Minimum wage: Good intentions, bad outcomes

This article was first published at Dhaka Tribune. However this version has a guest comment (via email) on the topic by the widely popular Senior Columnist of The Financial Times Mr. Tim Harford. He authored “The undercover economist” which is one of the best books on economics that I have read.

Recently, after rounds of negotiations the minimum wage for blue collar RMG workers was increased by 77%. The humanitarian in me rejoiced at the news, as I believe that their income was too low to support a decent standard of living. These people have been shedding blood, sweat and tears for our country and quite frankly they deserve better.

However, the economist in me was not so sure about how much it would help them or even the economy itself. Before you pigeonhole me as the stereotypical “crony capitalist,” I would ask that you at least peruse my reasoning.

Let me start with a bit of theory. Free market economists, particularly of the Austrian school of thought (Ludwig von Mises, Friedrich Hayek, etc) speak vehemently against any sort of government intervention.

Their logic, when applied to minimum wage, is simple. Setting a price above the market determined price will take the market to a disequilibrium and thus demand will be lower than supply.

Effectively, this would lead to higher unemployment and therefore a “deadweight loss” will be created. Now that I have covered the theoretical gibberish, it is time to discuss real life implications.

In reality, unemployment did clearly increase after the hike in minimum wages. Most RMG factories laid-off (close to 20%, if my sources are to be believed) employees in a desperate attempt to protect their thin profit margins. It was mostly employees from the unskilled category who were laid off. Entry requirements were also raised.

For example, in one particularly large factory, the minimum requirement for educational qualification was raised from individuals who had passed through Grade 6 to SSC graduates.

What this suggests is that the more skilled workers are being better off at the expense of the unskilled ones when minimum wages are raised. But the whole worker community is “not” benefiting from the wage hike, which would have been the ideal situation.

This would have been okay if the semi-skilled workers who still have a job got the full benefit of the hike. Unfortunately my hypothesis is that their cost of living, particularly rent (the largest expenditure) will adjust upwards quite sharply. This is because the rapid urbanisation and dense concentration of people gives a lot of bargaining power to the landlords.

Thus, when wages increase they can raise rents as well. I have already seen the effect of the wage hike on inflation in the CPI figures for January 2014. Non-food inflation rose by 1.7% MoM (month over month) driven mainly by “Gross rent, fuel and lighting” which grew to a staggering 3.37% MoM. Given that energy prices have not been adjusted upwards recently, I can conclude that its hikes in rent that drove most of the increase.

You can question my conclusion saying that there is a seasonality effect on rents because it is the start of the year. My counterargument is that an increase of such magnitude is quite unprecedented even when we look back at the numbers for past years.

My final argument is that some of the factories with a weak financial position will completely go out of business with the wage hike. All workers working in these factories will be out of work and there would be nobody to hire them as the industry as a whole is shedding workforce.

For these people, getting a lower wage is still better than getting no wage at all. One such early indicator is the fact that many factories have still not been able to comply with the directive.

Minimum wage is a great example of good intentions but bad outcome. In the words of the economist Henry Hazlitt:

“You cannot make a man worth a given amount by making it illegal for anyone to offer him less. You merely deprive him of the right to earn the amount that his abilities and situation would permit him to earn, while you deprive the community even of the moderate services that he is capable of rendering. In brief, for a low wage you substitute unemployment. You do harm all around, with no comparable compensation.”

What then is the solution? There is no magic answer. We have to first try and figure out why exactly the market priced the wages for our garments workers at such a low level.

I am definitely no expert on the RMG sector but would point to the following factors:

1. The large population base of the country leading to an oversupply of workers.

2. Lack of education resulting in very low productivity compared to peer countries.

3. Infrastructure and energy bottlenecks slowing down growth of entrepreneurial activity.

In my honest opinion, focusing on supply side policies such as education, healthcare and training to boost long-term productivity of the workforce would lead to a better outcome than a one-off hike in minimum wages.

Now for the more interesting part. Here is the email exchange between me and Tim Harford.

