You don’t understand Minimum Wages

I am a business owner, and I’d like to point out something: everything you think you know about minimum wages is wrong.

The case is often made that raising minimum wages will not do anything, because business will simply pass this extra cost along to customers in the form of higher prices. This is true, they will do exactly this. But the results are still positive for the business, the individual, and the community. Here’s why.

Let’s say a business pays employees $10/hour, the minimum wage. Lets say that labor makes up 50% of total costs. That is, in fact, really high. Most businesses’ labor is not that large of a slice of the pie. Once upon a time, I was a Starbucks Store Manager, and I had P&L visibility. This business, like other chain retail food service, often claims to be labor intensive, yet labor was consistently around 20% of revenue. This doesn’t account for the overhead labor, executives and accountants and marketers, but their cost is spread over tens of thousands of stores and wouldn’t dramatically change this number.

If minimum wages go up to, say, $15/hour, what exactly has happened?

Any business owner or their lobbyist will tell you, quite loudly, that costs have gone up and that this will force them to cut employment. Indeed, the wage has increased by 50%. Indeed, this means the business’ cost goes up 50%. If labor cost was 50% of revenue, the new labor cost is 75% of revenue. Obviously, prices need to rise by 25% to pay for the extra cost, or the business needs to cut a third of its labor (getting back down to 50% labor cost means shaving 25% from 75%, hence a third. Don’t get lost in all the numbers!). Most businesses are already running pretty lean. Sure, some inefficiencies are always available, but if a firm can cut a third of its labor requirement it would have done so already. So, naturally, prices will rise by 25%.

But the employee now makes 50% more. The cost of buying stuff has gone up 25%, but his purchasing power has gone up even more. The employee earning the new minimum now has more purchasing power than they did before, despite higher costs. The effect on the business will actually be increased sales, because the consumer has more income and the cost has been completely offset.

In this conversation, business owners always point out that their costs will go up. They never seem to understand that their customer’s purchasing power goes up at the exact same time.

This pattern holds true for every business where labor is less than or equal to 100% of revenue. That is to say, all businesses. Its very simple math. Unless labor cost is higher than revenue (in which case the business is already a zombie, or is making a strategic , short term investment), any increase in wage will always generate a higher purchasing power increase for the individual, even if every penny of the increase is passed along directly and unashamedly to consumers.

Even taking employment taxes and benefits into account does not change this math. I left them out of the simple model above, to make the math easier to follow. Taxes are always expressed as a percentage of wages, so the scale proportionally in the exact same manner. Benefits are either a percentage type, like a 401K, and scale up and down proportionally also, or they are a fixed cost, such as a medical premium, in which case they actually go down as a percentage of total revenue.

“The customer’s purchasing power goes up at the exact same time as the business cost.”

All of this works because it is a mandated minimum. If a business voluntarily tried to do this, it wouldn’t work. Why? Because they would be paying a higher cost, but not every customer would be receiving the benefit of a higher wage, since the firm does not employ every consumer. They may not be able to raise prices accordingly without possibly losing revenue to competitors.

The most affected groups are those who make a little above the new minimum wage, in this instance, people earning 15–20/hour, whose real purchasing power has declined. However, the Seattle experience has shown that the effect of the wage hikes at lower levels propagates upwards very quickly, resetting all wages at a higher level, increasing sales for all businesses, and creating a booming economy. In fact, this is really critical — the speed by which the increased wages spreads upwards through the employment chain is important — because the only threat to a higher minimum wage is when the effect does not ripple upwards. Allow me to explain.

When the minim wage goes up, anyone making the former minimum experiences the full purchasing power gain. Those who make more than the former wage, but less than the new one, also get a bump in purchasing power, but not all of it, unless their wage resets to proportionally higher then the new minimum. Those who make just above the new wage actually lose purchasing power, and perhaps quite a bit, unless their wage also resets higher. Those even further above lose purchasing power too, and how much exactly diminishes the further your wage gets from the new minimum.

