[Chapter 9 of Per Bylund's new book How to Think about the Economy: A Primer.]

How to Think about Regulatory Intervention

By regulations, we mean restrictions imposed on the economy by government: prohibitions, license requirements, quality or safety standards, price controls, quotas, and subsidies, etc. Although they differ in their specifics and in their stated purposes, they are all implemented to induce a change in the economy.

If regulations do not change anything, they are ineffective. This is because the specific restrictions are inapplicable or they are not enforced in practice. The point, however, is that all regulations are intended to impose some change and that they matter only if and to the extent that they do. Effective regulations, successful in producing the intended outcome or not, change behaviors and therefore the structure of the economy.

Some regulations are imposed on producers, whereas others target consumer behavior. The former may impose additional costs or prohibitions on some producers or artificially lower the costs of others. The purpose is to change the types of production projects undertaken and therefore the goods made available to consumers. The latter seek to change consumers’ behavior, which in turn affects producers because they must respond to the changed nature and structure of demand. In both cases, therefore, the outcome is a change in the economy’s production structure.

We know that the production structure is determined by entrepreneurs seeking to profit from satisfying consumer wants (chapter 5). Thus, for regulations to be effective, they must affect entrepreneurs’ behavior and change which production projects they choose to undertake. The observable outcome (what is seen), what did not occur as a result (the counterfactual or unseen), and the longer-term effects (the unrealized) are key to understanding the impact of regulations.

The Seen

The observable world is the obvious starting point to analyze a regulation’s effects but it can also be misleading. It is obvious because it is what we can see and measure. But studying it also leads to errors and premature conclusions because although the actual economy—its data—appears to provide straightforward facts about a regulation’s effects, it actually does not.

In a world in which a newly imposed regulation is the only change that takes place, we could easily compare the state of the economy before and after and thereby assess its effect. However, as the market is a process that is in constant flux, the regulation is decidedly not the only change—it is an imposition on the market’s ongoing unfolding and evolution.

Consider the case of imposing a minimum wage, which stipulates a price floor in the market. For such a regulation to be effective, its stipulated wage must be higher than what employers already pay. If the market wage is $10 per hour, the minimum wage must require that employers pay some higher amount—it must impose a penalty on or prohibit employers from paying a wage lower than the wage stipulated.

If the imposed minimum wage requires that employers pay $14 per hour, then that is the wage in the open market. Anything else would be illegal. Thus before and after comparisons would make it seem like people make more money after the imposition of the minimum wage. But do they? To figure this out, we must also consider what would have been the situation had a minimum wage requirement not been imposed—the counterfactual, or the unseen.

The Unseen

The “unseen” refers to the “other side” of the story—what otherwise would have happened. Since it does not happen, we cannot measure it. Yet it is the cost of any action or choice. If I choose steak for dinner, I forego all other possibilities I could have had instead. The highest value of those possibilities is the economic cost of the choice—the tradeoff is the value foregone.

Without a counterfactual, we look only at the presumed benefit but do not consider the cost. Thus, the analysis becomes one-sided, and we risk missing something important. We also cannot determine if it was a good or bad choice. Was it worth it? We need to know the cost to answer this question.

This applies also to regulations like the minimum wage in the example above. The typical purpose for a minimum wage is to raise workers’ wages. Considering only the seen would make the regulation seem successful, because after the minimum wage has been imposed there would be no one who makes less than $14 per hour. This would be a premature conclusion because we have not yet looked at the unseen.

We must thus ask what would have happened had that minimum wage not been imposed. It is important to recognize that the minimum wage does not magically raise wages but compels employers to not employ anyone for less than the stipulated wage. This is not the same thing as raising workers’ wages.

Let us consider an example of an employer who before the minimum wage is imposed has three employees. They are paid $7, $10, and $16 per hour respectively. The reason for their different wages is that their value contributions to the employer are not the same. The worker being paid $7 per hour is in job training, learning the trade, which explains the low wage. Once trained, and more valuable to the employer, the employee would expect to earn a higher wage in the future. The worker being paid $16 has a unique skillset that is particularly important to the employer’s line of production, making their contribution greater. This worker could easily get a job elsewhere if he was paid less. The worker earning $10 has no special expertise beyond job experience and therefore makes the market wage for regular workers, commensurate with his value contribution in the production process.

The employer would be unwilling to pay any of these workers more than their value contribution. They are employed for contributing to the value created, not subtracting from it. Paying them anything else would be charity—consumption, not production. The workers do not make less than their value contribution, either, because if they did, other employers could profitably hire them at a higher wage.

Now suppose a $14 per hour minimum wage is imposed. This means the employer is no longer allowed to pay anyone less than $14 per hour. The employer must decide whether to double the wage of the worker in training and raise the $10 per hour worker’s wage by almost half. The third worker, who already makes $16 per hour, is not directly affected. The employer is likely to let the worker in training go, because his productivity is lower than a regular worker’s—but his price is now the same.

