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Obama's Overtime Rule Defies Econ 101

Noah Smith is a Bloomberg View columnist. He was an assistant professor of finance at Stony Brook University, and he blogs at Noahpinion.
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The Barack Obama administration recently changed the rules for overtime pay. The rule affects only salaried workers, since hourly workers already receive overtime. Specifically, the new dictum mandates overtime pay for people earning salaries between $23,660 and $47,476, who previously weren’t guaranteed this benefit.

How should we expect this change to affect the economy and the workplace? The answer isn’t easy.

The temptation is to analyze it using the kind of simplistic intuition that often goes by the misnomer of econ 101. This is the idea that government rules about labor always end up pushing down wages and throwing people out of work. But that crude mental model just doesn’t work in the case of overtime rules.

The reason is that the econ 101 model of labor supply and demand assumes the price of labor is a single wage. But under overtime, there are actually two wages, not one. There’s the base wage, and there’s the wage paid on hours worked over the limit. With overtime rules in place, if you have 30 employees working 40 hours a week, that costs less than having 20 employees working 60 hours a week. So there’s no simple hourly wage, like in econ 101 -- it matters not just how many hours of labor you buy, but who you buy them from.

We can almost certainly expect overtime to push base wages down. This is because companies will try to adjust base wages lower so that employees’ total compensation stays about the same. Of course, this isn't always possible -- wages are “sticky,” meaning that it’s easier to give people raises than pay cuts. But it will mean that employers will restrain base wages from growing as much as they otherwise would. Employees will be more willing to accept this than they otherwise would, since they know that they’ll get extra money from the overtime hours. In the long run, this means lower hourly earnings for workers, though weekly earnings won’t change as much, and could even increase.

How about employment? There’s a good chance that overtime could lead to more people being employed, rather than less.

Suppose the generally prevailing wage is $20 an hour. Without overtime, it might make sense to hire one employee to do a job for 80 hours a week instead of two workers to do the same job for 40 hours each. The two-worker combination will be less productive than the single overworked employee, because they have to spend some of their time coordinating with each other. Though both options cost $1,600 a week, the second gets you less output, so you’d choose to hire just the one worker.

Under overtime rules, that calculus changes. Now, if you want to hire the single 80-hour-a-week employee, it’ll cost you $2,000 a week -- 40 of the 80 hours are overtime, so you have to pay $30 for each of those hours instead of $20. Now, it probably makes sense to hire the two workers, each for $20 an hour -- you’ll get a little less overall productivity, but you’ll save $400 a week!

In general, companies will probably react to overtime by doing both things -- cutting base wages, but also substituting more workers for longer hours. Reduced hours for some employees will probably translate into a higher number of jobs throughout society.

In other words, overtime rules might not really be primarily about boosting worker pay. They might be about creating jobs. Goldman Sachs predicts that this is exactly what will happen as a result of the new rule. The bank’s economists forecast a modest boost of about 100,000 new jobs.

Of course, that boost doesn’t necessarily make the new rule a good idea. Any policy with the potential to lower wages entails risk, as do the additional costs of regulatory compliance. And overtime rules probably will have other, less easily observable effects. For example, overtime pay gives employees an incentive to stretch out the time it takes to perform their tasks, spending more time at work in order to collect more money. That in turn gives employers reason to monitor their employees more closely. That might raise productivity at companies throughout the country, or it might simply waste effort and make work less pleasant.

So no one really knows what to expect from overtime rules. Meanwhile, the economics literature on the topic is relatively thin. Let’s hope that this policy experiment yields some good data that we can use to figure out its effects a few years down the line.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

To contact the author of this story:
Noah Smith at nsmith150@bloomberg.net

To contact the editor responsible for this story:
James Greiff at jgreiff@bloomberg.net