products? If so, then how were they forced out of business by their failure to compete successfully with other companies?

If anything is remarkable, it is Prasch’s view that free exchange is impossible unless the seller already has his needs met. In a division-of-labor economy, no one’s needs are met without a process of economic exchange. Unless a business can sell its products to consumers, workers cannot sell their labor to employers. No one’s needs are guaranteed; all are contingent upon the successful exchange of goods and services.

It may be objected, however, that workers at the lowest end of the economic ladder – workers whom the minimum-wage is specifically designed to help – are at a much greater disadvantage in terms of bargaining power than other, more affluent workers, because the poorer workers have very little if any savings in reserve. Accordingly, these workers cannot hold out as long as the more affluent workers, and therefore won’t be able to strike as good a bargain with their prospective employers.

Economist Alfred Marshall argued this point on behalf of all workers when he stated that labor was at a disadvantage bargaining with the employer, because it was burdened with a “want of reserve funds and of the power of long withholding.”(15)

But if a lack of reserve funds reduces bargaining power, then “why,” asks Morgan Reynolds, "were real wages nearly always rising under non-union capitalism? …Why did workers with great savings receive no higher wage than those with zero savings, even though they could “hold out longer”? Why did large firms pay higher wages than small firms, despite greater bargaining power by large enterprises ‘against’ their labor force?" (16)

Clearly, the answer is that (in the absence of monopsony) employees have alternatives in which employers are competing for their labor. As Adam Smith observes, “The scarcity of hands occasions a competition among masters, who bid against one another, in order to get workmen….”(17) A worker’s bargaining power consists precisely in the competitive demand for labor and in the availability of employment alternatives.

Nevertheless, Prasch draws the following conclusion: “The existence of a systemic inequality in bargaining power, based upon the abject condition of one party, forms an important condition and argument for minimum-wage legislation.”(18)

One important precondition of a bargain is the freedom of either party to accept or reject the other’s offer. Without that freedom, there is no real “bargain” in any legitimate sense of the term.(19) But observe that minimum-wage legislation interferes with that freedom by making the worker’s acceptance of an employer’s offer illegal, if the offer falls below an arbitrary minimum set by the legislation.

Far from improving a worker’s bargaining-power, minimum-wage legislation can have the effect of pricing him out of the market – of preventing him from obtaining employment at all. Instead of giving him an advantage in the labor market, as implied by the claim that it would improve his bargaining power, minimum-wage legislation would place a low-skilled worker at a decided disadvantage. The ability to charge a lower wage is one of the few tools that he possesses in competing with other workers for employment.

One of the ways in which minimum-wage laws intensify poverty is by preventing unskilled workers – especially teenagers – from acquiring the kind of work experience that would enable them to work their way up the economic ladder. If one cannot get a foot on the first rung of the ladder, then one cannot climb any further. On-the-job training is often an important means of acquiring the very skills that enable one to rise above the level of a minimum wage, and to escape the throes of abject poverty. As Economist Walter E. Williams observes, "Early work opportunities teach youngsters how to find a job. They learn work attitudes. They learn the importance of punctuality and respect for supervision. These things learned in any job make a person a more valuable worker in the future [and, I might add, help to increase his 'bargaining power']."(20)


Prasch’s arguments for the minimum-wage law fail at every level. We have seen that instead of increasing effective demand, the minimum wage law would reduce it, that instead of enhancing productivity, the minimum-wage law would hinder it, and that instead of raising the bargaining power of the least skilled workers, the minimum-wage law would deprive them of the right to bargain by making it illegal to accept a wage offer below an arbitrarily defined limit.

I find it surprising that Robert Prasch, Assistant Professor of Economics at Vassar College, would advance the kind of arguments that he has in favor of a law that lacks both theoretical and empirical support. Given the dismal quality of his article, one suspects him of harboring a hidden agenda that trumps any serious regard for economic science. That suspicion is borne out at the end of his article, when he states: “Finally, an increase in the minimum wage might also work to undermine systemic economic power and thereby be responsible for a more just, or at least a reasonable, distribution of society’s annual income.”(21) (Emphasis added) Note the characterization of income as a product of “society” rather than of individual producers who have a right to the product of their own effort. If income is a product of society, then society (i.e., the government) has a right to determine its distribution.

Here, I submit, is the real reason that Prasch is so enthusiastic about defending the minimum wage. He is an economic collectivist who evidently believes in a form of egalitarian or “distributive” justice”, even as he repudiates the individualist conception of “commutative” justice. For what could be more unjust to the least skilled workers in “society” than to prevent them from competing with other workers in their search for employment?! What could be more inhumane than to use the power of government legislation to price these struggling workers out of the labor market?!

If Professor Prasch really wants to help the poorest members of society, then he would be far better advised to endorse a repeal of the minimum-wage, and to allow each worker to negotiate his own wages and strike his own bargains with employers. That would surely be a far better approach toward improving the economic lot of these workers than demanding that the government restrict their freedom of contract by force of law.


(1) Robert E. Prasch, "In Defense of the Minimum Wage," JEI, Vol. XXX, No. 2, June 1966.
(2) (Ibid., 392
(3) Henry Hazlitt, Economics in One Lesson, (Arlington House, 1979), pp. 55, 56
(4) George Reisman, Capitalism (Jameson, Ottawa, 1990), p. 585
(5) Walter E. Williams, The State Against Blacks (New Press, McGrawHill, New York, 1982), pp. 33-51; Charles Brown, Curtis Gilroy, and Andrew Kohen, "The Effect of the Minimum Wage on Employment and Unemployment," Journal of Economic Literature 20 (1982): 487-528; Douglas K. Adie, "Teenage Unemployment and Real Federal Minimum Wages," Journal of Political Economy 81 (1973): 435-41; and John M. Peterson and Charles T. Stewart, Employment Effects of Minimum Wage Rates (Washington, D.C.: American Enterprise Institute, 1969.)
(6) David Neumark, Mark Schweitzer, and William Wascher, "Will Increasing the Minimum Wage Help the Poor?," Economic Commentary, February 1, 1999
(7) Prasch, 393
(8) Ibid
(9) Ibid, 393, 394
(10) Ibid, 394
(11) Ibid, 395
(12) Ibid
(13) John Bates Clark, The Distribution of Wealth: A Theory of Wages, Interest, and Profit (New York, Macmillan, 1914 [1899], p. viii.)
(14) Prasch, 395
(15) Alfred Marshall, Principles of Economics, 8th ed. (London: Macmillan, 1920), pp. 471-72)
(16) Power and Privilege: Labor Unions in America (Universe Books, New York, 1984, p. 26
(17) Adam Smith, The Wealth of Nations, ed. by Edward Canaan (New York: Modern Library, 1994), Book I, Chapter VIII, p. 78.
(18) Prasch, 395
(19) I owe this insight to Professor Charles Baird.
(20) Walter Williams, The State Against Blacks, p. 49
(21) Prasch, 395, 396
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