It turns out that around 20% of the US workforce currently makes less than the new $15/hour minimum wage from our example. That means the other 80% of employees will lose some amount of purchasing power if their wages do not reset. This is the only defensible economic argument against a minimum wage increase. However, even this should be ignored. The labor market is not static. Workers across the pay spectrum will demand increases commensurate with the new cost of living, and business will either provide them or suffer talent drain. Again, the experience in Seattle has shown that this happens pretty rapidly.

In fact, the target market of different industries helps here. Higher wage employers tend to not be concerned with the wage increase because the ensuing cost of living increase is a small fraction of their total cost and probably has no effect on the consumption of their product either way. Microsoft isn’t in danger of losing customers when the minimum wage goes up, and they will barely notice the cost of living adjustments to their bottom line. On the other hand, employers that pay lower wages and will see the biggest cost increases tend to have a product that is consumed more by consumers in the same income bracket as their employees, and hence their consumers gain the most purchasing power. Think McDonald’s.

The funny thing is, McDonald’s and ilk are the loudest critics of such increases, but they actually have the most to gain from these increases. In the simple model above, the business raised its price by the exact amount of the increased cost. But, remember, the firm’s customer has more income above and beyond the additional extra price increase. This is an amazing opportunity. The firm could have raised prices by more than its increased costs, while still being relatively cheaper to the customer. Let me explain.

The business’ cost went up by 25%, so they raised prices by 25%. The customer now has 50% more to spend, though. What if the business raised its price by 30%? The product is still cheaper to the customer than it was before the increase, so if they bought it before they are still going to buy it now, and probably buy more of it than before. Meanwhile, the business was able to raise its prices 5%, and the customer didn’t even notice. In fact, sales probably still went up, and margin definitely went up. In other words, the return on investment for a higher minimum wage is positive for lower end firms. Every dollar of increased wage returns more than a dollar of profit, with very little risk involved. Businesses like McDonald’s should advocate for an increased minimum wage.

There is a restaurant in Seattle, the Ram, that responded to the Seattle minimum wage increase in a typical, reactionary way. The day of the new minimum, they posted signs on their tables informing their customers that they would now see a 20% service charge on their bill to cover their extra cost, and that tipping would go away, with some of the new fee going to the server and the rest to the employer. Naturally, there was outrage. Customers revolted, talented employees fled, and eventually they reversed course.

A more nuanced approach would have been to simply raise prices. Customers are used to this, it happens often, and at that moment most consumers were expecting to see some of this as the new law went into effect. The Ram’s labor is probably similar to Starbucks, around 20% of revenue, so a mere 10% price increase would have been all that is needed. A $1.95 charge for a soda would now be $2.15. Customers probably wouldn’t have even noticed. They certainly would not have significantly modified their purchases. In fact, the business could have rounded up to $2.25 without much fanfare, and pocketed the extra revenue as pure profit.

“Smart businesses should advocate for an increased minimum wage.”

The problem is that business owners are too often locked into seeing the world through their costs. I get it. This is the one thing you can control better than anything else. They only see the new cost, never the new revenue. They are failing to see the opportunity. The smartest businesses should be promoting a new minimum wage, because they see it for what it truly is: not a wage hike, but a stimulus plan.

This doesn’t mean the minimum wage can go up forever. I don’t know the break point, I haven’t modeled it. I know the math always works for businesses. That’s not the problem. At some point, the minimum wage is so high that janitors and doctors are paid the same or almost so, at which point, why go through all the trouble of obtaining a doctorate? Would people do it anyways, for the joy of the profession? Or would we no longer be able to staff hospitals?

I am not sure how the economics would play out as the minimum wage got very, very high. I do know that we are no where close to such a worry, and there is a lot of room to make society better for individuals and businesses, and it starts with a higher minimum wage.

Written by Page Russell.

Follow me while I complain about stuff on twitter: @pagerussell