I’m Lovin’ It. But if that Counter Guy Gets $15/hour, I’m Lovin’ Less of It

I see that McDonalds employees from around the country have been walking off the job to protest low wages, even causing some restaurants to shut down temporarily.  What would happen, do you suppose, if McDonalds started paying its employees more?

Writing in ForbesTim Worstall makes the extraordinary claim that McDonalds could raise workers wages to $15 an hour and it would have no impact on the price of a Big Mac!  This is such an extraordinary claim that I will go ahead and quote it at length:

Hmm. Well, what else can we surmise about a rapacious capitalist organisation? In that ruthless pursuit of gelt and pilf for its shareholders it is going to gouge the customers for the absolute maximum that it can, yes? … What limits McDonald’s ability to entirely empty our wallets every time we want a hamburger is that there are other people who will also sell us one. Wendy’s, Jack in the Box, In and Out, there’s a multiplicity of places where we can go to fur our arteries. Which leads to our conclusion on pricing in a capitalist and free market economy. The capitalists charge the absolute maximum they can get away with, that ability being limited by the competition that comes from alternative suppliers.

Thus the price is not determined by the cost of production of an item. Which means that, if we raise McDonald’s production costs by increasing the wages of the workers, the price isn’t going to change. For it’s not production costs that determine prices: it’s competition that does. Another way to put this is that McDonald’s is already charging us the absolute maximum that it can for its current level of sales. Thus it cannot raise its prices if its production costs go up.

All of which means that the real change in the cost of a Big Mac, or the dollar menu, if McDonald’s workers were paid $15 an hour is: nothing. For production costs simply do not determine the prices that can be achieved in a competitive market.

I’m not sure I’ve ever heard anyone argue that costs don’t matter in determining prices:  Every text that I’ve taught out of walks through the logic of a firm’s profit maximizing decision — firms maximize profits by setting output where marginal revenue equals marginal cost.  So, costs do help to determine prices, at least the way I teach it.

So what is Worstall talking about?  Good question.   I can think of several scenarios where a steep increase in the wage rate would not increase McDonalds’ prices (in the short-run, at least).

The first is simple enough:  wages are a fixed cost and do not affect the marginal costs at all.  In the short run there is no effect.  For firms with a lot of salaried employees, it is possibly reasonable to assume that labor costs are fixed in the short run, but my restaurant experiences suggest that labor is very much a variable cost:  during busy times I stayed and worked more hours, and when no one was the restaurant they sometimes made me clean the restaurant (you’ve got time to lean, you’ve got time to clean), but then they would send me home.  So, I suspect that a sharp increase in the wage rate would indeed increase McDonalds’ marginal costs.  If there is a downward sloping demand curve for McDonalds hamburgers, then an increase in marginal cost would lead to higher prices and less output.

The second possibility is probably more what Wortstall had in mind – that McDonalds does not have a downward sloping demand curve for its product (as Worstall says: “it’s not production costs that determine prices: it’s competition that does”). In other words, the demand curve  at the firm level is perfectly elastic.  Then if only McDonalds raises its wages, then it would not be able to raise its prices.  That said, even with a perfectly elastic demand curve, higher marginal costs would lead to lower McDonalds output.

Of course, this second scenario only holds if McDonalds isn’t big enough to affect the industry short-run supply curve.  If McDonalds wages paid are big enough to move the marginal cost curve at the industry level, the prices for all firms would increase in a competitive industry! And any claim that wage increases don’t affect prices does not carry over in the case were all fast-food firms raised their employee wages.  If all firms pay higher wages, the industry short-run supply curve would shift to the left, leading to higher prices for everyone’s burgers in the short run, even in a perfectly competitive industry.  So an increase in the minimum wage to $15 would certainly lead to higher marginal costs, and therefore higher prices.

In other words, competition is a product of both supply (cost) and demand forces.  So, again, I’m not sure where the insight comes from that costs don’t determine prices: Costs are half the story.

Even if McDonalds didn’t raise prices in the short run, it is almost certain that prices would go up in the long run.  Whether a fixed or variable cost, higher wages would increase McDonalds’ average costs. In a perfectly competitive industry if only McDonalds faced higher wages, every McDonalds store would simply go out of business.  If every firm faced higher wages, then the long-run supply curve would shift to the left, leading to higher prices and less output.

A third scenario is that the industry is a competitive, increasing-cost industry, where McDonalds enjoys a substantial cost advantage.  If the wage increases are not substantial enough to raise McDonald’s long-run average costs above the industry price, then the wage increase would squeeze McDonalds’ profit margins without any other industry-wide impacts.  Such a result, however, is not driven by market competition, as Worstall avers, but on a possibility that McDonalds already enjoys a substantial cost advantage over others in the fast-food industry.

So, what’s the bottom line here?  If you double your employee’s pay, the market price is going to rise unless (1) you already enjoy a significant cost advantage over your rivals or (2) you go out of business.

For more on McD’s, check out this delightfully in-depth post from “the Grumpy Economist,” John Cochrane.  I seem agree with most of that, especially about the labor-capital substitution, though I am not really all that grumpy most days.