Crude oil and the cost of production theory of wages for unskilled labor

Unskilled labor is like crude oil. Before you read the rest of this post, my advice is not to take this as the complete Truth, but rather as an intriguing theoretical explanation of how domestic unskilled labor is priced.

Unskilled labor is a commodity like crude oil. Both are fungible goods. A worker is only non-fungible if he has some sort of skill, which means he’s no longer an unskilled worker.

Because commodities are undifferentiated, they tend to be priced very low. Providers of commodities can only expect to make a very slight profit over the cost of extracting or producing the commodity. Unless there’s a shortage. Before there was a shortage of crude oil, the cost per barrel was in the low to mid twenties, which was the cost of extracting it from a high cost oil field such as an offshore field in the Gulf of Mexico.

What’s the cost of producing a unit of unskilled labor? That would be the cost of keeping the worker alive. So the lowest salary that can exist for workers is the amount the worker needs to spend to remain alive. Otherwise the worker will die off and disappear. (In the U.S. few workers outright die: the worker either moves to another location, collects welfare, or supports himself with crime until he is convicted and then the state pays for his support while he’s in prison.)

The cost of production theory explains why the prevailing wage in New York City is higher than the minimum wage elsewhere. The higher cost of living in New York City requires a higher salary to keep workers alive.

Basically, the cost of an unskilled laborer is no different than the cost of a slave, because the slave owner would have to provide for the slave’s food, clothing and shelter, and also pay the interest on the loan he took out to pay for the slave. If only the Southern plantation owners understood how this worked we wouldn’t have had to fight a Civil War. So when someone says that unskilled workers are being paid slave labor-like wages, this is not a vast exaggeration but actually a very close approximation to the truth!

When there is talk about raising the minimum wage, someone always points out that a large share of minimum wage workers don’t “need” a higher wage because they are teenagers or retired people. This observation confirms the cost of production theory. The teenager and the senior citizen have a lower cost of production because their living expenses are covered by their parents or by Social Security.

Like crude oil, the demand for unskilled labor remains fixed by the amount of capital dedicated to using such labor. For example, the amount of cars in the United States is fixed, so when the price of oil increased from the low twenties to over $70/barrel, we continued to use the same amount of oil because we still had the same number of cars.

When oil was cheap, why didn’t we build massive numbers of cars until the price went up? Because oil is only a small part of the total cost of owning and operating a car. Similarly, unskilled labor is only a small part of the cost of operating the United States economy, so the demand curve for unskilled labor is extremely inelastic.

Unlike oil which is currently in a state of shortage, there is a plentiful supply of unskilled labor. There’s an entire world of unskilled labor, and if the labor can be used in a foreign country it’s even cheaper than using it here because of the lower cost of living in the foreign country. If there is a domestic shortage of labor then wages rise and immigrants come here from foreign countries to take advantage of the higher wages, and this causes the wages to drop back down to the subsistence level.

Of course Congress, if it wanted to, could enforce immigration laws and thereby create a shortage of unskilled labor resulting in wages rising above the slave labor-equivalent level, but Congress chooses not to do this.

There has been a lot of recent talk in the blogosphere about the impact of raising the minimum wage. Raising the minimum wage has the same effect as a group of oil exporting countries forming a cartel in order to enforce higher prices. As a result, the members of the cartel make higher profits and the oil importing countries still use the same amount of oil. Similarly, employers would still use the same amount of unskilled labor. They would just pay the higher wages because such wages represent only a small percent of the employers’ total expenses, just as gasoline represents only a small percent of the total cost of owning and operating a car. (I previously blogged about how a minimum wage doesn’t hurt the worker, but at the time I didn’t fully grasp how similar an unskilled laborer is to a barrel of crude oil.)

Some readers may take the previous paragraph to mean I support an increase in the minimum wage. Actually, I am agnostic about that. Skilled laborers and owners of capital benefit from the slaver labor-like wages paid to the unskilled workers. Who am I to say that the unskilled laborer deservers anything more? It’s a moral question, and this is a blog about discovering the way things work and not about preaching morals to anyone.

But the utilitarian in me might posit that the person living at a subsistence level has a higher marginal utility for money than the affluent. For example, what’s the big deal if some upper middle class people have to spend a few extra dollars a year on fast food and lawn care when people living at a subsistence level would enjoy that money so much more?

