Introduction

Brief History of the Federal Minimum Wage

Studies of the Impact on Employment of Raising the Minimum Wage

The Minimum Wage Game

 

Introduction

Back in April 2105, McDonald’s announced that in response to worker demands for higher wages, it would raise wages to the lowest paid employees to $1 above minimum wage. McDonald’s rationale for the pay raises was to increase the motivation of their employees to provide better customer service. As Kaja Whitehouse and Paul Davidson report in “McDonald's raises pay for 90,000 workers”:

McDonald's, which has been struggling with workers protests and sagging sales, plans to increase pay for some 90,000 workers starting in July, the company said on Wednesday.

The pay increase will lift the average hourly rate for its U.S. restaurant employees to $1 above the mandated minimum wage on July 1, the company said. McDonald's said it expects average wages to rise to more than $10 an hour by the end of 2016.

…

CEO Easterbrook said the pay increase is meant to motivate workers.

"We know that a motivated workforce leads to better customer service so we believe this initial step not only benefits our employees, it will improve the McDonald's restaurant experience," he said in a statement. "We'll continue to evaluate opportunities that will make a difference for our people."

Typical of those for and against higher minimum wage, the pro groups generally insisted that the dollar raise wasn’t sufficient, that the federal minimum wage should be raised to $15 per hour, while the anti groups warned that increases in wages would lead to higher prices, lower profits, and/or job losses.

Recently, McDonald’s reported that they have, indeed, been seeing greater worker productivity following the wage increases. Noah Smith, in “U.S. Companies, Try This: Raise Your Minimum Pay,” reports:

Recently, McDonald’s decided to raise wages for many of its hourly restaurant workers. The rise is modest, from about $9 to about $10, but already the company’s executives claim that they are seeing improvements in service quality:

“It has done what we expected it to --90 day turnover rates are down, our survey scores are up—we have more staff in restaurants,” McDonald’s U.S. president Mike Andres told analysts at a UBS conference... “So far we’re pleased with it."

…

But Why? If it helps the bottom line to raise wages, why haven’t companies done it already?

As Noah Smith asked in his article, if raising wages increases worker productivity, then why haven’t more minimum wage payers increased their wages above the minimum?

This analysis examines the dynamics between

1. Employers of Unskilled Employees, 
2. Unskilled Employees, and
3. Customers.

The purpose of the analysis is to better understand

• The circumstances under which employers of unskilled workers will generate net benefits by raising wages above the federally established minimum, and

• The impact that increases in the minimum wage have on players’ actions and outcomes.

 

A copy of the analysis can be downloaded by clicking on the link below this blog entry.

Brief History of the Federal Minimum Wage

Trends in the Federal Minimum Wage

Let’s start with a brief history of the federal minimum wage. According to U.S. Minimum Wage History,

A federal minimum wage was first set in 1938... The 1968 minimum wage was the highest at $10.85. The real dollar minimum wage … falls when Congress does not raise the minimum wage to keep up with inflation… The minimum wage has varied from a maximum of 99% of the poverty level in 1968 and has averaged 60% of the poverty level since 1989.  

Figure 1 illustrates the differences over time in

• Left-Hand Axis

♦ The federal minimum wage (in real dollars);

♦ The average hourly earnings by employees in the private sector (in real dollars); and

♦ The poverty level.

• Right-Hand Axis

♦ The minimum wage as a percentage of the average hourly wage, and

♦ The percentage of workers paid the minimum wage.

Figure 1

 

A couple of points to note from Figure 1:

• The minimum wage peaked in 1968 at $10.69 per hour, at a rate slightly below the poverty level ($10.91 per hour).

• Currently, the minimum wage is $7.25. If today’s minimum wage were at the same real level as the 1968 peak, then the current minimum wage would be 47.4% higher than it currently stands.

• At its peak in 1968, the minimum wage was 54% of the average hourly wage in the private sector. Currently, the minimum wage is 36% of the average hourly wage in the private sector. That is, the minimum wage has decreased over time relative to the average hourly wage. This reflects a combination of (i) people today having more education, and (ii) people with more education receiving relatively higher wages. (see Figure 2) (More on this below).

