Tax for Customer Protection

Government Controls: How Management Incentives Are Affected
Without bandying jargon or exhibiting formulae, without being superficial or condescending, the scientist should be able to communicate to the public the nature and variety of consequences that can reasonable be expected to flow from a given action or sequence of actions. In the case of the economist, he can often reveal in an informal way, if not the detailed chain of reasoning by which he reaches his conclusions, at least the broad contours of the argument.
E. J. Mishan
arlier chapters showed how the models of competitive and monopolistic markets
illuminate the economic effects of market changes, such as an increase in the price
of oil. This chapter will examine the use of government controls to soften the
impact of such changes. We will consider four types of government control: excise taxes, price controls, consumer protection laws, and minimum-wage laws. As we will see, government controls can inspire management reactions that negate some of the expected effects of the controls.
Who Pays the Tax?
Most people are convinced that consumers bear the burden of excise (or sales) taxes. They believe producers simply pass the tax on to consumers at higher prices. Yet every time a new (or increased) excise tax is proposed producers lobby against it. If excise taxes could be passed on to consumers, firms would have little reason to spend hundreds of thousands of dollars opposing them. In fact, excise taxes do hurt producers.
Figure 4.1 shows the margarine industry’s supply and demand curves, S1 and D. In a competitive market, the price will end toward P2 and the quantity sold toward Q3. If the state imposes a $0.25 tax on each pound of margarine sold and collects the tax from producers, it effectively raises the cost of production. The producer must now pay a price not just for the right to use resources, such as equipment and raw materials, but for the right to continue production legally. The supply curve, reflecting this cost increase, shifts to S2. The vertical difference between the two curves, P2 and P1, represents the extra $0.25 cost added by the tax.
Figure 4.1 The Economic Effect of an Excise Tax
An excise tax of $0.25 will shift the supply curve for margarine to the left, from S1 to S2. The quantity produced will fall from Q3 to Q2; the price will rise from P2 to P3. The increase, $0.20, however, will not cover the added cost to the producer, $0.25.

Given the shift in supply, the quantity of margarine produced falls to Q2 and the price rises to P3. Note, however, that the price increase (P1 to P2) is less than the vertical distance between the two supply curves (P2 to P1). That is, the price increases by less than the amount of the tax that caused the shift in supply. Clearly, the producer’s net has fallen. If the tax is $0.25, but the price paid by consumers rises only $0.20 ($1.20 ¬$1.00), the producer loses $0.50. It now nets only $0.95 on a product that used to bring $1.00. In other words, the tax not only reduces the quantity of margarine producers can sell, but makes each sale less profitable.
Incidentally, butter producers have a clear incentive to support a tax on margarine. When the price of margarine increases, consumers will seek substitutes. The demand for butter will rise, and producers will be able to sell more butter and charge more for each pound.
The $0.25 tax in our example is divided between consumers and producers, although most of it ($0.20) is paid by consumers. Why do consumers pay most of the tax? Consumers bear most of the tax burden because consumers are relatively unresponsive to the price change. The result, as depicted in Figure 4.1, is that consumers bear most of the tax burden while producers pay only a small part (20 percent) of the tax. If consumers were more responsive to the price change, then a greater share of the tax burden would fall on producers who would then have more incentive to oppose the tax politically. Indeed, we should that the amount of money producers would be willing to spend to oppose taxes on their product (through campaign contributions or lobbying) will depend critically on the responsiveness of consumers to a price change. The more responsive consumers are, the more producers should be willing to spend to oppose the tax.
Price Controls
Price controls are by no means a modern invention. The first recorded legal code, the four-thousand-year-old Code of Hammurabi, included regulations governing the maximum wage, housing prices, and rents on property such as boats, animals, and tools. And in A.D. 301, the Roman Emperor Diocletian issued an edict specifying maximum prices for everything from poultry to gold, and maximum wages for everyone from lawyers to the cleaners of sewer systems. The penalty for violating the edict was death. More recently, wage and price controls have been used both in wartime (during the Second World War and the Korean War) and in peacetime. President Richard Nixon imposed an across-the-board wage-price freeze in 1971. Prime Minister Pierre Trudeau imposed controls on the Canadian economy in 1975. President Jimmy Carter controlled energy prices in 1977 and later proposed the decontrol of natural gas.
Wage and price controls are almost always controversial. Like attempts to control expenditures, they often create more problems than they solve. We will examine both sides of the issue, starting with the argument in favor of controls.
