Friday, May 18, 2018

Arvind Kejriwal’s Unemployment Guarantee Scheme

The Arvind Kejriwal government in New Delhi has just guaranteed unemployment for many unskilled, semi-skilled and skilled workers by passing a tough minimum wage bill recently. As newspapers reported, President Ram Nath Kovind has given his assent to the Delhi government’s Bill to amend the Minimum Wages Act under which employers violating labour rules in the city will now face fine ranging from Rs 20,000-50,000 and jail term between one to three years. Last year the Kejriwal government increased the minimum wages of unskilled, semi-skilled and skilled workers by 37%. According to this new Act, for an unskilled worker, the minimum wages is Rs 13,350 per month while for semi-skilled, it is Rs 14,698. The minimum wages for skilled persons is Rs 16,182 in the national capital. 

Why we are terming this minimum wage act as a guaranteed unemployment act for the workers? A little understanding of how market determines wages of workers will go in a long way to understand the reason.

In the labor market, the wages of workers are determined by the combined forces of their demand and supply. The supply of labor is mainly determined by workers’ choice between how much of their time to allocate to either work or leisure. The demand for labor is determined by workers’ discounted marginal value productivity i.e., how much value a labor can produce for the customer of the firm. This also means, how much extra revenue he can generate for the firm. This means, how much wage a worker will get in the labor market is determined by his productivity. Higher the productivity, higher the wage and vice versa. For example, before worker Crusoe started working in firm Acme, its revenue was 500 rupees. After his joining, we assume other things to remain unchanged, revenue goes up to 600 rupees; this means, the maximum wage that Crusoe can get is 100 rupees.

Equipped with this fundamental knowledge of economic science, we are now ready to analyze the impact of minimum wage on labor market.

Now enters the government with its minimum wage. Minimum wage is a government mandated wage, which means it is compulsory to implement and those who do not implement can go to jail as the Kejriwal act shows, which is set arbitrarily by the bureaucrats above the market clearing wage. It sets a floor price of labor below which no employer can pay their workers without facing government wrath. We have seen above that the market clearing wage of workers reflect their marginal contribution in firm’s revenue and profit. We also know that no firm can survive for long in the market without making profit. Setting of minimum wage above this market clearing wage by the government means now firms are forced to pay workers wages which are more than their marginal contribution in firm’s revenue and profit. This creates a survival issue for the firms. Let us take one numerical example to understand how minimum wage impacts firm’s cost of production and thus profitability. For the sake of simplicity we here assume that the only cost of production for a firm is its wage bill. Suppose, before the implementation of minimum wage act,  Acme firm employs 10 workers and pays them 500 rupees/labor annual wages. So its total production cost is 5000 rupees. Its total revenue is 7000 rupees. This means, its total profit is 2000 rupees (Total Profit = Total Revenue – Total Cost). The government then mandates a minimum wage of 800 rupees. Now firm’s total production cost goes up to 8000 rupees while its revenue stays the same at 7000 rupees. Remember, government’s minimum wage act only increases wages of workers, but not their productivity which can enhance firm’s revenue. Acme is now making a loss of 1000 rupees. As I said above, in loss making condition firm cannot survive in the market so it will try to reduce its production cost. The easiest way to do so is to fire some of the workers. In our example, Acme firm will fire 4 workers to bring its cost down to 4800 rupees. This will wipe out its losses and it will again start making 2200 rupees profit as before.

As we saw above, the end result of minimum wage act is unemployment for those 4 workers who got fired. When the government implements minimum wage, this is what happens. Every worker whose marginal value productivity is below prescribed minimum wage will find himself unemployed. No firm will be willing to hire them because their productivity cannot justify their wages.

Not only firms will fire their present workers, but they will also refuse to hire new workers because that will add in their production cost without increasing their revenue. Firms will have more incentive to instead start replacing their labor force with machines. Again the end result is unemployment for the workers!

As economic science tells us, the socialist measure of “minimum wage” is not a right means for increasing the welfare of workers as their proponents, like Arvind Kejriwal, tells us. This policy only hurts the very workers for whom it is designed. It is a policy of guaranteed unemployment. The only way in which we can increase the material standard of living and welfare of our workers is to help them increase their productivity via accumulation of both physical and human capital. Both these processes require an economic policy of laissez-faire Capitalism. As long as we do not have this economic system in place, workers’ lives cannot be changed for better no matter how much government increases their minimum wage!

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