• The portion of workers that earn the minimum wage has decreased over time, from 13% in 1979 to 4% today. This probably reflects the fact that over time an increasing number of states have implemented minimum wages that exceed the federally mandated minimum (US Department of Labor, “Changes in Basic Minimum Wages in Non-Farm Employment Under State Law: Selected Years 1968 To 2016”).

Now let’s try to better understand the dynamics over time of wages for unskilled versus skilled workers. In “Skill Premium – Income by Education,” Our World In Data presents a breakout of the wage premiums over time accruing to skilled and unskilled workers (see Figure 2).

Figure 2

 

Source: http://ourworldindata.org/data/education-knowledge/skill-premium-income-by-education/

What the trends show is that wages of educated (skilled) workers have been increasing over time for both men and women, while wages of unskilled workers have been relatively constant over time for men, but increasing slightly for women. The increases in unskilled wages for women probably reflect a narrowing of the male-female wage gap.

Figure 3 presents the distribution over time of educational attainment by the population, which shows that people have become more educated over time.

Figure 3

 

Source: https://www.census.gov/hhes/socdemo/education/data/cps/historical/fig2.pg

The changes in the wage premiums shown in Figure 2 (increases in returns to education), combined with the distributions of educational attainment in Figure 3 (increases in portion of workforce that is educated), generate increases in the average wage over time, as illustrated in Figure 1.

The comparison presented above (in Figure 1) indicated that the minimum wage has decreased over time relative to the average hourly wage. When considered in light of the information presented in Figures 2 and 3, it becomes clear that the decreases over time in the minimum wage relative to the average wage are mostly due to increases in wages for skilled labor, rather than decreases in wages for unskilled labor.

 

Characteristics of Federal Minimum Wage Workers

Now, we ask: What are the characteristics of minimum wage workers? It turns out that minimum wage workers tend to be younger, less educated, unmarried workers in the food services industry. From BLS, “Characteristics of Minimum Wage Workers, 2014”:

Age. Minimum wage workers tend to be young. Although workers under age 25 represented only about one-fifth of hourly paid workers, they made up nearly half of those paid the federal minimum wage or less…

Education. Among hourly paid workers age 16 and older, about 7 percent of those without a high school diploma earned the federal minimum wage or less, compared with about 4 percent of those who had a high school diploma (with no college), 4 percent of those with some college or an associate degree, and about 2 percent of college graduates.

Marital status. Of those paid an hourly wage, never-married workers, who tend to be young, were more likely (7 percent) than married workers (2 percent) to earn the federal minimum wage or less.

Occupation. Among major occupational groups, the highest percentage of hourly paid workers earning at or below the federal minimum wage was in service occupations, at about 10 percent. Almost two-thirds of workers earning the minimum wage or less in 2014 were employed in service occupations, mostly in food preparation and serving-related jobs.

Industry. The industry with the highest percentage of workers earning hourly wages at or below the federal minimum wage was leisure and hospitality (18 percent).  Over half of all workers paid at or below the federal minimum wage were employed in this industry, the vast majority in restaurants and other food services. For many of these workers, tips may supplement the hourly wages received.

 

Pros and Cons of Raising the Federal Minimum Wage

Finally, here’s a very brief summary of the major pros and cons for and against raising the minimum wage, as presented by Chad Halvorson (his list of points, my summaries of his points):

Pros of Raising the Minimum Wage

• Economic Stimulus: Minimum wage workers will have more money to spend, which will ripple throughout and stimulate the economy.

• More opportunity for jobs: Economic stimulus (previous bullet point) will stimulate creation of more jobs.

• Reduced Expense for Social Programs: Many minimum wage employees are also on government social programs; if they earn more money, they will need less government support.

• Decreased Turnover Rate: Employees who are earning more money are generally happier and less likely to change jobs, which reduces the costs of hiring and training new employees.

• Inflation: The minimum wage has to keep up with inflation.

Cons of Raising The Minimum Wage

• Layoffs and Fewer Hirings: Higher wages increase costs. Business owners will have to reduce hours or number of employees to remain profitable.

• Price increase: Employers might have to raise prices to offset the costs of higher wages.