Figure 4.2 The Effect of an Excise Tax When Demand is More Elastic Than Supply
If demand is much more elastic than supply, the quantity purchased will decline significantly when supply decreases from S1 to S2 in response to the added cost of the excise tax. Producers will lose $0.20; consumers will pay only $0.05 more.

The Case for Price Controls
The case for price ceilings on particular products is complex. On the most basic level, many people believe that prices should be controlled to protect citizens from the harmful effects of inflation. When prices start to rise, redistributing personal income and disrupting the status quo, it seems unfair. Price controls may seem especially legitimate to people, like the elderly, who must live on fixed incomes, and have little means of compensating for the effects of price increases on goods like oil and gas.
Unearned Profits
Many proponents of price controls view the supply curve for a controlled good as essentially vertical. They believe that a price rise will not affect the quantity produced. Consumers will get nothing more in the way of goods, but producers will reap a windfall profit. Instead of an incentive to produce more, profit is seen as an economic rent—an exploitative surplus received by companies fortunate enough to be in the market at the right time.
Administered Prices
A technical argument for price controls is most often advanced by economists and public officials. Many economists maintain that a significant segment of the business and industrial community—the larger firms that control a sizable portion of industry sales— no longer responds to the forces of supply and demand. Firms in highly concentrated industries like steel, automobiles, computers, and tobacco can override market forces by manipulating their output so as to set price levels. Furthermore, they can manage the demand for their products through advertising campaigns. With market forces ineffective, control must come from the government. Price controls are the only way to avoid the production inefficiencies and inequitable distribution of income that result from concentration of industry. As John Kenneth Galbraith, a leading advocate of price controls, has put it, “Controls are made necessary because planning has replaced the market system. That is to say that the firm and the union have assumed the decisive power in setting prices and wages. This means that the decision no longer lies with the market and thus with the public.”1
Monopoly Power
Later in the course, we will see how a monopolist can be expected to restrict output in order to push up its price in order to earn greater profits. The case for price controls under monopoly conditions is, for many advocates of controls, a matter of “fairness.” The controls give back to consumers what they “deserve” in terms of lower prices. However, as we will see, under monopoly conditions, if the producer is forced to charge a (somewhat) lower price, the producer will rationally choose to increase the output level. Hence, price controls benefit consumers in two ways, first through lower prices and then through greater output.
The Case Against Price Controls
Just as the case for price controls is tied closely to the existence of monopoly power, the case against controls rests heavily on the competitive market model. Economists who
1 John Kenneth Galbraith, Economics and the Public Purpose (Boston: Houghton Mifflin, 1973), p. 315.
oppose controls feel that competition is sufficient to govern business behavior, including pricing decisions. Opponents of controls also stress the individual’s right to act without government interference—a right they see as crucial to a society’s ability to adjust to social and environmental change.
When we say that the prices of certain products should be controlled by government, what do we mean by “government”? Can government as we know it consistently reflect the public interest? Is government immune to human failings? Opponents of price controls emphasize that the pricing decisions made by any government agency will reflect the will of its staff. Personal preference will loom large in their decisions on what constitutes a just price and a just allocation of goods and services. Political considerations may also play a role. Firms with a talent for political maneuvering will have an advantage under a price control system. In other words, competitive behavior is not necessarily reduced by price controls, though its form of expression may be changed.
If price controls are complemented by a system of government allocation of supplies, then strikes, demonstrations, and violence may also influence government decisions. During the energy crisis of 1973—1974, and again in 1978, the federal government regulated the allocation of crude oil between gasoline and diesel fuel producers. When truckers received less fuel than they claimed they needed, independent drivers stuck, threatening to paralyze the nation’s commerce unless they got more fuel at lower prices. To ensure cooperation among drivers, the strikers blocked roads, vandalized the equipment of nonstrikers, and shot at drivers who ventured out on the road. One trucker was killed, and others were seriously injured. At least for a short time, such tactics were productive. The government agreed to earmark more crude oil for diesel fuel production and to lower the federal excise tax on diesel fuel. (Courts later declared those decisions illegal.)
Shortages and the Effective Price of a Product
In a competitive market, any restriction on the upward movement of prices will lead to shortages. Consider Figure 4.3, which shows supply and demand curves for gasoline. Initially, the supply and demand curves are S1 and D, and the equilibrium price is P1. Now suppose that the supply of gasoline shifts to S2, and government officials, believing that the new equilibrium price is unjust, freeze the price at P1. What will happen to the market for gasoline?