However the best way to help unskilled laborers is not to immediately raise the minimum wage. We should first attempt to raise wages by creating a shortage of workers by deporting the illegal aliens living here. If we don’t deport them, raising the minimum wage will create a black market in labor in which unscrupulous employers save money by paying illegal aliens wages below the legal minimum (see my blog post on the economics of cheating).

Comments

[michael vassar]

I am pretty confident that foreign unskilled labor is a VERY imperfect substitute for American unskilled labor. American "unskilled" laborers are in fact very skilled at English and at "remedial American culture", while foreigners are not. Immigrants are also generally selected for initiative, having the initiative to have come here, which creates a substantial difference between them and the unskilled populations of the US or of their native countries. The fact that they come here also suggests that they think that the returns to their assets are greater here than elsewhere. Even if this was not the case however, why would we possibly want to favor the relatively poor unskilled American laborers over both the relatively wealthy skilled American laborers AND the absolutely poor foreigners who wish to immigrate to the US?

Actually, wouldn't everyone be served MUCH better by simply making US citizenship a fungible commodity? Then unskilled American laborers could sell it and live cheaply in the developing world while skilled foreign laborers could purchase it and immigrate, possibly taking out loans to do so? Obviously we would need to do something about our current policy of granting citizenship to anyone born here, but that's a mess anyway, a relic of when it took months to cross the Atlantic.

In this proposal, it would also be possible to establish a basic income, which would go along with US citizenship. If the market price for citizenship was high enough, more citizenships could be sold in order to generate revenue for this income in a process analogous to stock dillution.

[nobody]

It should be pointed out that cheating is major problem faced by any cartel. Members of OPEC are known to break their production quotas.

Applying this concept, it should be clear that raising the min. wage has little impact in this country not for the reasons HS stated. It is more likely the result of signficant number of employers never having to pay those wages. They just find Mexicans who are willing to work for market price. Think for an employer's point of view. The money saved far outweight any risk assumed. Just in case, make regular contributions to both parties to keep the government away (or at least in a gridlock situation to keep the status quo).

This is why working class people in this country would be foolish to vote for democrat. If the democrats really cared about the poor, they would be the the one for building the fence. NYC mayor Bloomberg is quite right when he said that NYC needs these people. Without them, wages would go up signficantly and that would be bad for business.

It is not just unskilled workers are like crude oil. Virtually everyone is a commodity worker. Every few people truly have some unique skills that can not be done by someone else. This is why everyone is replaceable.

Similairly, 99.999% of the jobs out there are commodity jobs. The do not required some truly unique skills, and thus can be performed satisfactory by a large pool of workers. This is why employers rarely want the best and brightest. The job don't need that level of talent and don't really want to pay for it.

Now the real hard question. Knowing these facts, how can workers bees optimize his/her situations and make the most of out it?

[Half Sigma]

michael vassar: "The fact that they come here also suggests that they think that the returns to their assets are greater here than elsewhere."

Foreigners perhaps think that they can sustain themselves on less money than an American because of their more frugal living standards, so they are like Saudi crude oil ($10/bbl to extract) compared to American crude oil ($20/bbl to extract).

Also I agree that the average illegal Mexican immigrant is a better worker then the average American unskilled laborer who comes from the bottom 20% of society.

But the Mexican immigrant doesn't cause the native American from the bottom 20% to simply disappear.

nobody: "Virtually everyone is a commodity worker."

I've considered that the reason why skilled workers get paid more is because their wage has to sustain both their living expenses plus the capital required to gain their skills.

Workers only get paid well in fields where their wage is based on their scarcity rather than their cost of production.

[superdestroyer]

HS,

The effects that the price of labor has varies greatly among industries. In the petro-chemical industry, people are very well paid because labor is a very small fraction of the costs, in the restaurant business, labor is a huge costs and the biggest variable costs. Raising labor costs affects everyone.

There is also long and short term demand. Rising energy prices or rising labor prices have little short term impact but have huge long term impacts. Increasing fuel prices have little impact on the first day of the incrased but over time they can really hurt the economy if for no other reason than savings goes down.

Also, the minimum wage affects different parts of the US differently. Raising the minimum wage will do little for NYC workers since they all make above the minimum wage but will hammer the job makret in a place like El Paso Texas.

