States with lower minimum wages will feel the impact of California’s experiment

by Adam Millsap on April 8, 2016

in Economic Policy, Minimum Wage, Regulation, Unemployment

California governor Jerry Brown recently signed a law raising California’s minimum wage to $15/hour by 2022. This ill-advised increase in the minimum wage will banish the least productive workers of California – teens, the less educated, the elderly – from the labor market. It will be especially destructive in the poorer areas of California that are already struggling.

And if punishing California’s low-skill workers by preventing them from negotiating their own wage with employers isn’t bad enough, there is reason to believe that a higher minimum wage in a large state like California will eventually affect the employment opportunities of low-skill workers in other areas of the country.

Profit-maximizing firms are always on the lookout for ways to reduce costs holding quality constant (or in the best case scenario to reduce costs and increase quality). Since there are many different ways to produce the same good, if the price of one factor of production, e.g. labor, increases, firms will have an incentive to use less of that factor and more of something else in their production process. For example, if the price of low-skill workers increases relative to the cost of a machine that can do the same job firms will have an incentive to switch to the machine.

To set the stage for this post, let’s think about a real life example; touch screen ordering. Some McDonald’s have touchscreens for ordering food and coffee and San Francisco restaurant eatsa is almost entirely automated (coincidence?). The choice facing a restaurant owner is whether to use a touch screen or cashier. If a restaurant is currently using a cashier and paying them a wage, they will only switch to the touch screen if the cost of switching and the future discounted costs of operating and maintaining the touch screen device are less than the future discounted costs of using workers and paying them a wage plus any benefits. We can write this as

D + K + I + R < W

Where D represents the development costs of creating and perfecting the device, K represents the costs of working out the kinks/the trial run/adjustment costs, I represents the installation costs, and R represents the net present value of the operating and maintenance costs. On the other side of the inequality W represents the net present value of the labor costs. (In math terms R and W are: R = [ ∑ (rk) / (1+i)^n from n=0 to N ] where r is the rental rate of a unit of capital, k is the number of units of capital, and i is the interest rate and W = [ ∑ (wl) /(1+i)^n from n=0 to N ] where w is the wage and l is the amount of labor hours. But if this looks messy and confusing don’t worry about it as it’s not crucial for the example.)

The owner of a restaurant will only switch to a touch screen device rather than a cashier if the left side of the above inequality is less than the right side, since in that case the owner’s costs will be lower and they will earn a larger profit (holding sales constant).

If the cashier is earning the minimum wage or something close to it and the minimum wage is increased, say from $9 to $15, the right side of the above inequality will increase while the left side will stay the same (the w part of W is going up).  If the increase in the wage is large enough to make the right side larger than the left side the firm will switch from a cashier to a touch screen. Suppose that an increase from $9 to $15 does induce a switch to touch screen devices in California McDonald’s restaurants. Can this impact McDonald’s restaurants in areas where the minimum wage doesn’t increase? In theory yes.

Once some McDonald’s restaurants make the switch the costs for other McDonald’s to switch will be lower. The reason for this is that the McDonald’s that switch later will not have to pay the D or K costs; the development or kinks/trial run/adjustment costs. Once the technology is developed and perfected the late-adopting McDonald’s can just copy what has already been done. So after the McDonald’s restaurants in high wage areas install and perfect touch screen devices for ordering, the other McDonald’s face the decision of

I + R < W

This means that it may make sense to adopt the technology once it has been developed and perfected even if the wage in the lower wage areas does not change. In this scenario the left side decreases as D and K go to 0 while the right side stays the same. In fact, one could argue that the R will decline for late-adopting restaurants as well since the maintenance costs will decline over time as more technicians are trained and the reliability and performance of the software and hardware increase.

What this means is that a higher minimum wage in a state like California can lead to a decline in low-skill employment opportunities in places like Greenville, SC and Dayton, OH as the technology employed to offset the higher labor costs in the high minimum wage area spread to lower wage areas.

Also, firm owners and operators live in the real world. They see other state and local governments raising their minimum wage and they start to think that it could happen in their area too. This also gives them an incentive to switch since in expectation labor costs are going up. If additional states make the same bad policy choice as California, firm owners around the country may start to think that resistance is futile and that it’s best to adapt in advance by preemptively switching to more capital.

And if you think that touch screen ordering machines aren’t a good example, here is a link to an article about an automated burger-making machine. The company that created it plans on starting a chain of restaurants that use the machine. Once all of the bugs are worked out how high does the minimum wage need to be before other companies license the technology or create their own by copying what has already been done?

This is one more way that a higher minimum wage negatively impacts low-skill workers; even if workers don’t live in an area that has a relatively high minimum wage, the spread of technology may eliminate their jobs as well.

  • Dylan Pahman

    Generally speaking, I’m anti-minimum wage and pro-automation. So articles like this are hard to sort out. In the long run, automating other industries has been a good thing. I’d rather businesses decide to do it freely, but I still wonder what the long term effects might be in this case. If everyone was told from a young age, “You better learn to fix an automated ordering machine, or you won’t be able to find a decent job,” instead of the increasingly disingenuous, “You better get a high school diploma, or you won’t be able to find a decent job,” I’m not sure the former wouldn’t be better and more marketable than the latter….

    • Adam

      I am fine with automation/ capital-labor substitution as well and it will happen as capital costs decline over time. But I don’t like artificially speeding it up through distortions in the relative prices between automation and low-skill labor. In fact, it would be interesting to see how many people would be employed absent any minimum wage – would upper middle class people have butlers or maids instead of riding lawnmowers, dishwashers, and roomba vacuum cleaners? It’s hard to know exactly what effect the minimum wage has had on automation over the last 60 years, but without it some of the appliances that eliminated the need for human labor might have been delayed.

      • Dylan Pahman

        Unionization probably plays a role too. However, I suppose you could look at Switzerland—no minimum wage and low union participation there. Unfortunately, however, this just gets back to your point about the effect the California wage will have on other states. Switzerland may (in part, of course) have roombas because France has a minimum wage and greater union membership.

        • Adam

          I agree with you about unionization. And thanks for reading!

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