Ed Lotterman: Making sense of minimum wage basics

Special to the Idaho StatesmanApril 18, 2014 

The minimum wage is an issue at the national level and in many states. There is little chance of an increase at the federal level. My home state of Minnesota just passed a law that will boost the state minimum to $9.50 by 2016, but outcomes in other states are mixed. The common denominator is that the economic issues are largely the same at state and national levels. And some of the arguments made by both sides in the debate are similarly fallacious.

Most of these issues have been discussed at length - including whether employers would cut jobs as a result of having to pay higher wages. A related issue is how much business profits will suffer. Two of the sectors most strongly crying woe are the restaurants and grocery stores.

Ironically, these are two sectors that have little to worry about, especially compared with low-tech manufacturing and some agricultural sectors. To illustrate why this is true, think about the two Econ 101-level ideas that have not gotten due attention.

TWO CONCEPTS

The first is one from the branch of philosophy called logic. One common logical fallacy, or error in reasoning, that often occurs in economic arguments is the "fallacy of composition."

This error is to assume that what is true for an individual is also true for a larger group. The classic example: Just because one fan can see better if she stands up at a basketball game, doesn't mean that everyone would see better if they all stood up.

So, if one restaurant or supermarket would see profits drop when forced to pay employees more, does that mean that all restaurants and supermarkets will see their profits drop if all are forced to raise wages?

Of course not. But to understand why, you need to examine a second Econ 101 concept, that of "elasticity of demand."

This relates to how much demand for a quantity of something drops because of a given increase in prices. Specifically, it is the percentage change in quantity divided by the percentage change in price. If some good has an elasticity of -0.5, it means that if the price is increased 10 percent, the quantity demanded will fall by 5 percent. The more demand changes in response to price changes, the more "elastic" demand is. The less it changes, the more "inelastic."

Several factors determine the degree of elasticity. One is the number of substitutes that meet the same need. The more substitutes, the greater the quantity sold will change for a given price increase. Another way of looking at this question is the degree to which particular items or categories of items are necessities versus luxuries. Cancer treatments are a necessity; trips to Spain are a luxury.

The more something is a necessity, the more inelastic the demand for it is. That is, for a given change in price, the change in the quantity demanded will be small.

Elasticity also varies with how finely you define the product. Demand for ground beef is pretty elastic because people can switch to chicken or pork chops. But if you look at all meat taken together, demand is very inelastic, because most people are not enamored of giving up meat entirely for tofu and lentils. And if you aggregate up to "all food," or even "all food purchased in stores and supermarkets," demand is very inelastic.

NOT 'TRADABLE'

There is a final consideration, one important in the current minimum wage debate. If one store raises prices while all the other stores in the area don't, that individual store will see sales plummet. In other words, a single outlet faces very elastic demand. That might lead the store owner to think: "I can't raise prices, or I'll lose a lot of sales. So if I have higher payroll costs because of a higher minimum wage, my profits will drop."

That would be true if the minimum wage applied to just one store. But it applies to all of them. And what will happen, just as it always has with minimum wage increases in the past, is that grocery prices will rise slightly and profitability in grocery retailing will be about the same as always, both in terms of profits as a percentage of sales and relative to the companies' equity.

Groceries are not a "tradable good." If supermarkets raise prices marginally to pay mandated higher wages, people are not going to start driving to Shanghai to get groceries. But if a low-skill, labor-intensive manufacturer has a bigger wage bill and raises prices, his customers might well do so.

Restaurants, like grocery stores, don't sell a tradable product. Food eaten out is more of a luxury than basic staples bought from grocers. So it is somewhat more elastic. And elasticities vary from tony restaurants with famous chefs to neighborhood taverns or to chain hamburger, pizza or sandwich shops. The importance of minimum-wage-driven labor costs as a percentage of total costs also varies. But in general, except in the very short run, minimum wage increases of the degrees currently under consideration never have greatly affected restaurant sales and profits or the relative market shares of different classes of eating establishments.

The underlying lesson of all this is that to the extent increases in the minimum wage can be passed along to customers, the less business profits are affected. And the increased labor cost of a higher minimum wage overwhelmingly will be passed along to the general buying public. Some minimum wage advocates like to talk about how businesses can afford to pay more because of their high profits, but this is largely twaddle. Profits for firms that don't face competition from other states or other nations scarcely will flicker. Customers will just pay a little more.

Economist Edward Lotterman writes in St. Paul, Minn. Write him at boise@edlotterman.com.

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