There has been a ton of gum-flapping about the minimum wage hike and its supply-side effects.  No one has addressed the demand-side issues, and I believe there is plenty of meat on that bone.  When looked at from that perspective, the minimum wage increase is a bad thing.

Let me start by making a few assumptions.  Let me assume that the increase in the minimum wage has no supply-side effects.  While we know that is not true, these effects will only complicate the discussion.  In fact, those effects will worsen the demand-side effect.  Also, I am going to assume that the workers who receive the wage increase are spending the money and not saving it.  This is not such a far-fetched assumption as it is the justification for the increase.  The workers need the money to pay living expenses.

Now, economic theory tells us that equilibrium is reached when the quantity of a good produced at a given price equals the quantity consumers are willing to purchase at that price.  That’s supply and demand in its simplest form.  However, there is another factor that we must look at.  While it is a supply factor, it does directly impact the demand side.

A manufacturer cannot simply produce as many items as people want to buy.  There are certain costs that vary depending on the quantity produced.  For instance, if a particular product takes a boxcar full of some raw material to produce 1000 units, then a manufacturer will look at production in blocks of 1000.  It would be difficult for him to produce 1005 of the item because he would need a full boxcar for only 5 units.  The boxcar is only an example.  It could be buying another machine, setting up another line or hiring another employee.  The manufacturer will only produce an item when the revenue generated by that next item (the marginal revenue) equals or exceeds the cost of producing that item (the marginal cost.) That is to say; a manufacturer is not going to make something if he will lose money making it.

With those basic ideas in mind, we can now address the issue of a minimum wage increase.  As workers have more money in their pockets, they can buy more stuff.  Initially, excess manufacturing capacity can pick up the increased demand.  However, there comes a point when the excess capacity is gone.  Now, the manufacturer has to decide what to do.  In a perfect world, he would hire more people and they would produce more stuff and everyone would be happy.  Unfortunately, that brings us back to the issue of costs.  He can’t just rush out and hire more people.  He has to decide if he can support enough business to absorb the added costs of labor and raw materials.  If he believes that there is enough demand, he will go ahead.  If he does not, he has two options, neither of which is good.

The first option is to go ahead and produce the increased quantity.  To offset the increased costs, he has to raise prices. The second option is to not produce the increased quantity.  However, this solution isn’t any better.

If he keeps production level, demand will outstrip supply.  When that happens, price rises until supply and demand are back in equilibrium.  The quantity produced is the same, but now, the cost is higher.  That’s inflation.  Here’s how it works.

Let’s say a particular good sells for $100 and there is a demand for 100 of them and that is 100% capacity.  The manufacturer decides that the demand is a quantity of 105 but that additional 5 units cost too much to produce, so he sticks with 100.  That means that there will be 5 people who want to product, can afford it, but don’t get it.  A smart store owner might figure out that 100 people at $100 might easily be 100 people at $110.  He will raise his price for the good because people will still pay for it.  As long as he still sells 100, he makes more money.  Prices are higher.  That’s inflation.

Now we see the real effect.  Because of inflation, that increase in the minimum wage didn’t really do anything for the people who received it.  Because of the increased demand the increase created, prices rose.  The spending power of the people was not increased, and everyone pays higher prices as a result.  This leads to upward pressure on wages which leads to higher prices which lead to… This is known as a wage-price spiral.  It’s what we went through in the ‘70s.

Minimum wage increases serve only one purpose.  They make politicians look a little less slimy.  People who don’t know any better think that the extra money in their pockets is going to lead them to a better life.  They believe that because the politicians tell them it will.  The only people who get a better life from a minimum wage increase are the politicians who fool the people into voting for them because of it.