Dear Mr Tim,

I loved reading “The undercover economist” and also read a piece written by you advocating foreign buyers not to desert Bangladesh. Now I have a personal request to make. I recently switched from a NY based investment fund to a local stock brokerage in Bangladesh with the dream of improving the knowledge of finance and economics in the country. I also opened a blog to promote this and got a comment from Aswath Damodaran. I was hoping to get a similar comment from you which would be a big motivation for me and the entire country. I have a question for you which I cannot really figure out and I am hoping to get an answer from you.

 

Problem: Recently the Bangladesh government increased minimum wage by 77%. This sounds great because these workers shed their blood, sweat and tears for the country. However being influenced by Austrian economics I feel that this wage hike would not help the workers because 1. Their rents (large component of expenditure) would adjust and 2. A lot of workers (hearing about 20% in some cases) are being laid off. Furthermore we should also see deadweight loss.

 

So what then is the solution to help these workers? The only thing that comes to my mind is supply side policy like better education, healthcare and training but these are mid to long term policies. Would really love to hear your thoughts.

 

 

Hi Asif,

Sorry for the slow response. I agree, an effective short-term solution looks elusive. In the longer term the answer is surely “economic development” but of course we don’t know very much about how to promote that, either…
Kind regards,
Tim Harford

Tim Harford
Senior Columnist, The Financial Times
I’m @timharford on Twitter.
I spoke at TED, PopTech, and the Sydney Opera House.
The Financial Times, 1 Southwark Bridge, London SE1 9HL

Asif Khan, CFA

Asif Khan is presently a Research Analyst (Financial Sector) for Exotix which is a frontier market focused investment bank. He has more than 6 years of work experience as equity analyst in both buy and sell side roles across Asian frontier markets. Asif is a CFA Charterholder and has a dual major in Finance & Economics from North South University.

7 thoughts on “Minimum wage: Good intentions, bad outcomes

  1. I have a problem with the economic logic against the minimum wage. it typically boils down to the notion that you eat away the profits, therefore companies cannot pay, leading to unemployment. The solution as you have put it is education and so on, but that you will still need the people at the bottom undertaking the menial work….meaning the same lower wage.

    my issue is that when a company can pay workers are higher salary through their profits but those profits are being concentrated on higher management, then there is a discrepancy between what the lower workers earn, what higher management earn and what shareholders earn. While I do not think a study has been done, for larger companies I am very certain that a far more egalitarian distribution of profits is possible (perhaps even fringe benefits for lower workers).

    The state should not get involved, and we have instances such as Henry Ford who increased the market wage and gave better hours to his workers. The problem is when company’s are only thinking about hte bottom line, and there is huge discrepancies between salarys from the bottom to the top, I think this is a huge concern.

    1. Hi Rizwan,

      I think this is going to be a big post. Let me use bullets to make things clear.

      1. Education and training will improve productivity. In terms of productivity Bangladesh lags far behind. Higher productivity should allow owners to pay more.

      2. I am not sure how you are certain that a more egalitarian distribution is possible. If it was possible then market would have adjusted. I would recommend that you read what the classical economists have to say on the subject.

      3. As you can see what I wrote is not exactly my own invented theory. Tim Harford also agrees with me.

      Having said all these things I do agree that economists never agree with each other. If you have a method to make workers better off please share it here. I would love to see whether that is viable.

  2. I think the biggest drawback of the minimum wage is that it ensures people whose skills do not justify that wage will remain unemployed. In the case of Bangladesh, this new minimum wage law will make sure that the unskilled, especially the new entrants will be laid off because their skills no longer justify the wage they are being paid. They may be willing to work for less and over the years accumulate knowledge, skills and improve their overall living conditions. But the minimum wage law will make it illegal for the employer to hire him. So, this new law will only contribute to the youth unemployment of this country.

    Another effect I think the law will have will be the unemployment of women. Almost 80% of garment factory workers are females and in fact, it is this group that the do-gooders are more eager to help. Now if female productivity is less (I’m not saying it is, but it may be the case – not because of their sex, but for some other reasons) the only weapon the female employees have to compete against male workers is their willingness to work for low wages. But they are being denied of that chance and so, employers would not want to hire them anymore. They would much rather have male employees who would not need maternity leaves and can work longer hours. Now I believe that minimum wage laws were passed to improve the lives of the poor workers, but it’s having the exact opposite effect that their well meaning sponsors intend them to have.

