Reviving the Minimum Wage Debate (Part 2)

Gordon Lee/

In Part 2, we study costs of production, inflation, productivity and competitiveness.

Costs of production

A minimum wage policy will lead to increased costs for firms – but the degree to which costs increase is diluted by non-wage costs and higher wage earners.

Take a hypothetical firm, where 60% of total costs are labour costs. Even though 50% of its employees are low paid employees whose wages ($5/hr) will be increased with a minimum wage policy by 20% (to $6/hr), because they are lowly paid compared to managers and executives, they only constitute a third of the firm’s labour costs.

Even in this hypothetical firm with high labour costs as a proportion of total costs, a 20% increase in low wages increases the firm’s total costs by just 6% (60% x 50% x 20%).

Inflation

Even if we assume that every single firm in the economy is like our earlier example, with high labour costs and a high proportion of low paid employees, such that total costs of production in the entire economy increases by 6%, what will be the impact on inflation? The answer is that a 6% rise in total costs will lead to inflation (price rises) of less than 6%.

This is because firms respond to a rise in costs in a few ways; for example, by increasing productivity, saving costs by reducing working hours*, accepting lower profits, etc. – passing costs on to consumers is only one such way. No firm has the ability to pass on 100% of cost increases to consumers as price increases.

*According to the International Labour Organisation, Singapore has the longest working hours in the world.

Graphically, a rise in the costs of production by firms (upward shift of the aggregate supply curve from AS₁ to AS₂ by the distance between ‘a’ and ‘b’) leads to a rise in price from P1 to P2, instead of P1 to P3. This is because of the slope of the aggregate demand curve (AD).

It is also interesting to note that in the long run, the aggregate supply curve (AS_LR) is vertical, so an increase in costs will not itself lead to any price rises (i.e. no inflation).

But even if there is inflation, is inflation bad?

1. A stable and modest inflation rate is generally healthy – but inflation that is too high or too low is not. For example, the Bank of England is tasked to target inflation at 2% (±1%).

2. It is said that inflation erodes savings, but it is because of this effect that consumer spending is encouraged (which has a stimulating effect on economic growth).
3. It is said that inflation reduces competitiveness by making domestic products more expensive to export, but changes in exchange rates reflect changes in prices – with the end result being that inflation has little, if any, effect on the real price of exports (which is what customers overseas are concerned with).
4. It is said that inflation penalises the poor more than the rich. Whilst that is generally true, in this case, we are talking about a wage increase for low wage earners because of a minimum wage. In other words, building on our examples, even though prices of goods may increase (through inflation) by, say. 2% for everyone, a minimum wage would increase hourly wages by 20% for low wage earners.

The effect of inflation in this case is like a redistributive tax which taxes everyone by 2% (small compared to our other taxes), but which helps the lowest paid in the country. Redistributive taxes are not new (high-income earners pay more in income tax than low-income earners). The difference is that a minimum wage really helps the lowest paid in society, and can even have a stimulating effect on economic growth as the poor spend more as a percentage of their income than the rich. In other words, give a rich person $10 and he invests most of it and only spends $1 in the economy, but give a poor person $10 and he would save $1 but spend $9 in the economy. So redistributive taxes, besides having a social aspect of helping the poor and increasing social cohesion, also generate wider economic benefits for everyone.

Productivity

According to the above UBS Prices and Earnings survey [1], Singapore’s hourly wages (productivity) is 30% that of New York’s. This is because Singapore’s growth has thus far relied mainly on foreign workers – the influx of which suppresses wages and productivity. [2] Firms have little incentive to increase productivity if they are able to rely on cheap labour. A national minimum wage policy allows low paid Singaporeans to compete with foreign labour not on price, but on skills – and also provide the incentive for firms to invest in increasing productivity.

In other words, the number of Singaporean workers employed in the economy as a whole should increase against that of foreign workers. The economic case is to reduce the negative effects associated with a large foreign workforce – as evidenced from Singaporeans’ concerns over effects such as rises in house prices and congestion on public transport. Notes Associate Professor Hui Wen Tat at the LKY School of Public Policy, “a large foreign worker population generates significant negative externalities”.[2]

He also says, “A minimum wage law would also have the salutary effect of making employers more efficient in using their workers. It would encourage them to hire better-quality workers with the requisite skills or those who can be trained to acquire such skills, so as to justify the higher wages. Employers will thereby be compelled to boost productivity, move up the value chain, thus increasing the demand for higher-paid jobs.” [2]

The government already intervenes in the market by setting foreign worker levies, imposing foreign worker quotas and specifying minimum salaries for S-Pass and Employment Pass holders. But that does not directly affect the wages of low-wage Singaporeans. It might be simpler, more efficient and effective for the government to set a minimum wage (to replace its current policies) for local and foreign workers – and allow the market to work freely from there.

Competitiveness

1. As mentioned, price rises (which affect competitiveness) are less than the rise in costs. Consumers only care about the prices of goods that they pay for, not about the costs to firms.

2. Please see point (3) above under the section ‘Inflation’ for mitigatory effects of exchange rates on competitiveness.

3. Any productivity increases will also help to cushion the rise in prices.
4. What is probably more important for sustainable long term economic growth is that a minimum wage will help to shift the competitiveness of Singapore firms from price competition to competition based on innovation, ideas and quality products. So rather than understanding the issue as a reduction in the level of competitiveness, we should understand it as a shift in the nature of competition.

Conclusion

In practice, it is necessary to start off with a modest minimum wage. When the UK first introduced a minimum wage, it was at an initial level of £3.60, which increased wage bills across the economy by about 0.5% (although different sectors were affected differently), and costs of production by less than 0.5%. [3]

I hope I have shown that there are many extenuating factors that reduce the ills of a minimum wage. These ills must also be weighed against the benefits of a minimum wage – for e.g. productivity growth, economic stimulus, balancing of local-foreign worker composition in the workforce. We will look at more benefits in the next instalment, which will also examine Workfare.

To read Part 1 of this debate, click here.