A Solution to a Market Failure?
Traditionally, government interventions tend to be justified as
helping correct “market failures.” In certain
situations, the private interactions of companies and consumers are
said to produce economically inefficient outcomes. Policymakers
often imply that a regulation, tax, or subsidy can improve matters,
raising societal welfare.1
Labor markets can theoretically suffer from market failures too.
One example is a monopsony—an instance where one firm is the
single purchaser of labor.
As the sole buyer, a monopsony company’s demand for
workers is the market demand. Rather than hiring the staff
it needs at the prevailing wage, the monopsonist’s hiring
decisions therefore actually determine the market wage. This power
leads the company to hire fewer workers than it would in a
competitive market and at a lower wage rate.
Why is this? Since the supply of workers is sensitive to the
wage the firm offers, increasing pay to attract an additional
worker would mean having to pay this wage increment to all current
workers too. For a monopsonist firm, the total marginal cost of
hiring someone therefore exceeds the marginal cost of the
additional worker’s wages alone.
A profit-maximizing monopsonist will therefore only hire to the
point where its demand for workers is equal to the total
marginal cost of hiring. In other words, to maximize profits, the
company will hold down the wage it pays to all its workers by
limiting the number of people it hires. This results in economic
inefficiency—workers don’t find employment even where
their productivity for the firm would exceed the individual
marginal cost of hiring them. Wages and employment are below those
seen in a competitive market.
Where monopsony power exists, a minimum wage floor skillfully
set at the competitive wage rate can therefore improve economic
efficiency. By removing the monopsonist’s wage-setting power,
it will both end pay suppression and actually raise employment
(since the firm will now have no reason to restrict how much labor
In the past two decades, there has been extensive empirical
back-and-forth on whether minimum wage increases do reduce
employment (as the competitive model of the labor market would
predict).2 Although minimum wage campaigners
exaggerate the balance of the literature, some studies have found
that modest minimum wage hikes can have very small to no apparent
negative direct effects on employment levels.3
Monopsony power is held up as a potential explanation for these
results, although very few papers find a positive impact
on employment, as the monopsony model would imply.
But those advocating for a federal minimum wage hike to $15 per
hour today do not argue for higher wage floors on the basis of
monopsony power, probably for good reason.
Bureau of Labor Statistics data show that 80.3 percent of
employees who are paid at or below the federal minimum wage work in
three industries: retail, leisure and hospitality, and education
and health services.4 These industries do not tend to
be characterized by companies dominating local labor markets.
Indeed, using monopsony power as justification for a substantial
federal minimum wage hike necessitates a much broader claim: that
all U.S. employers of low-wage workers have a degree of monopsony
No, federal minimum wage hike advocates today argue that the
level of the wage floor should be raised to fulfill other social
policy objectives, such as reducing poverty or inequality, or that
it should simply be pegged to another metric, such as economy-wide
labor productivity or the cost of living.
As an example, Democratic presidential primary candidate
Elizabeth Warren recently claimed:
When I was a kid, a minimum wage job in America would support a
family of three. It would pay a mortgage, keep the utilities on and
put food on the table. Today, a minimum-wage job in America will
not keep a mama and a baby out of poverty.6
Her implication here is that policymakers should set the federal
minimum wage not according to the health of the economy, or its
impact on labor markets, but to maintain the purchasing power of
full-time minimum wage employees.
Other economists and thinkers use different comparator metrics.
In his 2013 testimony before the U.S. Senate Committee on Health,
Education, Labor, and Pensions, University of Massachusetts
economist Arindrajit Dube’s first three arguments in favor of
a federal minimum wage increase were that the minimum wage had not
tracked the trend in aggregate labor productivity, rising living
costs, or the path of median wages, respectively.7
In testimony for state committees, David Cooper of the Economic
Policy Institute regularly documents how current minimum wage rates
have not “kept up” with average wages or economy-wide
productivity levels and that minimum wages currently provide
incomes for full-time workers below various poverty
This bulletin does not dispute those claims. But it argues that
such comparisons are not appropriate for judging an appropriate
level for minimum wage rates. Devoid of broader context, not least
the labor market and firms’ ability to pay higher wages,
making such comparisons might lead to damaging policy
To Keep Pace with Productivity Trends?
Economy-wide labor productivity has risen faster than the
federal minimum wage over the past 50 years. Given a basic tenet of
economics is that compensation tracks productivity levels (i.e.,
output per hour worked), economists and campaigners for a higher
minimum wage hold up this observation as supporting evidence for
raising the wage floor.