At price P1, which is now below equilibrium, the number of gallons demanded by consumers is Q2, but the number of gallons supplied is much lower, Q1. A shortage of Q2 --Q1 gallons has developed. As a result, some consumers will not get all the gasoline they want. Some may be unable to get any.
Because of the shortage, consumers will have to wait in line to get whatever gasoline they can. To avoid a long line, they may try to get to the service station early— but others may do the same. To assure themselves a prime position, consumers may have to sit at the pumps before the station opens. In winter, waiting in line may mean wasting gas to keep warm. The moral of the story: although the pump price of gasoline may be
held constant at P1, the effective price -- the sum of the pump price and the values of time lost waiting in line -- will rise.
Shortages can raise the effective price of a product in other ways. With a long line of customers waiting to buy, a service station owner can afford to lower the quality of his service. He can neglect to clean windshields or check oil levels, and in general treat customers more abruptly than usual. As a result, the effective price of gasoline rises still higher. Again, during he energy crises of 1973-1974 and 1978, some service station owners started closing on weekends and at night. A few required customers to sign long-term contracts and pay in advance for their gasoline. The added interest cost of advance payment raised the price of gasoline even higher.
Figure 4.3 The Effect of Price Controls on Supply
If the supply of gasoline is reduced from S1 to S2, but the price is controlled at P1, a shortage equal to the difference between Q1 and Q2 will emerge.

Black Markets and the Need for Rationing
Besides such legal maneuvers to evade price controls, some businesses may engage in fraud or black marketeering. During the winter of 1973—1974, a good many gasoline station owners filled their premium tanks with regular gasoline and sold it at premium prices. At the same time, a greater-than-expected shortage of heating oil developed. Truckers, unable to get all the diesel fuel they wanted at the controlled price, had found they could use home heating oil in their trucks. They paid home heating oil dealers a black market price for fuel oil, thus reducing the supply available to homeowners. As always, government controls bring enforcement problems.
To assure fair and equitable distribution of goods in short supply, some means of rationing is needed. If no formal system is adopted, supplies will be distributed on a first-come, first-served basis—in effect, rationing by congestion. A more efficient method is to issue coupons that entitle people to buy specific quantities of the rationed good at the prevailing price. By limiting the number of coupons, government reduces the demand for the product to match the available supply, thereby eliminating the shortage and relieving the congestion in the marketplace. In Figure 4.4, for example, demand is reduced from D1 to D2.
The coupon system may appear to be fair and simple, but how are the coupons to be distributed? Clearly the government will not want to auction off the coupons, for that would amount to letting consumers bid up the price. Should coupons be distributed equally among all consumers? Not everyone lives the same distance from work or school. Some, like salespeople, must travel much more than others. Should a commuter receive more gas than a retired person? If so, how much more? Should the distribution of coupons be based on the distance traveled? (And if such a system is adopted, will people lie about their needs?) These are formidable questions that must be answered if a coupon system is to be truly equitable. By comparison, the pricing system inherently allows people to reflect the intensity of their needs in their purchases.
Once the coupons are distributed, should the recipients be allowed to sell them to others? That is, should legal markets for coupons be permitted to spring up? If the deals made in such a market are voluntary, both parties to the exchange will benefit. The person who buys coupons values gasoline more than her money. The person who sells his coupons may have to cut back on driving, but he will have more money to buy other things. The seller must value those other things more than lost trips, or he would not agree to make the exchange. The positive (and often high) market value of coupons shows that price controls have not really eliminated the shortage.
Figure 4.4 The Effect on Rationing on Demand
Price controls can create a shortage. For instance, at the controlled price P1, a shortage of Q2 --Q1 gallons will develop. By issuing a limited number of coupons that must be used to purchase a product, government can reduce demand and eliminate the shortage. Here rationing reduces demand from D1 to D2, where demand intersects the supply curve at the controlled price.

Furthermore, if the coupons have a value, the price of a gallon of gasoline has not really been held constant. If the price of an extra coupon for one gallon of gasoline is $0.50 and the pump price of that gallon is $1.25, the total price to the consumer is $1.75 ($0.50 + $1.25). The existence of a coupon market means that the price of gasoline has risen. In fact, the price to the consumer will be greater under a rationing system than under a pricing system. This is because the quantity supplied by refineries will be reduced.