• Competition Will Intensify: More overly- qualified people will compete with unskilled labor for minimum wage jobs.

• Applied Inconsistently: Many states have their own set minimum wages that are above the federal minimum wage.

 

Studies of the Impact on Employment of Raising the Minimum Wage

The impact on employment of increases in the minimum wage “is one of the most studied topics in all of economics,” and the general consensus of the empirical studies is that increases in the minimum wage have no discernable impact on employment. As John Schmitt indicates in “Why Does the Minimum Wage Have No Discernible Effect on Employment?”

The employment effect of the minimum wage is one of the most studied topics in all of economics. This report examines the most recent wave of this research – roughly since 2000 – to determine the best current estimates of the impact of increases in the minimum wage on the employment prospects of low-wage workers. The weight of that evidence points to little or no employment response to modest increases in the minimum wage.

John T. Harvey, in “Raising Minimum Wage Is Not The Answer,” provides an insightful and sensible explanation for this lack of impact on employment of increases in the minimum wage. He suggests that “Changes in wages are secondary factors in the national labor market; demand is, by far, the primary one.”

The results of economic studies of the effect of minimum wage laws on employment are actually very mixed. Some show that employment rises, some that it is unaffected, and some that it falls. Furthermore, they are often statistically insignificant …This is consistent with the above argument. Changes in wages are secondary factors in the national labor market; demand is, by far, the primary one. The falling unemployment of the 1920s was a result of the booming economy (driven in particular by the automobile industry), not a fall in wages; the Great Depression occurred not because wages suddenly jumped, but due to the fact that investment spending collapsed; World War II reversed this not with lower wages, but with rising demand created by the wartime economy; et cetera, et cetera.

Likewise, the most effective means of increasing the incomes of the poor is not to legislate an increase in their wages, but to stimulate the demand for labor to the point that firms are induced to pay more by choice. Make them want to pay in excess of the federal minimum wage because they cannot otherwise find enough employees to meet customers’ demands.

 

The Minimum Wage Game

I this section I examine the dynamics in the Minimum Wage Game. The players in the minimum wage game include (i) Employers, (ii) Unskilled Workers, and (iii) Consumers of the Employers’ products and services, who potentially include the Unskilled Workers themselves (see Figure 4).

My analysis focuses mostly on the Employer’s situation, since he is the one who makes the decisions as to whether or not to hire Employees and which wage rates to offer. My analysis seeks to answer two separate questions:

1.  Under what conditions in the economic environment will Employers be more likely to pay Unskilled Employees a premium over the minimum wage?

2.  Under what conditions in the economic environment will increases in the minimum wage have a larger impact on decreasing Employers’ incentives to retain and/or hire Unskilled Employees?

The first question is the classic issue explored in most studies of the impact of increases in the minimum wage on employment rates. The second question was inspired by the situation I described in the introduction to this analysis, in which McDonald’s has experienced increases in employee effort and decreases in turnover rates after having increased the amount it pays its Employees to a level above the minimum rate.

Figure 4

 

Simple Illustrative Model of Employers’ Profits

Before moving on to my model of the Employer’s situation, I thought I’d provide a very simple model to present the basic dynamics of the Employer’s profit maximization problem. The purpose here is to better understand the basic model as a means of understanding my slightly more complicated model of Employers’ profits for the Minimum Wage Game.

Suppose we have the following basic relationships:

Employers choose price to maximize profits, where

(1)  Profits = P · Q(P) – C(Q),

P is the price of Employers’ products;

Q(P) is Consumer demand (quantity) for Employers’ products, which is dependent on price; and

C(Q) is the cost to Employers of providing their products, which is dependent on the quantity of products sold.

Consumer demand is a simple function of price:

(2)  Q(P) = A · P^e

A is the constant of demand; and

e is the price elasticity of demand, that is, the sensitivity of demand to price; e < 0 and generally e < -1.

The Employer’s cost is a function of the labor needed to sell a quantity, Q,:

(3)  C(Q) = W · N(Q)

W is the wage rate; and

Each Employee can sell up to n units, so the number of Employees, N, needed to sell Q units is

(4)  N(Q) = Q / n,

where n can be considered a measure of Employee efficiency or productivity.