[Half Sigma]

superdestroyer: "Raising the minimum wage will do little for NYC workers since they all make above the minimum wage but will hammer the job makret in a place like El Paso Texas."

That assumes that the higher wage in NYC is based on scarcity. The point of this post is that wage is not based on scarcity but rather the cost necessary to keep the worker alive at a subsistence level, which is higher in NYC. This means that the worker in NYC doesn't actually provide any more value than a worker in El Paso, so there's no reason why raising the minimum wage in El Paso to NYC levels would cause any sort of "hammering" to take place.

[cpurick]

"Unskilled labor is a commodity like crude oil. Both are fungible goods. A worker is only non-fungible if he has some sort of skill, which means he’s no longer an unskilled worker."

No. Crude oil is crude oil. Someone in need of crude oil does not interview various barrels of oil, rejecting some and accepting others. It is either crude oil or it is not. But a responsible employer in need of unskilled labor is still choosy about whom he hires -- workers are not fungible. Not every unskilled worker can return a profit to an employer at $5.15/hr.

I'm going to skip some of your other statements that build on that particular fallacy. There's no point arguing about the workings of a model that's not founded in reality. But I'll be sure to point out some of the other ridiculous premises behind your so-called "reasoning."

"Before there was a shortage of crude oil"

There is no shortage of crude oil. "Shortage" implies that oil cannot be bought. A varying price rations oil such that plenty is available at the market price. Shortages are what happen when government price controls defeat the rationing function of price. No lines at the pump = no shortage.

"In the U.S. few workers outright die: the worker either moves to another location, collects welfare, or supports himself with crime until he is convicted and then the state pays for his support while he’s in prison."

Silly liberal. You're describing exceptions to the rule without even considering the rule itself: Most workers parlay their acquired skills and job experiences into better wages and better positions.

"Basically, the cost of an unskilled laborer is no different than the cost of a slave, because the slave owner would have to provide for the slave’s food, clothing and shelter, and also pay the interest on the loan he took out to pay for the slave. If only the Southern plantation owners understood how this worked we wouldn’t have had to fight a Civil War."

Plantation owners understood how slavery works, but apparently you do not. As a slave acquires skills and experience he becomes more productive, but his costs do not go up and he obviously cannot find another employer. A free worker, however, will naturally seek higher wages or a better job. It is those costs that the slave owner seeks to be protected from.

"when someone says that unskilled workers are being paid slave labor-like wages, this is not a vast exaggeration but actually a very close approximation to the truth"

In fact, an unskilled inexperienced worker probably does not even produce enough to live independently. Americans consume a lot, and that consumption demands productivity. The deficit of trying to live on the minimum wage is an important incentive to make oneself more productive. Imagine what an idiot somebody would have to be to guarantee "a living wage" to unskilled workers.

"the amount of cars in the United States is fixed, so when the price of oil increased from the low twenties to over $70/barrel, we continued to use the same amount of oil because we still had the same number of cars."

You are describing something that does not exist: perfect demand inelasticity. Obviously, people burn less oil at $70/barrel than they did at $50. Even if demand, at the current price, is still relatively inelastic, it is still elastic to some extent.

"unskilled labor is only a small part of the cost of operating the United States economy, so the demand curve for unskilled labor is extremely inelastic."

But not perfectly inelastic, which means that higher minimum wages will result in some additional unemployment. Some small number of people would lose 100% of their jobs as a result of raising the wage, just as surely as some of our unemployed today are out of work because of the current minimum wage. Supporting the minimum wage is like saying those people's jobs don't count, or that the economy is better off without those people's contribution.

"Unlike oil which is currently in a state of shortage,"

No it's not. You can get all you want for some $75/barrel.

"there is a plentiful supply of unskilled labor."

Wake up, dude. National unemployment is at 4.6%. It's hard to find the teeming masses of Americans rendered jobless by foreign workers. These are times where you can't find a competent worker in a McDonalds, because the labor supply is not "plentiful."

"Raising the minimum wage has the same effect as a group of oil exporting countries forming a cartel in order to enforce higher prices."

No. Actually it would be more like having all employers enter into a collective bargaining agreement with all workers capable of carrying their own weight at the new wage. The minimum wage prohibits employers from using the cheaper non-union workers who drive market wages down. Additionally, at a higher wage employers will demand more productivity from workers -- something that does not happen to higher priced oil. The cartel comparison is nonsense.

