The Minimum Wage vs. Welfare: Band-Aid or Salt? By Bryan Caplan

Peter Thiel entertains what economists would call a “second-best” argument in favor of raising the minimum wage:

“In theory, I’m against it, because people should have the freedom to

contract at whatever wage they’d like to have. But in practice, I think

the alternative to higher minimum wage is that people simply end up

going on welfare.” “And so, given how low the minimum wage is — and how generous the

welfare benefits are — you have a marginal tax rate that’s on the order

of 100 percent, and people are actually trapped in this sort of welfare

state.” “So I actually think that it’s a very out of the box idea — but it’s

something one should consider seriously, given all the other distorted

incentives that exist.”

Is he right? Maybe. A key insight of welfare economics is that one inefficient policy can counter-act another inefficient policy. But does this insight apply in this particular case? Let’s work through matters step by step.

First, imagine laissez-faire. There’s no welfare and no minimum wage. The low-skilled labor market looks just like this:

Figure 1: Low-Skilled Labor Market Under Laissez-Faire





There’s no involuntary unemployment, and the big black dot reveals the wage and quantity of labor.

Now imagine adding a minimum wage – but no welfare – to the mix.

Figure 2: Low-Skilled Labor Market With Minimum Wage But No Welfare

The big black dot still reveals the wage and quantity of labor. Thanks to the minimum wage, though, there’s now a lot of involuntary unemployment, marked in red. This is true despite the fact that the minimum wage increases the incentive to work. Why? Because the minimum wage also reduces the incentive to hire! Since a deal only happens if both demanders and suppliers of labor consent, the quantity of hours worked is the smaller of quantity demanded and quantity supplied.

Under laissez-faire, any able-bodied worker can get a job and stand on

his own two feet. The minimum wage deprives the unfortunate workers

shown in red of their ability to support themselves. Given this involuntary unemployment, the case for welfare is suddenly easier to make. What happens if the government in its mercy puts the unemployed on the dole?

Figure 3: Low-Skilled Labor Market With Minimum Wage and Welfare