So we have the Employer’s total profits are

(5)  Profits = P · Q(P) – C(Q)

      = (A · P^1+e) –  (A · W / n) · P^e

If we choose price to maximize profits, we get that the profit maximizing (i.e. optimal) price, P* solves the following first order condition:

(6)  (1+e) · (A · P*^e ) – (A · W / n) · e · P*^(e-1) = 0

Solving equation (6) for P* gives us:

(7)  P* = ( W / n) [e / (1+e)]

Note that since generally e < -1,

(8)  [e / (1+e)] > 0.

The optimal price in equation (2), together with equation (7), gives us the optimal quantity sold:

(9)  Q* = A · { ( W / n) [e / (1+e)] }^e

And from equation (4), together with the optimal quantity sold in equation (9), we get the optimal number of Employees:

(10)  N* = (A / n) · { ( W / n) [e / (1+e)] }^e

Based on our simple model, Figures 5 and 6 display the impacts on (i) price, P; (ii) quantity sold, Q; and (iii) number of employees, N; as each of the parameters of the model changes:

Figure 5

 

Figure 6

 

What this simple model shows is that generally

• Employers, Employees, and Consumers all benefit from higher demand and greater Employee productivity.

• Employers and Consumers are worse off when wage rates are higher. The Employees who keep their jobs are better off, because they are earning a higher wage. However, Employees who lose their jobs after the cost of labor increases are worse off (this is what the Anti-Minimum Wage group is basing their position on).

• Employers lose, while Employees may benefit a little, when Consumers are more sensitive to price.

Another dynamic that is illustrated in the simple model is the margin-volume tradeoff.

• High Margin: If (enough) Consumers are less sensitive to price, or alternatively, if (enough) Consumers are willing to pay a higher price for higher quality, then Employers will maximize profits by choosing a margin strategy. That is, they will maximize profits by catering to the Consumers with a preference for high quality, in which Employers increase quality, increase price, and decrease sales volumes. Consumers benefit from being able to Consume high quality products, Employees benefit from generating wage premiums to compensate for providing high levels effort to generate the quality products Consumers prefer, and Employers benefit from higher profits.

• High Volume: If, conversely, Consumers are more sensitive to price, then Employers end up playing a volume game. That is, they set prices at low levels, skimp on wage premiums so as to be able to offer lower prices, and sell larger volumes of lower quality products. Consumers who prefer lower prices benefit, but Consumers who would rather have higher quality products lose out, Employees lose out because they earn lower wages, and Employers lose out by generating lower profits.

 

More Complete Model of Minimum Wage Game

The simple model describes the situation that’s (i) examined in most studies of the minimum wage and (ii) discussed in most media articles on the minimum wage. However, there is an important element that the simple model fails to capture: product quality, which is enabled by Employee effort.

A more complete model of the situation would capture the impact of increases on the minimum wage, not only on employment levels, but also on the quality of products provided. One of the most notable aspects of product quality is customer service, which includes such characteristics as the attentiveness and speed at which Employees provide products and services to Customers. The provision of good customer service requires Employees to provide higher than minimum levels of effort in the performance of their work. In the food services industries, which employ almost two-thirds of minimum wage workers, customer service can be an important determinant of whether businesses thrive or falter.

In my model of the Minimum Wage Game, I specifically account for levels of effort and consequential levels of product quality that Employers and Employees provide Customers.  Under this more complete version of the Minimum Wage Game, we can better examine the impact of increases in the minimum wage, not only on levels of employment, but also on levels of product quality.

Unskilled Employees/Consumers

I assume Unskilled Employees choose the amount of Effort to provide each Employer so as to maximize utility, given the availability of welfare and unemployment benefits and the wage rates and prices offered by various Employers.

I assume that Employees, who are also Consumers, don’t like to exert effort for work, but they do enjoy consuming products and services. The amount they can consume is restricted by the amount they earn, and the amount they earn will depend on the amount of effort they provide Employers, where greater effort generates higher wages.