"the members of the cartel make higher profits and the oil importing countries still use the same amount of oil."

Except that people use less oil when the cartel fixes a higher price. The labor equivalent of this lowered consumption is called "unemployment." And when a cartel member lowers its prices nobody blames the customer, yet its the employer who gets blamed for hiring workers below the minimum wage. No, the more I look at your ridiculous cartel analogy, the more obvious it becomes that this is a union model. Perhaps you don't want to admit it's a union problem because you already know that the union's strategy is to keep its competitors unemployed?

"Similarly, employers would still use the same amount of unskilled labor."

Even leftists union economists know that less labor is purchased when wages are higher.

"I previously blogged about how a minimum wage doesn’t hurt the worker, but at the time I didn’t fully grasp how similar an unskilled laborer is to a barrel of crude oil."

Proof that people can become stupider over time.

"Some readers may take the previous paragraph to mean I support an increase in the minimum wage. Actually, I am agnostic about that."

You're lying. Your posts elsewhere betray you. You're obviously a liberal who's desperately seeking to rationalize a wage system that doesn't fit established models.

"But the utilitarian in me might posit that the person living at a subsistence level has a higher marginal utility for money than the affluent. For example, what’s the big deal if some upper middle class people have to spend a few extra dollars a year on fast food and lawn care when people living at a subsistence level would enjoy that money so much more?"

ECON 101: interpersonal utility comparisons are not valid. Yet that's exactly what you're doing.

The best option for unskilled laborers is for them to increase their skills and productivity. And the best possible incentive for this is a wage that does not reward people without skills.

[David F. Prenatt, Jr.]

How would you respond to the position that an expansion of the Earned Income Tax Credit is a much more effective and equitable way of helping the working poor than raising the minimum wage?

[Half Sigma]

cpurick, shortage of crude oil means that it's price is now determined by scarcity rather than its cost of production.

David, I don't really like the idea of Earned Income Tax Credit.

[michael vassar]

David Prenatt: It seems to me that an Earned Income Tax Credit is basically a subsidy for the employers of low wage workers, especially part time low wage workers.

Cpurick: You made some good points, but could you do so without all the ad-hominum attacks, ludicrous claims (like naive quotations of official unemployment numbers as if they represented the entire non-utilized labor force) and dogmatism? Your Econ 101 "fact" is clearly the invalid thing, not the interpersonal utility comparisons it criticizes. Those can be measured in a variety of ways. None of those ways are perfect, but the concept of utility is itself VERY FAR from being a perfect description of anything cognitively real. (see psychology 101 & up, especially Prospect Theory, Econ's 2002 Nobel)

Half Sigma: "the cost necessary to keep the worker alive at a subsistence level," is actually much much less than minimum wage. Look at the conditions under which people live in developing countries. Even in Manhattan, workers could be fed rice, beans, and multi-vitamins in dorms 2 hours outside of the city, housed in a pre-fab home (http://www.rocioromero.com/LVSeries/LVL.htm) costing under $35/square foot, and shipped into the city by bus. If they were actual slaves, this might represent a baseline level of care. With modern sanitation they would still have a far better life expectancy than early American slaves. The actual economic status of unskilled workers in America appears to me to be the result more of cultural than of economic decisions.

[cpurick]

"shortage of crude oil means that it's price is now determined by scarcity rather than its cost of production."

That's not the economic definition of shortage. However, you apparently find it convenient to redefine economic terms when their traditional meanings (and traditional economics) do not support your position.

"ad-hominum attacks"

With a ridiculous position comes ridicule.

Official unemployment figures work well enough to show that unemployment is relatively low.

As for interpersonal utility comparisons, the most common use of the phrase on the internet goes something like this: "Your argument is wrong because it makes an interpersonal utility comparison." Sounds like a recognized fallacy to me.

[Half Sigma]

michael vassar, while that prebuilt house looks nicer than my apartment in Manhattan, the problem is zoning. Society has basically decided to not make housing affordable. Especially in the NYC area.

[michael vassar]

But my point was not that good housing was affordable but rather that if we were really paying slave wages people would live in shitty pre-fab 100 miles from the city and commute by bus. They could live on a few dollars per day plus the bus fare and subway fare.