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Please explain the broken window fallacy and how it can be used to explain the hidden costs of price fixing, minimum wages, and inflation.

I think it is a good idea to remind people to look beyond the impact of those immediately affected by a specific government policy. It is easy to see employment in an industry that is protected by tariffs. However, it is not easy to see how that impacts job creation in other industries, government revenues, wages, productivity, and standards of living (for instance).

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  • John Moser commented  ·   ·  Report

    The hidden cost of a low minimum wage is an excellent example of broken window fallacy.

    When minimum wage is low, high-productivity firms can't compete with low-productivity firms: the gap between wages becomes large, and labor-saving technology has to save MUCH more labor for a productive firm to be cost-effective, and thus competitive with a low-productivity firm.

    Many say, well, but if minimum wage were higher, wouldn't firms reduce employment? And the answer is yes, an individual firm would; but what does that mean?

    Broken window fallacy: well these workers do need work, after all.

    If you go about smashing windows, you make work for the glazier. This is a loss because it's unproductive, as if the glazier weren't replacing broken windows, they could be making new windows, and retiring glaziers could be replaced by shoemakers or carpenters.

    The same is true of a low minimum wage: if the hours invested by the low-wage glazier hand-producing flat glass were replaced by fewer hours invested by the high-wage, skilled glazier using advanced processes and tools, then more glass could be made with fewer glaziers. An increased minimum wage—relative to per-captia GDP—causes this efficiency gain.

    Just like with the broken window, the reduction in demand for glaziers—even with an increase in demand for glass—leaves us with labor we can apply to other uses. These workers may now make shoes, table, medical supplies, or all other manner of things. Retiring glaziers are replaced with skilled glaziers, with college-educated engineers, with computer programmers, with doctors and nurses, all manner of people more-productive than glaziers using the old methods.

    The broken window fallacy drives an unfortunate tendency for countries to think of minimum wage as a "balance between equity and competitiveness," when it's really a balance between equity and the limits of economic flexibility. At a substantially high minimum wage, the economy is still flexible and perhaps even optimal; but above an exceedingly high point—which may even be as much as 100% of per-capita GDP, although 67% is a known-stable level—wage compression accelerates.

    That is to say: wages get closer together as you raise minimum wage because market forces increase other wages, but higher wages increase less than lower wages. As minimum wage increases, the rates of increases across the wage structure become more-similar, until a 10% increase in minimum wage causes a 10% increase in mean average wage. Raise minimum wage too much beyond this and the wage distribution requires more money than there is spending—mathematically. That means wages squeeze closer together once again because the market cannot find the money to pay for the effects minimum wage has on other wages, and the market starts to fall apart.

    Everything has its limits, after all. You can't just set minimum wage to $10,000 an hour and expect good things to happen; you can, so it seems, set it to $21/hr in mid-2020 and expect pretty much only good things to happen, certainly only good things after 14 quarters with the wage indexed to per-capita GDP (this has been measured).

    So long as you don't do something egregious, a higher minimum wage simply redistributes, rather than reducing, demand for labor. Higher minimum wage increases competitiveness for productive businesses, rather than unproductive businesses: rather than "even the least-productive need work," many less-productive workers end up in more-productive jobs, while others simply have higher pay (yeah, we're not replacing retail shelf stockers any time soon on current technology, and they're not getting more productive; but their pay is a small part of the total wage bill anyway, so increasing it has effects on prices so small our monetary policy is TRYING to make greater inflation, and would simply back down a little to compensate).

    This is all, of course, non-obvious, because the micro view that Firm A will replace labor with capital is both correct, natural, and naturally expanded to the incorrect conclusion that firms in aggregate will use less labor. Such reasoning begs the question of how and why people have any jobs at all.

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