Employers

I assume Employers choose which wage premiums to set (above the minimum wage) and prices of products and services to set so as to maximize profits, given efforts provided by Unskilled Employees and demand from Consumers for Employers’ products and services.

I assume Employers can generate profits, either by selling high volumes of low quality products at low margins, or by selling low volumes of high quality products at high margins. I assume that sales of higher quality products are more profitable than sales of lower quality products.

I assume the production of high quality products requires Employees to put forth higher levels of effort. Due to the greater profitability associated with higher quality products, Employers are generally willing to pay Employees higher wages if they put forth more effort. However, I assume that at the time Employers must set their wage rates, they don’t know what level of effort Employees will end up providing.

Let’s examine the Employers’ profit functions in more detail.

Employers’ Price Functions

I assume Employers choose prices, P, to set for their products and services and then sell the amount of goods and services demanded by Consumers at that price, Q(P).

I assume price is a function of the wage that Employer j pays Employees relative to the wage other Employers pay similar Employees. Since the analysis focuses on the minimum wage, I assume workers at issue are unskilled and the wage rate Employers pays their workers is taken relative to the minimum wage. In this case, we have

(11)  P = P( 1 + Wage Premium )

I assume that wage premiums differ across Employers, where Employers whose products and services require greater Employee effort pay higher wage premiums.

Employers’ Demand Functions

I assume the demand functions that Employers face depend on the prices they charge, where higher prices lead to lower demand by Consumers.

I assume the demand functions also depend on the quality of the Employers’ products and services. Employees who put forth more effort for their Employers contribute to higher product qualities and better customer experiences. So, Consumer demand will increase with Employee effort.

There are generally factors other than those associated with efforts provided by Unskilled Employees that affect demand for Employers’ products and services, such as product quality and consistency. I capture those indirectly in the constant of demand and the constant of price (higher quality Employers will generate higher sales volumes and higher prices, all else held constant).

Finally, as indicated in the section above, Impact on Employment of Raising the Minimum Wage, perhaps the most important factor contributing to the demand for Employers’ products and services is a “booming economy.” As a proxy for the state of the economy, I use Consumer income, reasoning that Consumers who have more income have greater demand for products and services, which creates a booming economy.

So now we have the Employers’ demand functions as:

(12)  Q = Q (Population Income, Employee Effort, Price),

Employers’ Cost Functions

I subdivide Employers’ costs functions into three sub-components:

(i) A component capturing the wage costs for Unskilled Employees;

(ii) A component capturing the turnover costs associated with hiring and training Unskilled Employees; and

(iii) A component that captures all other costs, including wage costs for Skilled Employees.

So, putting the three cost components together gives us Employers’ cost functions as:

(13)  Total Costs  = Total Costs (Wage Costs + Turnover Costs + Other Costs)

Employers’ Profit Functions

Putting all the pieces of the Employers’ profit functions together yields the following.

Employers choose Wage Rates, Number of Employees, and Price to

(14)  Max [P( 1 + Wage Premium ) • Q(Population Income, Employee Effort, Price) ]

– Total Costs (Wage Costs + Turnover Costs + Other Costs)

Theoretical Impact of Higher Wages on Employers’ Profits

Now let’s consider how various factors in the economic environment affect Employers’ profits.

The price at which Employers choose to sell their products and services must be high enough so as to enable them to cover their costs.

Furthermore, the price at which Employers choose to sell their products and services will be constrained by the extent of competition in the market: The greater the extent of competition, the less ability Employers have to set prices at higher levels. This pressure to keep prices low serves to keep margins low. What this means is that in a competitive environment (i.e., when profit margins are low and it’s difficult to increase prices), increases in costs that do not have any associated impacts on increasing revenues (i.e., demand) or decreasing other costs (i.e. turnover) will threaten the viability of businesses.

The optimal prices that Employers choose for their products and services will be affected both directly and indirectly by the choice of wage rates.

Higher wages lead to

• Higher prices, which decrease demand.

• Higher Employee effort, which
  • Increases demand; and
  • Increases reputation, which enables higher prices.
  • Higher population income, which increases demand.
  • Higher wage costs.
  • Lower turnover, which decreases turnover costs.