In his 2013 Senate testimony, for example, Dube said, “It
is quite remarkable that had the minimum wage kept up with overall
productivity [from 1960], it would have been $22 per hour in
Although Dube stressed that he was not suggesting that the
minimum wage be increased to that level, the comparison is clearly
used to imply that the minimum wage could be increased
significantly without adverse consequences. The comparison implies
that the underlying productivity of the affected workers has been
increasing, but their pay has not, perhaps because of increased
market power on the part of employers.
Comparing the federal minimum wage to aggregate productivity
trends in this way is problematic, though, for two reasons.
First, state, local, and city governments across the country
already often set minimum wages significantly higher than the
federal level, particularly in higher-productivity regions.
Right now, 29 states and the District of Columbia have minimum
wages higher than the $7.25 per hour federal level. Washington and
Massachusetts, for example, have $12 minimum wage laws. In cities,
wage floors are often higher still. New York City has a $15 minimum
wage, and the minimum wage is $16.09 in SeaTac, Washington.
Economist Ernie Tedeschi has estimated that, as a result, the
average effective minimum wage across the whole United States is
$11.80 per hour for 2019.9
Even if minimum wages are considered a worthy policy tool and
productivity a good guide to setting their level, setting minimum
wages in line with the productivity conditions within a locality
makes more sense than setting a homogenous higher wage floor for
the whole country. Country-wide productivity statistics mask vast
productivity discrepancies across regions.
But a more important flaw in linking the minimum wage to
economy-wide labor productivity is that the productivity
performance of all workers tells us little about the productivity
performance of minimum wage workers. Different industries,
different companies, and even different workers within
organizations are likely to experience different productivity
growth rates over time.
A productivity growth series solely for minimum wage workers is
not available and would be nearly impossible to put together.
Examining industry productivity data from 1987 through 2017,
however, highlights that using aggregate productivity trends to
estimate what the minimum wage level should be is problematic.
The federal minimum wage in 1987 was $3.35, which is $7.32 in
2017 dollars.10 Since then, private nonfarm
labor productivity has increased by an average of just under 2
percent per year.11 If the federal minimum wage had
increased in line with trend productivity over that period, it
would have increased to $13.22 by 2017 (see Figure 1).
Yet labor productivity in the restaurant sector (often regarded
as a better proxy for a typical minimum wage industry) rose by an
average of just 0.4 percent per year between 1987 and 2017 (with
unit labor costs increasing by 3.3 percent per year).12
If pegged instead to this productivity measure, the minimum wage
would have increased by just 13 percent in real terms over three
decades, rising to $8.25 by 2017.
Given that the actual federal minimum wage was $7.25 in 2017 and
that 22 states had minimum wages higher than $8.25, this
productivity series and start date imply that minimum wages were
higher in 2017 than justified by restaurant productivity trends
since 1987 in much of the country.13
Some subsectors have had even worse productivity performances.
Labor productivity in “drinking places for alcoholic
beverages” (i.e., bars and pubs) actually fell, on average,
by 0.2 percent per year since 1987. If pegged to this trend
productivity rate, the federal minimum wage would have fallen, too,
to $6.89 in 2017 (see Figure 1).
None of this proves that current minimum wage rates in many
parts of the country are too high. Nor does it tell us what the
minimum wage “should be,” in the sense of the true
productivity levels of workers in individual companies or sectors,
or whether employers have market power to pay workers below
competitive market rates. We might also, of course, expect
improving productivity in manufacturing sectors to “spill
over” somewhat into other low-productivity minimum wage
sectors due to competition for labor, as outlined in William
Baumol’s “cost disease” thesis.14
What this scenario analysis does show, though, is the danger of
spurious comparisons between economy-wide productivity and the
level of the federal minimum wage. Making the link between the two
explicit might lead us to deliver much higher wage floors than are
justified by the productivity of workers in certain sectors or
regions, causing significant localized job losses or other economic
Cost of Living
Minimum wage hike campaigners often compare the federal minimum
wage to living costs. Sometimes they compare it to economy-wide
inflation trends, but often they consider the cost of specific
“essentials,” too, such as housing or childcare.