Perhaps the most damaging aspect of a rationing system is that the benefits of such a price increase are not received by producers—oil companies, refineries, and service stations—but by those fortunate enough to get coupons. Thus the price increase does not provide producers with an incentive to supply more gasoline. (If the increase went to producers, their higher profits would encourage them to search for new sources of oil and step up their production plans.)
Consumer Protection
Less than one hundred years ago the general rule of the marketplace was caveat emptor— “let the buyer beware.” The individual consumer was held responsible for the safety, quality, and effectiveness of his purchases. The seller could assume liability for the safety and effectiveness of goods and services, but only through a contract endorsed by both parties. The same rule applied to contracts: the buyer was responsible for what he signed. Although consumers could sue sellers for breach of contract or for fraud, no government agency would initiate the suit. Nor did government protect citizens in other ways from the products they bought.
During this century, however, product liability has gradually shifted from the consumer to the producer and the seller. Both court decisions and changes in the law have contributed to this shift. Many now see consumer protection as a government function.
The Case for Consumer Protection
The argument for relieving consumers of product liability resembles the argument for regulation of utilities in many respects. Both cases hinge on the costs of gaining information and the problems created by external benefits and costs and monopoly power.
External Benefits
When two cars collide, both cars will sustain less damage and both drivers less injury if just one of the cars is equipped with protective bumpers. Thus people who do not buy protective bumpers can benefit from others’ investments. If many car buyers ignore the benefits others may receive from their purchases, the quantity of shock-absorbing bumpers sold will be less than the socially desirable or economically efficient amount.
This analysis of external benefits can be extended to include the concept of consumer protection. Suppose the supply curve in Figure 4.5 is the industry’s willingness to offer protective bumpers. The demand curve D1 represents consumer demand based on the private benefits to consumers, while D2 represents private plus public (external) benefits. Under competitive conditions, the quantity produced and sold in the marketplace will be Q1—even though up to Q2, the total benefits of bumpers exceed their cost. The private benefits of the bumpers are small enough that many people cannot justify purchasing them.
Graphically, the vertical distance between the two demand curves, ab, represents the external benefits per bumper sold that are not being captured by the market. Government can close this gap by setting product standards. By requiring new cars to have shock-absorbing bumpers, government effectively increases demand from D1 to D 2. It forces people to expand their purchases from Q1 to Q2, thus capturing the external benefits shown by the shaded area abc.
Figure 4.5 The External Benefits of Consumer Protection
Private demand for shock-absorbing bumpers is shown by the demand curve D1: total demand (private plus public, or external, benefits), by D 2. The vertical distance between the two curves represents the social benefits from each bumper. In a free market, Q1 bumpers will be sold. If all benefits are considered, however, the efficient output level will be Q2. By requiring people to purchase Q2 bumpers, government can capture the external benefits shown by the shaded area abc. If the government requires consumers to buy more than Q2 bumpers, however, excess costs will be incurred. If Q4 bumpers are purchased, their excess social cost, shown by the shaded area cde, will offset their social benefits (abc). The net social gain will be zero.

This approach can be extended to a wide range of goods and services that offer significant external benefits, from safety caps for drugs to protective devices for explosives. This argument does not justify unlimited government intervention, however. We cannot conclude, for example, that all automobiles must have shock-absorbing bumpers. Such a requirement might result in the purchase of far more than Q2 bumpers. Beyond Q2, the marginal cost of safety bumpers is greater than their marginal benefit. An excess burden, or net social cost, is incurred when the public must purchase more than Q2.
If the public is required to purchase Q4 bumpers, for instance, the excess burden will be equal to the shaded area cde. The social cost of extending purchases to Q4 just equals the social benefits of extending purchases to Q2 (shown by the area abc). Consequently, there is no real net social benefit in moving to Q4. If the required number of bumpers is greater than Q2 but less than Q4, some net social benefit will be realized. At Q3, the excess social cost cfg is smaller than the social benefit abc. Some net benefit will be realized.
Up to a point, then, consumer protection can be socially beneficial. Society, however, can end up purchasing too much of a good thing. It is possible to make the world so safe that few resources are available for any other purpose.
Nevertheless, governments tend to require safety devices for all products in a category. Determining the optimum quantity is so difficult and costly that a blanket rule is preferable. Yet as opponents of consumer protection point out, the blanket rule itself may be extremely costly if it requires more than the socially beneficial quantity to be produced. Ultimately, the question comes down to the actual costs and benefits of particular product standards.