The relative magnitudes of these impacts of higher wages on profits depend on

• The ability of the Employer to raise price when wages are higher.

• The sensitivity of demand to price and the sensitivity of price to wages.

• The sensitivity of demand to employee effort and the sensitivity of price to reputation.

• The sensitivity of population income to increases in minimum wage and the sensitivity of demand to increases in population income.

• The magnitudes of impact of higher minimum wage on total costs:
  • The portion of employees that are paid minimum wage,
  • The portion of total costs attributable to labor, and
  • The impact of higher minimum wage on turnover.

 

Model Impact of Changes in Minimum Wage on Game Outcomes

Now let’s consider how increases in the minimum wage affect Employers’ and Employees’ actions. 

Unskilled Employees

When minimum wages are higher, then Unskilled Employees face better options, since alternative Employers must offer a higher minimum wage, regardless of the effort Employees choose to deliver. This provides less incentive for Unskilled Employees to choose higher levels of effort. This dynamic will be explained in more detail below.

Employers

Higher minimum wages

• Require higher prices to cover the higher wages,

• Generate greater Consumer demand from the wealth effect, and

• Generate lower Consumer demand from the price effect.

Employers have two options. They can either reduce wage premiums to minimize costs and try to generate as much volume as possible at the lowest prices possible, given the higher minimum wage.

Alternatively, Employers can try to appeal to Consumers who value high quality by increasing wage premiums in an attempt to increase Employee effort so as to increase quality. Unfortunately, however, as minimum wage rates increase, it becomes more difficult for Employers to find Employees who are willing to put forth effort, since there is generally less to gain from doing so. More specifically, when minimum wages are higher, the wage premiums that Employers can afford to offer Employees to provide higher than minimum levels of effort decrease. To illustrate, suppose you have the situation depicted in Figure 7.

Figure 7

 

In Figure 7, the minimum wage is set at Min W.

Employer 1 only needs his Employees to provide a minimum amount of effort to do their jobs, and he can afford to pay his Employees up to a maximum wage of Max W₁, which is equal to the current minimum wage. So, at the current level of minimum wage, Employer 1is required to pay his Employees the maximum amount he can afford to pay them. In other words, Employer 1 can offer no wage premium above minimum wage, but that’s okay, since he requires only minimum effort from his Employees.

Employer 2 requires Employees to put forth a small amount of effort above the minimum level, and he can afford to pay his Employees up to a wage of Max W₂ to do so. In other words, Employer 2 can afford to pay Employees a premium of (Max W₂ – Min W) above the minimum wage to induce them to provide a small amount of effort above the minimum level.

Employer 3 requires Employees to put forth more effort than the amount of effort required to perform Job 2, and Employer 3 can afford to pay his employees a wage premium of up to (Max W₃ – Min W) to provide that level of effort.

And similarly for Job 4.

Now, suppose the minimum wage is raised from Min W to Min W’.

At the new minimum wage, Min W’, Employer 1 can no longer afford to pay his employees even the minimum wage. He must either use fewer Employees than he really needs, find some other way to cut costs, our go out of business.

At the new level of minimum wage, Min W’, Employer 2 can no longer afford to pay his Employees a premium above the minimum level, so he is forced to use Employees who only provide the minimum level of effort. That is, Employer 2 must now settle for providing products and services of a quality below that which he would like to provide.

Employees who work for Employer 3 earn the same wage as they did before, Max W₃, but now they’re only being paid a premium of (Max W₃ – Min W’) above the minimum wage rate to provide the effort required to perform job 3. As an alternative, Employees who currently work for Employer 3 can now put forth less effort, only the minimum level required to get a job, and still earn almost the same amount of money, Min W’. In other words, Employees who currently work for Employer 3 now have the option of sacrificing only a small wage premium to be able to find a job where they don’t have to work very hard.

From the example, it becomes clear that as the minimum wage rises, it becomes more an more difficult for Employers of Unskilled Employees to find Employees who will be willing to provide the effort that those Employers need in order to be able to provide higher quality products and services. So, Employees end up providing lower levels of effort, because they can now afford to do so, and Employers are forced to cut the quality of the products and services they provide Customers. With lower quality products, competition turns to price, which further inhibits Employers’ abilities to afford to pay Employees higher wage rates to provide higher levels of effort.