Minimum wage hike proponents have a point that if one believes a
federal minimum wage is necessary to solve a market failure, it
should be set at the “right” level to fix the failure
in real terms. In practical policy, index linking the minimum wage
so that it tracks the general price level in the economy therefore
makes some economic sense in theory (even if, in reality, recent
evidence suggests that such linking leads to larger negative
effects on employment than nominal adjustments).15
As Figure 2 shows, however, the real value of the minimum wage
in 2017 dollars has fluctuated wildly over the past six decades,
peaking in 1969 at $10.91 per hour and troughing at $6.18 per hour
in 2007. The real level of the federal minimum wage today is
similar to that seen in 1994, 2002, and 2008.
Yet when campaigners compare the real level of the minimum wage
from the 1960s to that of today, they are implicitly saying that
the real level in the 1960s was the “right” one. This,
clearly, has not been the call of numerous administrations and
Congresses, which have considered that level to have deleterious
labor market consequences and so have allowed the minimum wage to
fall in real terms to reduce those consequences. Allowing the real
minimum wage to fall by keeping its nominal value fixed is probably
a more politically palatable tool than complete abolition of the
The long and short, then, is this: index linking the minimum
wage to the price level makes sense if you are confident that the
wage is currently at the right real level to alleviate any market
failure. But any claim as to the latter statement is controversial,
as numerous surveys of economists show.16
It makes no sense whatsoever, though, to imply that the federal
minimum wage should be raised to reimburse workers for highly
localized living costs (such as expensive housing or
It is important to remember that employers pay employees for the
perceived value of the work the employees undertake, not to
compensate the employees for their rent, food, energy,
transportation, clothes, or childcare bills (which differ hugely by
family and locality and are beyond employers’ control).
High living costs are, of course, a very underdiscussed cause of
economic hardship in the United States. My own research has found
that typical poor American households face high prices for
essential goods and services because of misguided interventions and
regulations. These regulations can cost them anywhere between $800
and $3,500 in total per year.17
Rather than tackle the structural causes of these high prices,
minimum wage hike campaigners want businesses to bear the cost of
compensating workers for their high living expenses. That is not
economically sensible. Putting the full burden of the cost of
living on shareholders and customers of the firms hiring low-wage
workers—in other words, willingly divorcing pay rates from
the work employees undertake, market conditions, or firms’
ability to pay their employees—could risk a significant
diminution in low-wage job opportunities.
Another metric used by advocates for higher federal minimum
wages is to compare earnings for full-time minimum wage workers
with various poverty thresholds (which differ by household
composition). The rationale here, again, is that the minimum wage
should be used for targeted poverty reduction rather than just to
correct market failure.
Someone working full-time (40 hours per week) earning the hourly
federal minimum wage in 2017 would have obtained a pretax income of
$15,080. That income was below the federal poverty threshold for a
one-parent under-65 household with a dependent child, which is
$16,985.18Minimum wage hike
campaigners’ conclusions are therefore simple: raise the
statutory hourly wage floor to raise the income levels of these
It is certainly true that for the minimum wage workers who kept
their jobs and hours, raising the hourly wage floor significantly
could lift them above the relevant poverty line. Yet poverty is
measured at the household level. The very reason why minimum wages
have not been used as a primary tool to reduce poverty for
households is that they were not considered particularly well
targeted or effective for that purpose.
First, people who earn around the minimum wage are often not
from households in poverty. A 2017 Government Accountability Office
(GAO) report found that just 13 percent of families with a worker
earning an hourly wage between the federal minimum wage and $12 per
hour were in poverty.19 Many people earning around the
current minimum wage are second earners (particularly part-time
workers) or young people who live in households with parents who
are not poor.
Second, minimum wage hikes could have adverse consequences on
employment prospects by reducing labor demand. The GAO report shows
that minimum wage earners are more likely to work fewer hours than
those earning higher hourly rates. The risk, then, is that higher
minimum wages reduce demand for labor hours from low-productivity
workers with already weak labor market attachment, as analysis
found after Seattle’s minimum wage hike to $13.20
These observations are why economists have long concluded that
in-work income transfers to families with children through programs
such as the earned income tax credit (EITC) are better targeted at
reducing poverty. These transfers encourage work among recipients
while boosting incomes of poor households, rather than discouraging
employers from hiring.21
Yet federal poverty thresholds ignore the EITC and other
transfers that have expanded in recent decades. Comparing the
income for a full-time minimum wage earner to poverty thresholds
can therefore paint a very misleading picture of the living
standards faced by households below the poverty line.22
The metrics that $15 minimum wage advocates use to make the case
for substantial minimum wage hikes are not, on their own,
economically sensible benchmarks by which to set minimum wage
Economy-wide productivity growth can be a poor guide to
productivity trends for minimum wage workers and different
localities, and it tells us little about whether firms have the
power to set below-market wage levels.
