Evan's Easy Economics: #11 Real vs Nominal Wages

In my other Evan's Easy Economics articles, we've so far discussed supply and demand, marginal utility, time travel, trade, how wealth is created through production, and unintended consequences. In other economic-related articles I've written, we've discussed socialism vs. capitalism, whether economics can really be treated as a science, profits in general, how governments generate their money, how they spend their money, and how individuals work together.

This article is to discuss the common mistakes made when discussing or thinking about money. People will often confuse the idea of how much something costs in money and how much it costs in effort.

Real Wages vs. Nominal Wages

In our example of Johnny Speeshoes and our time traveling (see above), we encountered the wonders of nominal wages versus real wages. When we went back in time, we could have been paid trillions of dollars, but we still wouldn’t have been able to buy an iPod or a Hybrid vehicle. The technology and productive power just didn’t exist. On the deserted island, even though Johnny had all his money he still couldn’t buy a Big Mac.

A nominal wage is, basically, how much you get paid. A real wage is, basically, how much you can afford. Johnny was being paid a lot of money, but he couldn’t afford anything on the island. In 1900, he couldn’t afford the wonders of the year 2010; he had a large nominal wage, but had a relatively small real wage. If we went back in time and gave everyone a billion dollars, they would have a fantastically large nominal wage, but still would have a lower real wage than those of us earning an average wage in today’s world.

Making Sense of it: Minimum Wage

This begins to show us the problems of inflation, minimum wage, Socialism, and many other strange governmental interferences in the market that try to make things nice, but usually just end up making things worse. We’ll talk about inflation and Socialism later, but for now let’s briefly talk about minimum wage.

I can easily show that minimum wage is an insane idea with just one simple sentence: If raising wages actually increased the wealth of the population, then why don’t we just make minimum wage $900 trillion per second? Obviously this idea is ridiculous, and thus so is minimum wage. They are just the exact same thing, just on a differing scale: just because nominal wages increase, real wages do not.

Suppose the average wage was $1 an hour. Wouldn’t life be terrible? So many people would be making $1 an hour instead of what they would normally be earning! But, wait a minute, if the majority of the world is making $1, then things would be a lot cheaper! If a businessman only had to pay his workers $1, then prices would plummet (thanks to competition)! Suddenly $1 would be worth a lot more than it used to. If the average wage were 1 dollar, then no one would be able to afford $30 for a steak or $200 for a suit, and it wouldn't cost $30 or $200 because the entire chain of labor required to make the products would be drastically lower than it is now. The nominal wage would decrease, but the real wage would remain about the same. This is simply because the production of the population is the same, its just that the amount of money we give for “a hard day’s work” is being defined in a slightly different way.

If suddenly we increased minimum wage to $8 trillion per minute, then we’d all be rich!.... until logic returns to out brains and points out that everything would cost an astronomical amount of money. If an employer has to pay more for labor, then the prices of the things he sells will increase. Plus, people could actually afford paying upwards of $7 trillion for an ice cream cone. The nominal wage would be a lot higher, but the real wage wouldn’t change much.

In both examples the market was in a general state of equilibrium until nominal wages changed dramatically. The result would have been a drastic all-around wackiness in the markets that would probably ruin a good number of people’s lives, followed by a new state of equilibrium. The simple fact is that nominal wages don’t really change amount you can afford. If we could simply dictate that everyone is able to buy everything they could ever want, then the world would be a much better place; but life just doesn’t work this way. The amount of money in the system might change, but not the scarcity of the resources.

Making Sense of it: Widgets and Man Hours

If it took 10 man-hours, and one pound of steel to make a widget, let's see what would happen if we played around with the nominal wage and the real wage. If we charge $1, $10, or $100 per man-hour, then the price of a widget would be a minimum $10, $100, or $1,000, respectively.

This makes enough sense, but let's look at the unseen. If we had a $10, $10,000, or just $1 per man-hour rate across the economy, then not only would the widget-making-labor cost that much, but so would the price of the steel-processing-labor, and so would the price of the iron-mining-labor, and so would the price of the pickaxes-for-mining-iron-labor, and so would the wood-for-pickaxes-labor, and all the way down the list of industries needed to make the resources for a widget.

This shows that the price of the steel for every industry would decrease/increase if we changed the wage rate across the board; if the price of “labor” changes, then all things that use “labor” (i.e., everything) will change as well. If nominal wages decrease, real wages don't really change much. Increasing nominal wages does not allow us to be wealthier!

Minimum Wage Hurts the Wage Earner

So far we’ve been looking at the wide spread production costs involved with altering wages. Let’s now look at the other effects of changing nominal wages.

Minimum wage, along with all other price controls can lead to strange results. Indeed, if we force businesses to pay each worker a minimum of $10 an hour because we want to help the workers, then we will instead hurt the worker. To begin with, not every worker is the same, it would be foolish to think so. Some workers are simply better at producing certain things than others, some workers are more experienced than others, some workers are unskilled compared to others, and, at the risk of sounding rude, some workers are mentally or physically handicapped.

If a company has to pay someone more than what that person is worth to the company, then the company will be losing money for each hour that person is employed. For example, if someone is only able to produce $7 worth of goods each hour, but the employer is forced to pay them $10, then for each hour he is employed the company loses $3. It would make much more sense for the company to just fire the person and search for a better worker. If, instead, we were to allow the company to pay that person whatever they chose necessary, perhaps $6, then the individual would not only have a job and a source of income, albeit a relatively small one. They would still be benefiting the company, but, more importantly, they'd still be benefiting themselves.

So, even though we were trying to help the poor and unskilled workers with a minimum wage, we actually made them lose their jobs. Imposing a minimum wage leads to unemployment. And, as we’ve seen, increasing nominal wages doesn’t actually make anyone richer.

Michael Moore Mistakes

In Michael Moore's new film “Capitalism: a Love Story” he makes a very interesting point that actually counters what he's arguing.

I'm not sure exactly where he got the numbers, nor how he manages to shuffle randomly a time span ranging over 60 years, nor how he is able to reach the conclusions he makes, nor how he was able to produce an entire film about the evils of mercantilism/corporatism but still call the movie “Capitalism”…

...But! if we ignore all this, he makes an interesting statement: wages stayed stable from 1980 to 2000 while productivity increased 45%.

First and fore most, this is absolutely incorrect: according to the Social Security website – the average wage in 1980 was $12,513 and the average wage in 2000 was $32,154 (it took me about 2 minutes to look up this information… not sure how he could have missed something so easy). But, if we ignore this as well, he somehow uses this to prove that companies are evil and unions are good, but let's ignore this, too, for now.

For now let's just look at what this means: if people are being paid the same amount as before (even though they are not), but they're putting out 45% more production, then they are receiving an increase in their real wages. Their money in 2000 has, apparently, gained upwards of 45% of its 1980 value – if everyone makes more things but earns the same amount of money, the supply of goods increases, the demand for goods stays the same, and if the supply of money stays the same (which Moore claims, not me!), then the money that people get paid would be worth more.

Of course there are a billion other factors that took place that completely change the scenario (inflation!), and Moore didn't in anyway make an effort to discuss them. But we'll just ignore them for now, the same way he did.