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Drawing Lines: An Unapologetically Liberal Answer

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During a recent visit to America, I stopped by the University of Chicago to meet with a colleague and ran into a student. We discussed his experience, how much I enjoyed my time there as a student, and the concepts I hope to communicate to students as an Executive-in-Residence at the Booth School of Business in the autumn.

The conversation turned to my current research, which involves living in an area near the Uganda-Sudan border. The student then asked me an excellent question: "Your work in emerging markets involves a lot of unemployed people and a lot of poor people. Why is the minimum wage local, while at least one poverty line is global?"

I gave a sufficient, but imperfect, answer and I hope to improve upon that answer here.

To address this question, let's make sure we know what a minimum wage is, what the world poverty line is, and how the two differ.

A minimum wage is a regulatory mechanism whereby the state intentionally distorts the labour market by setting a wage (often hourly or daily) below which wages cannot be paid (importantly, however, people are generally allowed to work for nothing, so only an artificial trough between zero and the minimum wage contains wages that are prohibited). As a result of this government tampering, many workers at the bottom of the wage scale no longer earn a wage that represents their marginal product of labour (imagine taking Worker A away from the firm, then adding him back in - the value Worker A adds is his marginal product of labour). Employers who violate minimum wage rules may face threats from the state to their pecuniary or even penal interests.

The world poverty line is not precisely the same from place to place, at least not in the sense typical consumers would consider two things the same. The poverty line created by the World Bank is drawn at an arbitrary value of 1.25 U.S. dollars using 2005 purchasing power parity (how much would one U.S. dollar be able to purchase in Country X?), taking into account the cost of consumer goods in Country X. The numbers are then updated using interim inflation estimates. Hence, the poverty line does not fall at precisely the same place everywhere in the world. Rather, it attempts to approximate a similar level relative to local prices, in local currency.

The two differ in that the minimum wage is an enforceable legal construct, while the world poverty line is an economic benchmark. Simply knowing this, it should not be surprising that the two have different purposes and are architected via different processes.

It is also important to recognise that the two are both designed with at least a philosophical reference to poverty, but that neither is constructed in reference to the other. I know of no jurisdiction that sets its minimum wage at the world poverty line. Further, I know of no jurisdiction whose minimum wage is set as a fixed coefficient for the world poverty line. There is not, to my knowledge, any paper by the working group on poverty at the World Bank or by any other major group of economists working on emerging markets (or developing countries, the two being similar but distinguishable) that suggests the world poverty line should be set with reference to a local minimum wage rule.

Where do these things come from? Minimum wage laws are generally designed by legislators who were trained as lawyers. Minimum wage laws are prevalent in post-industrial developed democracies. Meanwhile, poverty metrics are generally designed by economists or econometricians. Generally, poverty metrics are propagated by multilateral organisations, particularly those focused on development economics.

A piece of the answer to the student's question lies in the fact that if one draws a Venn diagram showing the countries with a minimum wage and the countries with a high prevalence of poverty (I am using the word poverty here in the World Bank sense, not in the intranational relative sense), the overlap between the two is small. When one considers only countries with rigorous enforcement of a minimum wage, the overlap area shrinks substantially. One reason the world poverty line and the minimum wage may seem out-of-step is that, in most of the world, they do not coexist.

Some may stop at this point and ponder whether the imposition of a minimum wage would help pull workers out of poverty in these areas with a high concentration of impoverished residents. In fact, why don't we impose a minimum wage of £10,000 per hour; we'll all be wealthy? No, this is not how things work (though this is a good thought experiment, as it demonstrates the undesirable distortions that even a much smaller minimum wage creates). The way to pull large numbers of people out of poverty is to create economic growth, and dramatic economic growth tends to happen in places with no minimum wage (or no minimum wage enforcement).

From July 1897 through July 2010, there was no minimum wage regulation in Hong Kong. In 2007 (the last year before the current minimum wage law was proposed), the unemployment rate averaged slightly more than 4%. During all but wartime periods, Hong Kong experienced a rate of growth that outpaced most other cities in the region, despite having access to inferior natural resources. Nearly every success story of the last fifty years when one looks at sustainable growth involves a country with no minimum wage or an unenforced minimum wage. Due to a variety of factors (many of them completely decoupled from whether or not a minimum wage exists), very few on the island live on the very low wages described by the World Bank's poverty line (or even its reference line, which is set at roughly double the poverty line).

Why do developed countries, then, have minimum wage rules? Minimum wages can be seen as a partial privatisation of social welfare costs. People whose marginal products of labour are very low are overpaid (their marginal wages are unrelated to their marginal products of labour), shifting the excess cost of supporting this person away from government and inflicting it on industry.

So, then, returning to the question at hand: The world poverty line serves a different purpose from a minimum wage. The world poverty line is an effort to approximate the amount of money required to meet a person's basic needs and then to convert that amount into local currency, taking into account local purchasing power. A minimum wage is a localised (national, regional, or even municipal in some cases) attempt to artificially inflate the wages of workers to impose the costs associated with these people on private employers and shareholders rather than appropriating these costs from the public budgets.

This takes us back to my answer in Chicago (reproduced as accurately as possible):

"The minimum wage is a local political decision, while the world poverty line is a global metrics decision. The former is defined by its local uniqueness, while the latter is designed for its global comparableness. Sometimes a minimum wage will be three times the world poverty line, sometimes it will be five times the world poverty line, and sometimes it will not exist at all. Minimum wages are not a solution to poverty, but they are certainly a very inefficient way to outsource the management of poverty. All minimum wages are related to poverty lines (though not necessarily the world poverty line), but not all poverty lines are related to minimum wages (very few are). The world poverty line is helpful in considering how many people in a given area are not economically self-sufficient; the minimum wage less the worker's marginal product of labour is a back-of-the-envelope proxy for non-state welfare spending. I hope that helps."

And I hope it does.