Some economists and journalists claim that a "living wage" mandate would actually help businesses. Our guest poster Ryan Bourne says this is a prime example of motivated reasoning and half-baked economics, and gives four reasons why the claim is nonsense.

It is common for Living Wage campaigners to say that adoption of the Living Wage “would benefit staff and businesses.” Why? By increasing pay, it is claimed, firms can reduce turnover, reduce time that their workers take off sick and encourage greater worker effort. This in turn will raise productivity. Some pseudo-economists claim this is evidence of the "efficiency wage" phenomenon.

Unfortunately, this is the economics of motivated reasoning. It reminds me a bit of when environmentalists say “subsidising wind farms won’t just be good for the environment, it will create jobs too”. It implies there are no trade-offs — that the Living Wage imposition or increase is an unadulterated good.

There are big problems with this narrative, two of which Alex Tarrabok explains over at Marginal Revolution (making similar arguments as I have here before) and two which I’ll add below.

The first is that the "efficiency wage" theory has always been a theory of persistent unemployment. Yet the Living Wage campaigners also say that their policy will not cause unemployment. In the efficiency wage model, as Alex explains:

The question that motivated efficiency wage theory was not why firms should raise wages but why firms don’t cut wages when they should. The answer they gave was that firms don’t cut wages despite unemployment because they fear that workers will respond to lower wages with reduced productivity. ...

Instead of being desirable, the efficiency wage is a problem because lower wages would reduce unemployment and be better for the economy as a whole.

This would imply that efficiency wages entail trade-offs that can be welfare-reducing, through reducing employment — hardly the line Living Wagers are pushing.

Second, though, and importantly, efficiency wages in these models are set by profit-maximising firms — i.e. individual companies are assumed to operate according to what is best for them. The Living Wagers are implying that they know as campaigners what is best for companies — that firms are currently ignoring potentially large productivity improvements that campaigners are able to observe. It seems very unlikely to me that huge numbers of employers are this irrational given how firms track these things.

Third, the Living Wage campaigners assume that the "efficiency wage" effects that some companies can see in terms of improved productivity could be generalised across a whole sector or the whole economy. But whilst it might be true that at the firm level paying a higher wage may mean one is able to recruit and retain from a better (and at the low pay end more reliable) pool of people, this effect dissipates if everyone is paying more.

Finally, even if we were to assume that widespread or statutory adoption of the Living Wage lowered turnover of employees from firms operating in low-skilled industries, it is unclear why it is assumed that this would be good for productivity at an economy-wide level. The higher wage in these sectors might reduce the incentive for workers to move to higher-skilled, higher-paying sectors over time.

Again, we are left with the assumption that the Living Wage campaigners not only know better what is optimal for businesses in terms of profitability, but also what the optimal rate of turnover of jobs for strong productivity growth is.

In short, for the Living Wage campaigners to be right, economic theory has to be wrong: Living Wage campaigners have better knowledge of firms’ profitability than firms themselves, and the campaigners have a better grasp of optimum turnover rates for low-skilled workers than dynamic market processes.

To be honest, I highly doubt that many campaigning for a Living Wage have discovered a way to raise economy-wide productivity painlessly through firms increasing wages. Instead the productivity argument is an ex post rationalisation. Many like the idea of higher wages because, they say, they are "fairer," and so are drawn to arguments that support that these do not have negative effects.

Ryan Bourne is the Head of Public Policy at the UK’s Institute for Economic Affairs (IEA).

He is a co-author of "The Minimum Wage: silver bullet or poisoned chalice?" and "Smoking out red herrings."

This post previously appeared at the IEA’s blog, and at Anything Peaceful.