The employer cannot afford to simply raise the $10 worker’s wage because his value contribution is more than $10 but less than $14. But by tweaking the production process, cutting benefits, and abolishing other perks, such as afternoon coffee breaks, this worker can be kept at the higher rate of $14. At least for now.

The seen, therefore, is that this employer paid an average wage of $11 per hour before the regulation was put in place and $15 per hour after. An obvious gain! The regulation worked. It magically raised workers’ wages.

The unseen, however, paints a different picture. If nothing had happened in the economy to change worker productivity or the profitability of the business, there would be three workers employed at a total of $33 per hour. Now there are two workers at a total of $30 per hour instead. Also, the lower-paid employee is now working harder to justify his higher wage.

Was the imposed regulation worth it? Economics cannot answer this question because it is a value judgment. But it can identify the regulation’s result and, therefore, show whether the regulation fulfilled its promise of raising workers’ wages (it did, for one worker; but it also resulted in another worker being laid off).

There is more to the story, because the seen and the unseen only consider effects in the present. However, as we now know, the economy is a process—the world we live in today has implications for the future too.

The Unrealized

Understanding that the market is a process provides further insight into the real effect of regulations on the economy beyond the seen and the unseen. To see how, we will continue the minimum wage example and work through the logic step by step with and without the regulation.

After the minimum wage has been imposed, the worker in training is laid off. Rather than making some money and gaining the experience necessary to propel his career, he is now looking for a job. However, as all employers are compelled to pay $14 per hour, the threshold to get a job is much steeper than before. Without training the worker just starting out cannot find a job where he would contribute at least that much to the bottom line, and since he also cannot get the experience that would increase his productivity, he remains unemployed.

Meanwhile the workers who retained their jobs are increasingly frustrated. The highest-paid workers feel unfairly treated because they did not receive a raise while the less productive colleagues received a 40 percent increase for no obvious reason. And now pressure to perform is higher too, and the more skilled worker is expected to assist the less skilled worker to make production run smoothly. It was better when there were three workers even though the third worker was still learning the trade. Now the two of them are struggling to produce what the three of them produced easily before.

The skilled worker, in turn, believes he earned a raise and is bitter about losing some benefits he used to enjoy. He remembers when he could take a coffee break, talk to colleagues, relax, and de-stress. It is more difficult to keep up now and he feels worn out as the weekend nears. Not to mention that the worker has been told not to expect a raise for the foreseeable future because his productivity does not warrant a higher pay.

This is the seen with an imposed minimum wage of $14 per hour.

In the counterfactual world, where there is no minimum wage, all three workers remain employed. Initially they are paid the same as before: $7, $10, and $16 per hour, respectively. But as the worker in training gains experience, his productivity increases, and the employer raises his wage, first to $8 and then to $10 when he’s as productive as other workers on the job market. Why would the employer raise the wage? Stepped raises may have been contracted earlier. Or maybe the employer wants to pay the worker a fair wage because otherwise he would look for and get gainful employment elsewhere.

The other two workers also increase their productivity and get raises. The employer can afford this because he did not have to increase one person’s wage by 40 percent but also because the workers produce greater value. The workers are paid higher wages because they contribute greater value and therefore contribute to the combined wealth and well-being of company, and society in general. So soon, they are paid $10, $12, and $17 per hour, respectively—a total of $39 per hour, an 18 percent increase paid for by increased production.

But this is still not the whole story. The wages earned by the three workers are their purchasing power, which they use to buy goods others produce. The workers’ demand, a result of their contribution to supply, makes revenue in other businesses possible.

We can now see that the difference between the seen and the unseen—the regulation’s cost—is not merely the unemployed worker. This is the immediate effect, which reduces total output but increases the marginal wage and output (by excluding the worker with the lowest productivity). However, what is also lost is the experience that this worker would have gained, and therefore his increased productivity over time. His future jobs and perhaps his career are lost. His increased production is also lost, and therefore the value he would have created for consumers, who will not be able to purchase those goods.

The unrealized are all those valuable opportunities that never come to be because of the regulation: the value of the goods that would have been produced, the trainee’s career, the workers’ demand for goods. The economy is on an overall lower-value trajectory, which means the loss is all the value that would have otherwise been attained.

This shouldn’t be surprising, because free-market production, albeit imperfect, is driven by entrepreneurs seeking to profit from serving consumers. When this order is upset, entrepreneurs cannot pursue what they expect will be the highest-value uses of scarce resources. This means that the most productive projects—including the job opportunities they create, at wages based on the expected value contribution, and the highest-value goods for consumers—will be lost. The unrealized is the true cost of regulations, and it far exceeds the unseen.