External Costs
The argument for consumer protection based on external costs is closely related to the argument for pollution control (a point to be taken up later in the book). If the consumers who use a product do not bear all the costs associated with its use, they will tend to consume more of the good than is socially desirable. In the process they will impose a cost on others. For example, a person who buys a spray deodorant incurs a private cost equal to its money price. If the release of the chemicals used in aerosol sprays has a harmful effect on the earth’s ozone layer, as many scientists believe, however, the use of such products imposes an external cost on nonusers. At the very least, the public incurs a risk cost from the use of aerosol sprays.
Curve D in Figure 4.6 shows the market demand for spray deodorant. The supply curve S1 shows the marginal cost of producing the good, not counting the ozone effect. In a competitive market, the quantity of spray deodorant purchased will be Q2. If producers have to compensate those who bear the external costs of their product, however, their supply curve will shift to S2, and the quantity purchased will drop to Q1. The vertical distance between the two supply curves represents the external, or ozone, cost of each can sold. By including this cost in the price of the product, the government reduces social costs by the shaded area.
Figure 4.6 The External Costs of Consumer Protection
Curve S1 represents the supply curve for spray deodorant, not including external costs. Curve S2 represents the total cost, including harm to the earth’s ozone layer. Thus the vertical distance between S1 and S2 shows the external cost of producing each can of spray deodorant. In a free market, Q2 cans will be produced—more than the efficient level, Q1. Government can eliminate over¬production by internalizing the external costs of production, shown by the shaded area.

The argument does not necessarily demonstrate that spray cans should be banned. The amount of government regulation should depend on the degree of external cost. If
the use of spray cans will ultimately cause the destruction of life on earth, then the external costs are quite high and a complete ban is in order. If costs are lower, a less stringent policy might be appropriate.
Monopoly Power
Consumer advocates suspect that some firms use their market power to restrict the variety of products available to consumers and to reduce their quality, safety and effectiveness. The monopolist, in other words, can choose not only what price and quantity of a given product to offer, but what features it will have. Left to itself, the monopolistic firm will maximize profits by finding that one combination of price, quantity, and product features that minimizes costs and maximizes revenues.
Consumer advocates argue that most consumers want safer, more effective products than they can now obtain and are willing to pay competitive prices for them. They see consumer protection laws as a means of forcing monopolistic producers to provide what the public wants.
Information Costs
The complexities of modern technology can be overwhelming. Proponents of consumer protection argue that consumers cannot hope to comprehend the ins and outs of the dozens of products they must consider, from color televisions to prescription drugs. For instance, the production of cereals and meats is so far removed from common experience that consumers have little idea what chemicals may be added during processing. Without adequate information and the technical ability to comprehend it, consumers cannot make rational choices based on true costs and benefits. Therefore product safety experts must protect them.
This line of reasoning resembles the argument for a standard requiring shock-absorbing bumpers. Like the bumpers, consumer information benefits far more people than those who pay for it. That is, there are external benefits associated with its provision. The market demand for information, like the market demand for protective bumpers, will not fully reflect its social benefits. Because of external benefits, the quantity of information produced and purchased will fall short of the efficient level. By intervening in the market to supplement the information flow, government can increase social welfare.
The Case Against Consumer Protection
Some of the arguments against consumer protection have already been mentioned. In this section we will reemphasize them and highlight some additional points. As these arguments and counter arguments suggest, consumer protection is a complex issue, and it is difficult to find an efficient solution to the problem.
Competition as a Form of Consumer Protection
No one can reasonably expect to be protected against all the whims and exploitative efforts of businesses. The cost of complete protection would be prohibitive, and the benefits often too small to justify the cost. Thus we should not expect the market system to protect consumers completely against unsafe products and services. The relevant question is whether the market or government is more efficient in accomplishing the task of consumer protection.
In answering that question it is important to remember that few consumers are as powerless as consumer protection advocates maintain. Although one person can do little to coerce producers into providing safer, more effective goods and services, collectively consumers have considerable power of persuasion. They can offer to pay more for a safer product—and there is some price that profit-maximizing entrepreneurs will accept for such a product—or they can turn to different producers to obtain what they want. If producers do not offer what consumers want, and if they repeatedly produce shoddy merchandise, more and more consumers will move to other producers or purchase substitute goods. For example, if the Coca-Cola Company persisted in selling drinks that had lost their carbonation, consumers could move to Pepsi, 7-Up, or other substitute drinks. The fear of losing customers helps keep producers in line, pressuring them to offer the goods customers want.