It follows that in response to increases in the minimum wage, Employers will generally be forced to resort to the low quality-low margin option, even if they would prefer to provide higher quality products.

Results from the Model

I plugged some numbers into my model and tested the results for different levels of the minimum wage, while holding constant the level of Employee effort. The results are shown in Figure 8.

Notice that when I hit a “high” level for the minimum wage, the Employers’ profit-maximizing wage premium becomes negative, meaning that Employers would prefer to pay Employees less than the minimum wage. The case “Min Wage: H” corresponds to the results for Employers’ preferred choice of wage premium when the minimum wage is high. That is, Employers pay Employees less than the minimum wage. In contrast, the case “Min Wage: H*” corresponds to the results for Employers’ constrained choice, in which they are constrained to pay at least the minimum wage.

The model shows that as the minimum wage increases:

• Wage premiums paid by Employers decrease sharply, but net wages (the minimum wage plus the wage premium above minimum) increase a bit.

• The number of units sold increases sharply, as Employers decrease prices, despite the increase in the minimum wage. The decrease in price is funded from the Employers’ profits. In other words, Consumers and low effort Employees benefit from higher minimum wages at the expense of Employers.

• Despite the increases in the wage rates, the total number of employees actually increases a bit, due to the strong increase in demand (i.e., number of units sold).

• As minimum wages increase, the lower wage premiums and better alternatives available to Unskilled Employees both serve to increase Employee turnover.

Figure 8

 

As the minimum wage increases, Unskilled Employees face better alternative options among Employers, independently of the effort they choose to provide. This leads Employees to provide less effort when minimum wages are higher. As such, Employers will generally end up in the low margin-high volume scenario, as depicted in Figure 8.

It follows that the ultimate effect of increases in the minimum wage will be a convergence of wage rates across Employers for Unskilled Employees down toward the minimum wage, resulting in less effort provided, and higher sales volumes of lower quality products.

So Unskilled Employees who prefer to provide less effort are better off at the expense of

• Unskilled Employees who prefer to provide more effort (that is, consume more products);

• Consumers who prefer to consume higher quality products; and

• Employers who prefer to provide higher quality products.

Employers take a large hit on profits. Existing Employers may very well choose to continue operations at the lower profit rate. However, new Employers who were thinking about entering the market to provide higher quality products or services when minimum wages were lower might now refrain from doing so, since their expected profitability is now much lower.

As we see, one consequence of higher minimum wages in more competitive environments is the potential for a “race to the bottom” on product quality. For more details on this issue, see my earlier blog post, “Are We Destined for a Race to the Bottom on Product Quality?”

 

Employer-Employee Actions and Payoffs Matrix

Now let’s take a closer look at the Employer-Employee game dynamics.

Different Employers offer Unskilled Employees either the minimum wage, W, for low effort jobs or a higher wage that includes a wage premium, W x (1 + w), for jobs that require higher-than-minimum levels of effort. A portion, h, of Employers pays Unskilled Employees the minimum wage, while a portion, (1 - h), pays a rate above minimum.

Unskilled Employees choose a level of effort to provide Employers, either low effort or high effort. At the time Employers hire Unskilled Employees at the offered wage, Employers don’t know which level of effort Employees will end up providing. They assume that Employees will provide low effort with probability r and high effort with probability (1- r).

Unskilled Employees assume they can always find a job paying the minimum wage W. Unskilled Employees know that Employers don’t know which level of effort Unskilled Employees will provide until after the Employees have been hired, work for a period of time, and receive the contracted wage. Unskilled Employees who only (plan to) provide the minimal level of effort thus know that they might be able to get a job that pays a premium and get paid that higher level of income, despite it being unearned, for at least a short period of time.

Figure 9 provides the matrix of possible choices and outcomes.

Figure 9

 

Low Wage, Low Effort

If Employers offer lower wages and receive lower levels of effort from Employees, then Employers end up with modest profits by selling high volumes of low quality products at low prices.

