April 18, 2005
The Economics of the Basic Income Guarantee
By Matt Ginivan
Tim Carter's proposal to abolish the minimum wage and establish a government guaranteed basic income is misguided. The labor market reaches an equilibrium when the price-setting relation (PS) and the wage-setting relations (WS) are equal. PS is essentially firms' bargaining position and the WS is essentially workers' bargaining position. The wages that workers demand are determined by the price level (P), and some function of the unemployment rate (u) and all other variables (z). z includes all factors that affect wages given the expected price level and the unemployment rate; this includes unemployment benefits such as Tim's "basic income."
W = P f(u,z)
The relationship between the wage demanded by workers, W, and the price level, P, is positive. The higher the price level, the higher wages workers will demand.
So far Tim is right. A basic income will give workers more "walk away" power at a given price level and a given level of unemployment. The problem is that these are not given.
Equilibrium in the labor market exists when PS = WS. The price firms charge for their goods in equilibrium is equal to their labor costs, W, multiplied by 1 plus some markup, x. The markup, x, is a constant value determined by how much market power firms have. In a perfectly competitive market, x = 0. To the extent that markets are not perfectly competitive, x is some positive value.
P = W (1 + x)
The relationship between price level and wages is positive. The higher wages firms pay, the higher prices they will have to charge.
So lets set PS = WS. To do this, first convert each formula so that real wages, wages divided by price level, are on the left side.
WS: W/P = f(u,z)
Remember that x is a constant value so the entire right side of the equation is a constant. Therefore if you increase z, (as Tim advocates), unemployment must increase. In the short run, higher unemployment benefits may temporarily increase wages, but in the medium and long run, the labor market will return to equilibrium.
To summarize: At a given unemployment rate, higher unemployment benefits lead to a higher real wage. A higher unemployment rate is needed to bring the real wage back to what firms are willing to pay.
So the net effect of Tim's plan would be to raise unemployment with NO effect on real wages.
Matt Ginivan is a junior at Princeton University where he majors in political economy. He is the captain of the rugby team and runs a blog at www.princetonlibertarians.org.
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