Differences in Risk Taking
Some people are more willing than others to assume the risk that goods and services may be defective, ineffective, or unsafe. They differ in the personal value they place on avoiding risk. Thus some will participate in dangerous sports like hang gliding, while others would not dare. Some people will take a chance on buying a used car or toaster, while others would always insist on (and pay more for) new merchandise. If surveys are correct, most drivers are willing to accept the risk of driving without seat belts—although a few would not go around the block without them. Everything else held equal, people with a strong aversion to risk will demand safer products than those who prefer to take their chances.
Such differences in the willingness to assume risk may reflect differences in economic circumstances. Some believe that the demand for safer products is positively related to income. The rich are far more likely to buckle their seat belts than the poor. Even the choice of restaurants by the rich and poor may reflect different attitudes toward risk. People with low incomes patronize greasy-spoon restaurants, accepting the risk of food poisoning. They may reason that they are better off by eating cheaply than by spending more to protect their health.
If all consumers were willing to accept the same degree of risk, it would be relatively easy to protect them through product standards. Government regulators would simply determine the level of risk acceptable to all, and set their standards accordingly. Of course, consumer choice would be restricted. Some ineffective or less safe products would no longer be offered for sale. In the real world, as we have observed, consumers differ in their risk aversion. Uniform standards would force those who are comparatively
efficient in coping with risk, or who have no real aversion to risk, to buy safer products. Assuming that safety is not a free good, the cost to consumers would increase—and in economic terms, that amounts to a misallocation of resources. People who do not have children, for example, must still pay for childproof caps on drug bottles.
If full liability for product safety and effectiveness were shifted to the producer, the same type of problem could develop. Again, consumers would be unable to choose their preferred level of risk. When producers assume the risk, they might decide to discontinue certain product lines to avoid lawsuits and damage claims, or they might buy insurance to cover their newly acquired risk cost, raising the price to the consumer. In effect, consumers would be forced to buy insurance against unsafe or defective products. They would no longer have the option of insuring themselves, perhaps at a lower price.
The Needs of the Poor
Many people support consumer protection because of their concern for the poor, who may be unable to afford the information necessary to make an informed choice. The poor may also be the least capable of understanding technical product information, and the least able to endure the losses associated with defective goods and services. Opponents of consumer protection point out that the poor often prefer to buy low-quality goods and services because they are less expensive. They pay less so they can have more of other goods and services. If less safe (but cheaper) products are removed from the shelves, then, the burden of consumer protection falls disproportionately on the poor.
MANAGER’S CORNER: The Importance of Manager Incentives in the Minimum-Wage Debate
Political support in Congress for another hike in the federal minimum wage is growing. Following the lead of President Clinton, who called for an increase in the minimum wage in his 1999 State of the Union message, Senator Edward Kennedy (D-Mass.) and Representative David Bonior (D-Mich.) have proposed that the minimum hourly wage be raised by $1, or from $5.15 currently to $6.15 in two steps over the next year and a half.2
Indeed, even Republican members of Congress appear ready to press for their own increase in the minimum wage this year. Representative Jack Quinn (R-NY) has argued, “I believe it is a forgone conclusion that some type of minimum wage increase bill will be approved in this session of Congress. Rather than fight the thing and have Republicans being dragged kicking and screaming to a vote on the minimum wage, I say to my party, ‘Why not take the lead?’”3 Other political interest groups will draw on the support of many members of Congress in their effort to defeat any proposed increase.
2 The Kennedy and Bonior companion bills would, if passed, raise the minimum wage from $5.15 to $5.65 on September 1, 1999 and to $6.15 an hour on September 1, 2000 [House, U.S. Congress, 106th Cong., 1st Sess., “Fair Minimum Wage Act of 1999,” H.R.325 (January 19, 1999); Senate, U.S. Congress, 106th Cong., 1st Sess., “Fair Minimum Wage Act of 1999,” S. 192 (January 19, 1999)].
3 As quoted by Janet Hook, “GOP Relaxes Opposition to Minimum Wage Increase Politics: Republican Leaders Hope to Head Off Campaign. Hike May Be Tied to Tax Cuts,” Los Angeles Times, April 12,
Both sides to the heated debate that is also unavoidable will once again restate old and tired arguments, and they both will be off course in their arguments. In considering a new round of minimum wage increases, both minimum wage proponents and opponents need to reconsider how a minimum-wage hikes will affect labor market incentives and manager reactions to what Congress legislates. By the same token, managers in markets affected by any new minimum-wage increase need to be mindful of the competitive forces afoot that will cause them to react to an increase in ways that they might not always like.