If other Employers pay higher wages, then Employees may quit and try to find higher wages elsewhere. This situation will be more likely when there are enough other Employers offering wage premiums above the minimum rate, that is, that is, if (1- h) is large enough, and/or if the wage premium, (1 + w), is large enough.

Low Wage, High Effort

If Employers offer lower wages and receive higher levels of effort from Employees, then they will generate larger profits from higher quality products. However, the high productivity Employees won’t be happy with the lower wages. These Employees will quit and try to find a different Employer who offers higher wages, especially if there are enough Employers out there who offer a wage premium, that is, (1 - h) is large, and/or if the wage premium offered for the high level of work, (1 + w), is high.

High Wage, Low Effort

If Employers offer higher wages and receive lower levels of effort from Employees, then Employers end up with a loss, because they end up selling a low volume of low quality products at a high price (reflective of the high wage). If there are enough Employees out there who put forth higher levels of effort, that is, if (1- r) is large enough, and/or if the wage premium, (1 + w), is large enough, then Employers will choose to fire low effort Employees, pay the turnover costs, and try their luck with new Employees.

High Wage, High Effort

If Employers offer higher wages and receive low volumes of high quality products at high prices. Both Employers and Employees are generally happy with the situation and stick with it.

 

Conclusions

The impact on employment of increases in the minimum wage “is one of the most studied topics in all of economics,” and the general consensus of the empirical studies is that increases in the minimum wage have no discernible impact on employment.

However, there’s an important element that’s not being captured in these studies, nor in discussions, of the minimum wage: product quality that is enabled by employee effort. One of the most notable aspects of this type of product quality is customer service, which includes such issues as the attentiveness and speed at which employees provide products and services to customers. The provision of good customer service requires employees to provide higher than minimum levels of effort in the performance of their work. And in the food services industries, which employ almost two-thirds of minimum wage workers, customer service can be an important determinant of whether businesses thrive or falter.

When levels of effort and consequential levels of product quality that employers and employees provide customers are captured in the analysis, some interesting insights emerge.

Employers induce Employees to provide levels of effort above minimum levels to their work by paying them a wage premium above the minimum rate. Employees motivated by these higher wages provide the effort that Employers need in order to be able to offer Customers good customer service. What this means is that any product or service for which good customer service — or other similar aspects of product quality — is an important part of the consumption experience will benefit from, if not require, Employers to pay Employees wages above the minimum level.

However, as the minimum wage rate increases, it becomes more difficult for employers to be able to afford to pay employees sufficient wage premiums that will induce Employees to provide enough effort. Without these wage premiums, product quality – customer service – suffers.

The ultimate effect of increases in the minimum wage will be a convergence of wage rates across employers for unskilled employees down toward the minimum wage, resulting in less effort provided, thereby generating lower quality products. As competition heats up in such an environment, what we are left with is a race to the bottom on product quality.

While the lowest paid echelons of Unskilled Employees benefit from increases in the minimum wage, most everyone else suffers:

• Unskilled Employees who would rather be paid higher wages to provide more effort no longer have that opportunity;

• Customers who would rather consume products and service with higher levels of quality – better customer service – no longer have that opportunity;

• Employers who would rather generate higher products by offering with higher quality products at higher prices no longer have that opportunity.

Finally I note that historical studies of the impact on employment levels of increases in the minimum wage have yielded “no discernable impact.” However, these results may very well fail to reflect future impacts on employment levels of increases in the minimum wage. This is due to the fact that technology, namely automation, has now become an economically viable alternative to many types of (unskilled) labor. Such alternatives to unskilled workers become ever more attractive as minimum wage rates increase. In other words, the advent of cheap automated services will provide a real threat to future employment of those types of workers most likely to earn the minimum wage.

McDonald’s has managed to generate better customer service and lower turnover by increasing their employees’ wages by $1 above the minimum rate. The chain “expects average wages to rise to more than $10 an hour by the end of 2016.” But what will happen if and when the minimum wage is raised to $15 an hour? Will McDonald’s still be able to pay a wage premium to its workers to generate better customer service and lower turnover? Or will we be seeing more self-service kiosks, rather than smiling workers’ faces, at McDonald’s