Markets work, in general. That’s like saying, people are healthy in general. But people do fall sick. Similarly, occasionally markets fail. That’s when you need intervention, not otherwise. But it cannot be any random intervention. The treatment has to fit the etiology of the disease. So also, market intervention has to be specific to the kind of failure the market suffers from. We must therefore first be sure why the market failed and only then try to fix it. If legislating a minimum wage is the solution, we need to ask what the market failure is.
Competitive markets usually perform as best as can be expected. But no market is perfectly competitive although many can be considered to be so for all practical purposes. Quite often but not in all cases, those markets that are not competitive are so because of government intervention in the first place. India, being a socialist country, presents many instances of governments distorting markets. To take a specific familiar example, consider what used to be before the liberalization of the telecom services market in India.
The government had a monopoly on telecommunications in India. It was a public sector monopoly; it barred the entry of other firms in the telecom sector. Regardless of whether public or private, monopolies restrict supplied quantity, which leads to lower quality and higher prices. Lacking any competition, the monopolist makes super-normal profits and ends up reducing social welfare. In cases like these (and we should note that there are many), the way to improve social welfare is to open the market to competition — which the government finally did in the 1990′s. We know how the telecom sector improved once that happened.
The improvement in the telecom sector was entirely predictable for anyone familiar with basic economic principles. The question is why didn’t the government do it sooner. The answer is because a public sector monopoly is good for the people in the government (politicians and bureaucrats) and the workers of the sector. Powerful vested interests normally trump the interests of the public.
Another example is of an improved sector following the removal of government mandated monopoly is the civil aviation sector in India. We also know that story too well. In any case, the government continues to maintain monopolies in other sectors. The railways is perhaps the most striking example. Until the government lets go, the railways will continue to be a disaster story.
The first basic lesson is that governments do distort markets and it ends up costing the public dearly. The second basic lesson is that unless there’s some reason to believe that there’s a market failure, it is good to just let well-enough alone.
So now let’s talk about labor markets, a topic I had touched upon in a previous post on minimum wages. First, let’s ask if there are failures in labor markets and if so, what’s the source of the failure. Second, can something be done about it. It could be possible that the failure is such that nothing can be done about it, or if anything at all is done, it could make a bad situation worse. Sometimes we are powerless to intervene. Finally, if indeed something can be done to improve the situation, is the government the right agency to fix the market failure or is it something else.
Let’s take a simple case. Imagine that the employer has monopsony power. That is, it is the only employer of the labor available in a particular market. A monopsony is the equivalent of a monopoly. We term the single supplier of a good (or a service) in a particular market a monopoly, while the firm which is the single buyer (“demander” if you will) of a good or a service is called a “monopsony.”
A monopsony, like a monopoly, has market power. What that means is that monopolies and monopsonies have the power to set the price. That is, they can dictate terms. A monopoly can dictate the price at which the good or service is sold, and a monopsony can dictate the price at which it buys the good or service. Contrast this with a firm operating in a competitive market. In a competitive market, a firm is a “price taker” — meaning it cannot set a price, and instead can only sell its product at a price that is outside its control and which it is compelled to take.
A monopsony in the labor market — in other words, a firm that has the market power to determine the wage at which it hires labor — will a lower wage than what would prevail in a competitive labor market. In that case, it is possible to increase social welfare by mandating a wage that is higher than what the monopsonist would pay and which is therefore closer to the wage that would result if it had been a competitive market. Bottom line: a minimum wage makes sense if the firm has power in the labor market.
It can be argued that in most cases the labor markets are competitive and therefore no intervention is warranted. But then how does one explain why the wages are so low that it attracts the attention of well-meaning people? It is because there is an excess supply of unskilled labor relative to demand. Prices are jointly determined by supply and demand in a free market. Low prices change to high prices only if the supply contracts or the demand expands.
Mandating a price floor (which is what a minimum wage is) does not affect the supply or the demand — although it does affect the quantity supplied and the quantity demanded. At a higher wage, the quantity supplied increases and the quantity demanded decreases. That means there is an excess supply. The limited quantity that is demanded therefore has to be rationed.
Where previously say 100 people were employed at a lower wage, at a higher wage say only 80 people are employed. So the 80 are better off but the 20 are worse off. Minimum wages have redistributive effects. You cannot make all 100 better off — only some of them gain and the remaining lose.
There is a general principle which should be noted. It is never possible to do only one thing. When you try to do something, other things also happen — things that are not intended. If you imagine that by introducing a minimum wage, you only change the wages and nothing else changes, you come up against what Garrett Hardin has called the First Law of Human Ecology: We can never do merely one thing.
Here endth the lesson.