The Natural Minimum Wage
Very few economists realize that the pure free market has its own natural minimum wage
July 1, 2006
Fred Foldvary, Ph.D.

The U.S. House of Representatives has passed legislation to increase the federal minimum wage from $5.15 to $7.25 over three years. The bill, now being considered in the Senate, is linked to other issues, but here I will focus only on the minimum wage.

The pure free market has its own natural minimum wage. Very few economists realize this, because it is a classical concept which was thrown overboard when economic thought became post-classical or neoclassical. Classical theory contained the concept of the margin of production, the least productive land in use. Land beyond the margin is submarginal and unused, and thus has no rent, so the margin is also the best land that one can obtain free.

At the margin of production, after paying for capital goods, the rest of the output constitutes wages. We can consider the wage level the earnings of an unskilled worker at the margin, on a newly claimed plot of land using, say, eight hours of labor. It is the first worker's marginal product on marginal land. The wage at the margin of production sets the wage level for the whole economy, since workers of equal skill are mobile and will flock to where the wage is highest. So employers need not pay more than what a worker can get at the margin.

Thus is the extensive margin of production the natural minimum wage for the economy. If any employer offers less than that, no worker will apply, since he can go to the margin and get more. But in practical terms, what and where is the margin?

Look up, look down, look around, there are margins all over. The most overt is the margin of cultivation where farms end and the wilderness begins. Another margin is the ocean where anyone may take a boat out and go fishing. The top stories of buildings are urban margins, as one can build another story without paying any more land rent; likewise digging down to build underground is also a margin.

A common marginal occupation in developing countries is peddling. The worker is self-employed and, without paying rent, strolls down the sidewalks selling food and trinkets, and maybe postal cards to tourists. Others shine shoes in the park or sell newspapers. These workers generally earn the market's minimum wage.

In the USA, most cities require peddlers to obtain a license or seller permit, which requires a fee that is in many cases so high that peddlers are prevented from operating legally. In many cities, peddlers must also obtain a sales tax license and collect sales taxes. For an unskilled worker just barely making a living, this is too high a barrier.

The legal minimum wage is only the beginning of the labor cost to employers. The firm also has to pay taxes for unemployment, disability, social security, and medical care. There is also an overhead cost of hiring and managing labor. The firm bases its hiring decision on the total cost of hiring another worker, so the tax wedge pushes down the wage offered. If there is a legal minimum wage, then taxes and overhead have to be piled on top of the minimum. In effect, the legal minimum wage is a tax on firms which employ unskilled labor.

If the firm was already making only a normal profit, then it cannot in the long run reduce its profit, so the firm will either raise its price or else go out of business. Entrepreneurs who would have started a new enterprise see this higher cost and decide not to start a business. The higher cost of labor reduces the number of workers employed, creating chronic unemployment and higher governmental welfare costs. In some cases, workers are still employed, but the firm reduces non-controlled compensation such as training or fringe benefits.

Society and the economy would have higher wages and more employment if instead of a legal minimum wage, we let the market set the natural minimum wage. A natural minimum wage can only be attained if we abolish all taxes and arbitrary restrictions on labor and enterprise, with public revenue instead coming from the rental yield of land.

Collecting the land rent for community revenue would also prevent the margin of production, and wage level, from being pushed to a lower level by those holding land for speculative gains due to expanding commerce and public works.

Raising the legal minimum wage is political fraud, because it is a tax that does not appear on the government budget. Within today's tax structure, realizing that ultimately, the higher legal minimum wage is paid for by taxpayers, workers, and consumers, it would be better to directly subsidize the incomes of the poorest folks rather than seek to impose a higher implicit wage tax on employers and workers. Raising the minimum wage also pacifies reformers and prevents the more fundamental reforms that would create prosperity for all.

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Fred Foldvary, Ph.D.

FRED E. FOLDVARY, Ph.D., is an economist and has been writing weekly editorials for since 1997. Foldvary's commentaries are well respected for their currency, sound logic, wit, and consistent devotion to human freedom. He received his B.A. in economics from the University of California at Berkeley, and his M.A. and Ph.D. in economics from George Mason University. He has taught economics at Virginia Tech, John F. Kennedy University, Santa Clara University, and currently teaches at San Jose State University.

Foldvary is the author of The Soul of LibertyPublic Goods and Private Communities, and Dictionary of Free Market Economics. He edited and contributed to Beyond Neoclassical Economics and, with Dan Klein, The Half-Life of Policy Rationales. Foldvary's areas of research include public finance, governance, ethical philosophy, and land economics.

Foldvary is notably known for going on record in the American Journal of Economics and Sociology in 1997 to predict the exact timing of the 2008 economic depression—eleven years before the event occurred. He was able to do so due to his extensive knowledge of the real-estate cycle.