Housing and childcare costs are unrelated to firms’
ability to pay or the value of the work minimum wage employees
undertake. And comparing the income of someone working full-time at
the federal minimum wage to existing poverty thresholds ignores the
role of anti-poverty programs and the fact that many minimum wage
earners are not poor.
Campaigners’ arguments often imply that minimum wages
should be linked to productivity measures, living costs, or poverty
thresholds. The evidence presented above suggests that translating
these arguments into policy could produce damaging labor market
1. Ryan Bourne,
‘Market Failure’ Arguments Lead to Misguided
Policy,” Cato Institute Policy Analysis no. 863, January
2. For a full treatment of
this question, see Ryan Bourne, “A
Seattle Game-Changer?,” Regulation 40, no. 4
(Winter 2017/2018): 8-11.
3. Doruk Cengiz et al.,
“The Effect of Minimum Wages on the Total Number of Jobs:
Evidence from the United States Using a Bunching Estimator,”
April 30, 2017.
4. Bureau of Labor
Statistics, “Characteristics of Minimum Wage Workers,
2017,” BLS Report no. 1072, March 2018.
5. Alan Manning,
Monopsony in Motion: Imperfect Competition in Labour
Markets, Chapter 1, Introduction, http://personal.lse.ac.uk/manning/work/mimintro.pdf.
6. Ryan Bourne,
“Sen. Warren Misses the Mark on the Living Wage
Debate,” The Hill, January 2019.
7. Statement by Arindrajit
Dube before the U.S. Senate Committee on Health, Education, Labor
& Pensions hearing on “Keeping Up with a Changing
Economy: Indexing the Minimum Wage.”
8. David Cooper,
“Raising the Connecticut Minimum Wage to $15 by 2022 Would Be
Good for Workers, Businesses, and the Connecticut Economy,”
Testimony to the Labor and Public Employees Committee of the
Connecticut General Assembly, March 7, 2019.
9. Ernie Tedeschi,
“Americans Are Seeing Highest Minimum Wage in History
(Without Federal Help),” New York Times, April 24,
10. Bureau of Labor
Statistics, CPI Inflation Calculator.
11. Federal Reserve Bank
of St. Louis, Federal Reserve Economic Data, Private Non-Farm
Business Sector: Labor Productivity, https://fred.stlouisfed.org/series/MPU4910062.
12. Bureau of Labor
Statistics, “Productivity and Costs by Industry: Wholesale
Trade, Retail Trade, and Food Services and Drinking Places
Industries,” July 2018.
13. Niall McCarthy,
“The States With a Higher Minimum Wage than the Federal
Standard [Infographic],” Forbes, January 5,
14. William Baumol and
William Bowen, Performing Arts: The Economic Dilemma: A Study
of Problems Common to Theater, Opera, Music and Dance
(Cambridge, MA: MIT Press, 1966).
15. Peter Brummund and
Michael R. Strain, “Does Employment Respond Differently to
Minimum Wage Increases in the Presence of Inflation
Indexing?,” July 2018.
16. IGM Forum, “$15
Minimum Wage,” Chicago Booth Business School, September 22,
17. Ryan Bourne,
and the Cost of Living: Income-Based vs. Cost-Based Approaches to
Alleviating Poverty,” Cato Institute Policy Analysis no.
847, September 2018.
18. U.S. Census Bureau,
Poverty Thresholds for 2017 by Size of Family and Number of Related
Children under 18 Years, https://www2.census.gov/programs-surveys/cps/tables/time-series/historical-poverty-thresholds/thresh17.xls.
Accountability Office, “Low-Wage Workers: Poverty and Use of
Selected Federal Social Safety Net Programs Persist among Working
Families,” GAO-17-677, September 22, 2017.
20. Ekaterina Jardim et
al., “Minimum Wage Increases and Individual Employment
Trajectories,” NBER Working Paper no. 25182, October
21. David Neumark,
“Reducing Poverty Via Minimum Wages, Alternatives,”
FRBSF Economic Letter, December 2015.
22. John F. Early,
the Facts About Inequality, Poverty, and Redistribution,”
Cato Institute Policy Analysis no. 839, April 2018.