Minimum Wage and Prices

Raise the minimum wage

There is a lot of talk about raising minimum wage.  Of course this is a tough political issue with one side claiming it will cost jobs and the other side claiming people can’t live on $7.25 an hour.  This blog is about neither of those things.  This blog is about what will happen to prices.

The short answer is, prices will go up as minimum wage goes up.  Many of you loyal readers know that costs don’t drive pricing, so you may be wondering why increasing minimum wage (a cost) increases prices?

First, some numbers and some math.  And to keep it easy, let’s focus on McDonald’s.  According to Market Realist, 24.6% of McDonald’s revenue is taken up by their labor costs.  (Most restaurants run between 25 and 40%).  Even with these low labor costs, McDonald’s only makes 3.6% profit.

Throughout the blog we will assume that labor rates will double with the new minimum wage.  Unions are asking McD’s to go from $7.25 to $15 minimum, more than double.  Of course, not everyone at McD’s is only making minimum wage, but to be consistent, let’s just assume overall labor costs double.  The same story will hold true if labor costs only go up 40%, just the numbers won’t be as big.

First, what happens if a single McDonald’s owner decides to double wages on his own.  If he doesn’t increase prices, he will go out of business.  He just added another 24.6% of his revenue as additional cost which swamped his tiny 3.6% profit.  He’s now losing money.  For every dollar in revenue he brings in, he will spend $1.21.

Alternatively, he could raise prices.  In order to maintain his 3.6% profit margin, he would have to raise prices about 25%.  Do you think if a single McDonald’s had 25% higher prices than competing restaurants, that would effect whether people go to that McD’s or another McD’s or another fast food restaurant? Of course.  Again, he would likely go out of business since his business would fall off due to high prices.

So a single McDonald’s can’t significantly raise wages for his or her employees without jeopardizing the business.

The same story holds true if all McDonald’s franchises decide to double wages.  Instead of paying 25% more at McD’s many people would shift their preferences to Burger King, Wendy’s, Subway, Taco Bell, etc.  McDonald’s as a chain would become less competitive and would suffer harm.

If you disagree with that previous paragraph, meaning you think McD’s could raise prices by 25% and be fine even if everyone else doesn’t, then please answer this.  Why doesn’t McD’s raise prices by 25% today (without increasing wages) just to make more profit?

Finally, what happens if ALL fast food restaurants had to double their rates?  In this case, all prices would go up approximately 25%.  That 3.6% profit margin is an established equilibrium price in the market.  All fast food chains would increase prices to cover their increased costs and the market would probably find the same 3.6% equilibrium point.  This is identical to what happens to the price of gasoline when the price of oil goes up for everybody.  Every station raises prices, yet the market eventually settles to the same equilibrium margins.

On April 1 Seattle, WA began implementing their new minimum wage of $11 per hour going to $15.  Seattle suburbs though still have the older state minimum wage of $9.47 (the highest in the nation).  What will happen is restaurants inside the city limits will raise their prices if they want to stay in business and those outside the city limits will not. Those deep inside the city limits will be fine because all local competitors will also raise their prices.  Those far outside the city limits will remain unchanged because all local competitors remain unaffected.

The challenge will be those restaurants near the border.  A McD’s owner just inside the city limits needs to raise prices to cover costs, but may not be able to because of competition just on the other side of the border. This will cause some restaurants on the wrong side of the city limit to close their doors simply because they can’t compete with nearby restaurants that have lower costs.

At the same time, we will see some restaurants just outside the city limits raise prices because they can.  A McD’s owner just outside the border will have less competition because those inside the city limits need to raise prices.  This owner just outside the border may choose to raise prices and, since his labor costs didn’t change, will make more profit.  It’s much better to be the McD’s owner just outside the border.  (It’s better to have lower costs than your competition.)

In the end, increased minimum wages will increase the prices we pay at restaurants. They have to. Otherwise these restaurants will go out of business.  They aren’t even making enough profit to cover the proposed increase in wages.  Raising minimum wage acts like a tax on diners where the tax is redistributed to those who make less.  Everybody pays more so some people can make more.  Opinions differ on whether this is good or bad, right or wrong.  Whether benevolent or evil, it is a truth.  Prices must go up as minimum wage increases.

Photo by The All-Nite Images