    I absolutely agree that education is probably the best way to improve the conditions we currently have. But then again, I think it’s the failure of the government to provide decent schooling, which has been a governmental responsibility especially in the countryside. And now that these poorly educated people come to look for jobs in the cities, they can’t because apparently their skills do not justify the wage they have to be paid. So in essence, it is a law that discriminates people with low skills.

    In his book South Africa’s War against Capitalism, Walter E Williams wrote that racist Trade Unions were the main proponents of higher minimum wage laws in the apartheid South Africa because it would cause the employers to hire more whites than blacks. Suppose a white laborer is working for $5 an hour and an unskilled black man comes in and wants to work for $1. Still the employer cannot hire him because it’s illegal. So, it has contributed to creating a vicious cycle of poverty and unemployment among the blacks.

    A question to be asked here is, why was the wage so low – clearly there was an oversupply of workforce. But I think another factor also contributed to the low wage. It was the existing minimum wage. I think the owners thought that since they were already paying the minimum wage, it would be useless to pay any more. If wages were determined by the free market, then maybe, just maybe, the owners could pay more since there was no obligation to pay a minimum amount.

    And well, to be very honest, I think the new minimum wage law will not create a drastic change in the quality of lives of the workers. It will only contribute to higher inflation and as you mentioned – rising rents which already has happened. Owners and managers will not cut back on their consumption, but it will be a disincentive for new investments. Small factory owners cannot afford to pay the high wages and will go out of business, thus further contributing to unemployment. What if no new factories are made? What would the minimum wage/productivity be if the total amount of capital today was the same as it was 100 years ago? (Quoted from Milton Friedman)

  3. By reviewing the all the talented states, it make senses to us to enforce the supply side of the economy as well as the supply side of the labor market should be controlled along with the demand backward pricing and lets see our elite society can give up some of their higher living standard in order to make the rest happy a bit of standard of living. Surely, Classical economists stick to their points of Adam Smith’s “Invisible hand” to take care the market itself. Whereas Keynes recommended a bit of government intervention to get thinks back to recirculate. I think, most of the economists today are evolving with their think tank and can never disagree at least rationally, that if some of us is better of, then there is must some other who are worse off. The problem we have, as a third world is not only the minimum wage and safety standard, it also means to make the trade off of choices. It Government itself corrupted itself and giving the opportunity to the elite class using the labor of worse off groups of society then Keynes statement is in question and it also applies to Adam’s Smith’s “Invisible hand” it turns out to be very visible. Some amount of control must be put in order to things get back into its track it we want a co-existent living on the earth. As a third world country it’s not the poor countries problem and I may prefer to call it a negative effect of the globalization.

    Every single individual, I think, wants his or her own freedom ,as the rich countries themselves want their control within their border regardless of forming the allies or enmities. As it also true, what IMF chief recently said, control your own internal affairs within your border. But, slightly disagreeing to agree that would be appreciate it we as a whole think of the very fundamental theory of opportunity cost. What Mr. Mozena did is greatly commendable to come ahead with one steps of solution to this problem.

    And I think, it’s time to think literally rather than theoretically. Since, we know a fact that it’s the problem of our root level politics and some elites. Why don’t we form a general conformity with the real opportunity cost and being better off leaving the state or diminishing rates of return, while we can establish an economies of scale to measure things up a little bit! even if it causes RMG sector’s bottom line to decrease a bit doesn’t necessarily mean, it can’t have a bargaining power with foreign pressures with some strategy. That’s why our analysts are needed to correct the mistakes of the market economy or the so called “Invisible Hand” of Adam Smith.

    PS: No disrespects to any economists or analyst, as because, they are the one who think of society’s betterment and educate us constantly to have a view in general for the wealth of nation and its emerging economy.

  4. You should not label an email reply as a comment from some reputed economist! This is bad strategy. It shows your integrity to spread the financial knowledge in a perfect manner.

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