The History of the Minimum Wage in Current and Constant Dollars
In emerging debate, much will likely be made of how the current federal minimum wage of $5.15 an hour has no more purchasing power than the minimum wage of the early 1950s, a fact that can be seen in Figure 4.7. The chart shows that the minimum wage in current dollars has risen in a series of nineteen steps from 25 cents an hour when the first federal minimum wage took effect in October 1938 to $5.15 currently. However, in constant, (February) 1999 dollars the minimum wage rose irregularly from $2.92 an hour in October 1938 to $7.70 an hour in 1968, only to fall irregularly from the 1968 peak to its current level of $5.15, which is a third less than the 1968 peak. As can also be seen, the real value of the 1999 minimum wage was slightly below the real minimum wage when it was raised at the start of 1950 (at which time it was $5.25 in 1999 dollars). In recent years, the real minimum wage has fallen only slightly in real terms from $5.25 in October 1997, at which time the minimum wage was last raised, to $5.15.4
The Two Sides to an Old Debate
When the next minimum-wage bill reaches the floor of Congress, it is all but certain that many opponents and proponents in and out of Congress will once again lock political horns over the proposal, no matter what the proposed increase is. While the political partisans can be expected to repeat past claims in earnest, they all will once again be off base on the likely employment consequences of the minimum-wage increase.
1999, p. A1. Quinn’s bill would delay the full $1 increase until September 1, 2001, but it would go one step further and raise the minimum wage annually by the consumer price index after September 1, 2002 [House,
U.S. Congress, 106th Cong., 1st Sess. “Long Term Minimum Wage Adjustment Act of 1999,” H.R. 964 (March 3, 1999).
4 Over the past six decades, the percent of nonsupervisory workers covered by the federal minimum wage has risen from 57 percent in 1950 to 87 percent in 1988 (the latest year of available data). This rise in the coverage of the minimum wage should have led to any increase in the minimum wage to have a progressively greater negative employment effect over the years, which is what economist Marvin Kosters has found [Marvin H. Kosters, Jobs and the Minimum Wage: The Effect of Changes in the Level and Pattern (Washington, D.C.: American Enterprise Institute, 1989), p. A-13].
House Majority Leader Dick Armey, a long-time opponent of the minimum wage, has already declared that the proposed $1 increase in the minimum wage is the “wrong thing” to do, mainly because the increase would significantly reduce employment of the country’s low skilled workers.5 No doubt, Armey is thinking in terms of a supply-and¬demand model that he once taught in his economics classes at North Texas State University. Consider Figure 4.8. If the market is competitive and free of government intervention, the wage rate will settle at W1. Suppose, however, that politicians consider that market wage too low to provide a decent living. They pass a law requiring employers to pay no less than W2. The effect of the law will be to reduce employment. Employers will not be able to afford to employ as many people, and the quantity of labor demanded will fall from Q2 to Q1. Those who manage to keep their jobs at the minimum wage will be better off; their take-home pay will increase. Other workers may no longer have a job. The will either become permanently unemployed or settle for work in a different, less desirable labor market. If the minimum wage displaces them from their preferred employment to their next-best alternative, their full wage rate—that is, their money wage plus the nonmonetary benefits of their job—will have been reduced. If they become permanently unemployed, their money wage will have been reduced from a level judged politically unacceptable to zero.
Figure 4.7 The History of the Minimum Wage in Current and Real Dollar Terms
The minimum wage rose in current dollars from $.25 an hour in 1938 to $5.15 until late 1999. However, in real (1999) dollars, the minimum wage rose from $2.92 in 1938 to $7.70 in 1968, only to fall back to $5.15 an hour in 1999.

To make matters worse, the introduction of a minimum wage increases the number of laborers willing to work (see Figure 4.8). Thus the workers who would have had a job at W1, and who have fewer employment opportunities at W2, must now compete
5 “U.S. Republicans Concede GOP Support for Minimum Wage Boost,” Dow Jones News Service, 1999 (as found on the Dow Jones Interactive Publication Library, April 28, 1999).
with a larger number of workers. Indeed, many of these new arrivals to the market will take jobs once held by menial workers at the market-clearing wage, W1.
