Minimum wages and profitability

The debate over the impact of the minimum wage has been one of the most intense and most controversial in the field of economics. This is in large part because the literature on the subject is contested.

On the one hand, critics argue that a price floor in the labour market would result in greater unemployment, since an increase in the wage rate will increase the cost of hiring an additional worker, so firms would employ less (Leamer et al, 2017). Conversely, proponents of the minimum wage assert that the resulting unemployment is inconsequential in comparison to the benefits gained (Cengiz et al, 2017; Allegretto et al, 2018; Rinz and Voorheis, 2018). The supposed benefits include: poverty reduction, improving worker morale (and, thus, raising labour productivity) and offsetting the negative impact of employers with market (monopsony) power.

Now, I don’t want or need to voice my opinion on these matters – at least not in this piece anyway. Instead, today I intend on focusing on the impact of the minimum wage on one specific, but crucial, aspect of the economy: (aggregate) business profitability. This requires us to explore this issue through a macroeconomic viewpoint, rather than the conventional microeconomic perspective. Let us begin.

Suppose, if the minimum wage increases. Then, firms would be legally obliged to increase the wages of their employees to the wage rate equal to the price floor. As a result, employing workers at higher wage rates to produce the same amount would result in higher (average) costs, hence profits it is argued must be lower.

But, this view is wrong because it is predicated on the fallacy of composition. While, higher wage costs are a problem for any individual firm, they are not necessarily a problem for all firms (in aggregate). Just as one person’s spending is another’s income, a similar parallel can be drawn to businesses. In the overall economy, one firm’s revenues are another’s costs. If workers spend their additional incomes, then what businesses in aggregate lose from costs they gain from higher revenues (through increased spending and higher sales).

This line of thinking draws our attention to a more complex yet more precise view of aggregate profit. It is more complex because it involves some mathematical identities and it is more insightful because it allows us to establish a relationship between capitalist’s profits, workers’ wages and overall expenditure in the economy.

Let us use the conventional expenditure equation for national income (Y):

Y = C + I + G + NX

where C is consumer spending, I is private investment, G is state expenditure and NX is net exports (the difference between total exports and total imports).

We can also express aggregate national income as the sum of its claims:

Y = P + W + T

where P is total profits, W represents total wages and salaries and T is state income, or total taxes.

We can solve this for aggregate profits, which is given by:

P = (C – W) + I + (G – T) + (X – M)

In other words, the profit equation suggests that gross profits is equal to aggregate consumption (C) minus total wages (W), plus gross investment (I), plus the budget deficit (G – T) and plus the surplus of exports over imports (X – M).

The above equation is a variation of Kalecki’s famous profit equation. The only real difference is that I have chosen not to divide the consumption component (C) into: total capitalists’ consumption, total workers’ consumption and gross worker’s saving.

So, from this equation we can observe that aggregate profits will be higher if gross investment is higher, if the fiscal deficit is higher, if net exports are higher and, crucially, if overall consumption is higher relative to total wages.

Thus, if overall consumer spending falls relative to total wage income, then (all other things being equal) total profits will fall. In other words, overall profits will decline if the higher wage rate paid by firms to their employees does not return to them in the form of increased consumer spending, increased sales and higher revenue.

Now, this is assuming that net exports and the budget deficit remain constant. Of course, the data suggests that this is not the case: presently, the UK is running a large current account deficit and is on trend to eliminate the overall budget deficit around the middle of the next decade.

Interestingly, the two deficits may have a potentially larger adverse impact on gross profits than labour market price controls.

While, in this piece, I have discussed the minimum wage through a macro lens, the microeconomics is still very important. Simply looking at the macro dimension is insufficient to evaluate the full impact of a minimum wage. All that I had intended for this piece was to add a different dimension or viewpoint rather to the minimum wage debate. The primary purpose of this post was a rather simple one: to demonstrate the effect of a minimum wage increase on gross profits. And from this we were able to understand that minimum wages are not necessarily an anti-business policy. In fact, it is possible for a minimum wage to improve overall business profitability.

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