It is construction season in this city and, while idling with hundreds of other drivers, I wondered what economic lessons we can learn from gridlock.
Traffic patterns emerge through the interaction of thousands of drivers making individual decisions to minimize their travel time. In the week after the end of construction, traffic patterns return to normal. Travel habits reform, adapting to the new opportunities provided by repaired roads and new routes.
This is an example of a self-organizing mechanism, otherwise known in economics as a Nash equilibrium. John Nash, the subject of the movie A Beautiful Mind, won the Nobel Prize for realizing that our individual decisions must account for the decisions of everyone else driving or participating in the economy. A steady state, or sustainable equilibrium, occurs where each of us makes the best decision in the context of everyone else’s best decision.
The "invisible hand" is another possible way of describing a Nash equilibrium. Ascribed to Adam Smith, the popular understanding is that Smith viewed the economy guided as if by an invisible hand.
Further, coupled with his idea that each of us acting in our own self-interest will collectively produce the highest well-being for society, it is an easy leap to conclude that Smith defended a non-interventionist and laissez-faire economic policy.
In fact, part of this story is bunk. Adam Smith only mentions the invisible hand three times in his important books. Indeed, he seems not to have seen this as a useful or central idea. It was contemporary economists who linked the idea of a self-organizing market to the invisible hand, possibly to justify non-intervention in market processes.
Market processes are universal, even in centrally planned economies and unique settings. Black markets and side payments always seem to emerge, such as mushrooms on a lawn after rain, in the strangest settings. A famous article published just after the Second World War described the market process of a prisoner of war camp, where cigarettes served as money.
While market processes may be universal, we often do not like the outcomes. Markets do not guarantee that results of transactions are fair. Markets also fail due to poor information or where our consumption and production behaviour creates social costs.
However, when we intervene in markets to change outcomes, the law of unintended consequences often rears its head. Minimum wage — an important example — illustrates the problem with trying to force the invisible hand.
Many jurisdictions are trying to reduce poverty by increasing minimum wages. It seems like an intuitive approach. The goal of $15 an hour is a common refrain among anti-poverty activists.
Opponents argue that raising the minimum wage will force businesses to reduce employment and increase poverty. Which view is correct?
A landmark study by the economists David Card and Alan Krueger in 1993 seemed to turn conventional economics on its head and demonstrate that increasing minimum wages among young fast-food workers did not raise unemployment.
But before we accept these results, it is important to understand that Card and Krueger only studied employment in a specific labour market, teenagers working in fast-food restaurants, and only for 11 months.
The National Bureau of Economic Research has just released a much more detailed study of Seattle’s experience with minimum wage. This research looked at the effect of increasing the minimum wage across all labour markets, not just in the low-skill employment sector where the policy has its initial impact. This study examined the two-step increases in minimum wages from 2013 to 2016 that saw a total increase to US$13 from US$9.47.
The key finding was that while average wages (across all occupations and levels) increased three per cent over the study period, total hours declined by nine per cent. The author writes that this implies an average loss in income of $1,500 per year, hardly the poverty reduction anticipated.
The key idea is that labour markets are linked, just as drivers in gridlock. To see this, think about a standard work year of 2,000 hours. A $15 minimum wage implies an annual income of $30,000.
Now, imagine a flight attendant earning $36,000 annually who gets up at 3 a.m. to make the 5 a.m. red-eye to Toronto and how he/she might react to a $15 minimum wage. Any increase in minimum wages for those with no skills and low responsibilities tends to create upward pressure on all wages upstream.
Employers who cannot pass the entirety of cost increases to consumers (which are most) will adjust their hiring with the net effect of reducing employment and incomes.
Anti-poverty activists need to stop forcing the invisible hand and abandon minimum wages as a policy. It rarely works to legislate outcomes. A basic income, as well as increases to the child benefit and working income supplement, are much more effective methods to address poverty in our current economic context.
Gregory Mason is an associate professor in the department of economics at the University of Manitoba.