On the other side of the argument, Bob Herbert, a columnist for the New York Times and a minimum-wage supporter, approvingly quotes a study from the Economic Policy Institute, a Washington, D.C.-based think tank, that found the last approved minimum-wage hike raised the incomes of 10 million Americans.6 Herbert writes, “The benefits of the increase disproportionately help those working households at the bottom of the income scale. Although households in the bottom 20 percent (whose average income was $15,728 in 1996) received only 5 percent of total national income, 35 percent of the benefits from the minimum wage increase went to these workers. In this regard, the increase had the intended effect of raising the earnings and incomes of low-wage workers and their households.’’7 Moreover, in the growing debate proponents like Herbert will continue to cite statistical studies that show that a minimum wage hike will have no (or minimal) impact on the count of low-wage jobs, which is what the Economic Policy Institute study found.8
Figure 4.8 The Standard View of the Minimum Wage
When Congress raises the minimum wage from W1 to W2, the number of workers hired goes from Q1 to Q2, while the number of workers who are willing to work goes from Q1 to Q3. The result is a “surplus” of workers equal to Q3 – Q1. Some workers gain at the expense of others.
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Herbert is convinced that such findings should give minimum-wage critics reason to eat their words. Herbert reminds his readers of Cato Institute’s chairman William Niskanen (and former acting chairman of President Reagan’s Council of Economic Advisors and opponent of minimum-wage increases) comments made in the middle of the previous debate over increasing the minimum wage, ‘‘It is hard to explain the continued support for increasing the minimum wage by those interested in helping the working poor.’’9 Herbert and other minimum-wage supporters will point once again to
6 Jared Bernstein and John Schmitt, “Making Work Pay” (Washington, D.C.: Economic Policy Institute, 1998, mimeographed).
7 Bob Herbert, “In America; The Sky Didn’t Fall,” New York Times, June 4, 1998, p. A27.
8 Bernstein and Schmitt, “Making Work Pay.”
9 Ibid.
the empirical work of Princeton University economists David Card and Alan Krueger who concluded in 1994 that the minimum-wage increases in the federal minimum wage in the early 1990s had no measurable negative effect on employment in New Jersey fast-food restaurants (and may have actually increased employment slightly).10 They also insisted in 1998 insisted that more recent employment data from the Bureau of Labor Statistics corroborate their earlier findings.11
Nevertheless, opponents will continue to argue, as they have in the past, that if Congress raises the cost of low-skill labor, less than a fifth of the wage gains will go to households with incomes below the poverty level and more than half of the wage gains will go to households with more than twice the poverty income threshold.12 They will also stress that several hundred thousand jobs are bound to be lost. Some employers will not be able to afford as many workers, and other employers can be expected to automate low-skill jobs out of existence. The opponents will back up their claims with their own statistical studies that will show that some low-skilled workers will be made better off (those who keep their jobs) but only because other low-skilled workers will be made worse off (those who are unemployed).13 For example, the Employment Policies Institute, another Washington, D.C. based think tank, commissioned a study of the labor market impact of a $1.35 increase in the minimum-wage in the State of Washington and found that by 2000, the increase can be expected to destroy 7,431 jobs in the state, causing the affected workers to lose $64 million in annual income.14
Both sides to the debate will once again be wrong in their assessments of the minimum-wage increase because they have both failed to recognize that employers are a lot smarter and are pressed far more by the forces of their labor markets than the political combatants seem to think. Neither side seems to realize that Washington simply doesn’t have the requisite power over markets to significantly improve worker welfare by wage decrees, no matter how well intended the legislation may be. This is why so many
10 David Card and Alan B. Krueger, “Minimum Wages and Employment: A Case Study of the Fast-Food Industry in New Jersey and Pennsylvania,” American Economic Review, vol. 84 (1994), pp. 772-793; or David Card and Alan B. Krueger, Myth and Measurement: The New Economics of the Minimum Wage (Princeton, N.J: Princeton University Press, 1995).
11 David Card and Alan B. Krueger, “Unemployment Chimera,” Washington Post, March 6, 1998, p. A25.
12 As reported by Kenneth A. Couch, “Distribution and Employment Impacts of Raising the Minimum Wage,” FRBSF Economic Letter (San Francisco: Economic Research, Federal Reserve Bank, February 19, 1999, no. 99-06), p. 1. Couch cites Richard V. Burkhauser, Kenneth A. Couch, and Andrew J. Glenn, “Public Policies for the Working Poor: The Earned Income Tax Credit Versus Minimum Wage Legislation,” Research in Labor Economics, edited by Sol Polacheck, pp. 65-110.

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