What Would Ronald Do?

I found an article by Venessa Wong in Bloomberg Businessweek entitled “This is What Would Happen If Fast-Food Workers Got Raises.” It helped explain why fast food employees should not be paid their requested wages of $15 an hour – not that the absurdity [see comments – it actually is not absurd!] of this notion needed an extensive explanation. It did, however, raise interesting questions about how a monopoly would react to these demands and how these demands would reflect a firm’s market power.

In late July, fast food employees held one-day strikes where they formally announced their brazen demand for wages of $15 an hour. Wong explained that, on average, a fast food employee earns roughly $9 an hour. The demanded pay raise is two-thirds of what most fast food employees are currently making and would increase their wages to more than twice the federal minimum wage of $7.25.

According to Wong’s research, company-owned McDonald’s and Burger King restaurants operate with profit margins hovering above 10 percent. The requested pay raise would wreak havoc on the companies’ profits. Wong’s research on restaurant financials showed that, “if payroll costs doubled and other expenses didn’t decrease, menu prices at McDonald’s would have to go up about 25 percent…likely sending price-sensitive consumers elsewhere.”

Let’s consider a monopoly facing the same demand from its employees and how it would react. Let’s say McDonald’s has a monopoly on cheeseburgers. A profit-maximizing monopolist, like Ronald McDonald, would set the price of his cheeseburgers at the point where the marginal revenue of making a cheeseburger meets the marginal cost of making a cheeseburger. When company employees demand higher pay, the negative-sloping marginal revenue curve will not move, but the upward-sloping marginal cost curve will shift up. The shift in the marginal cost will intersect the marginal revenue curve at a higher point, forcing Ronald to raise the price of his cheeseburgers.

If we take McDonald’s out of the monopoly model and into a competitive market, we can test for market power using the Lerner index. The equation for the index is (p – c)/ p, where “p” is market price and “c” is marginal cost.  Stephen Martin says in his textbook, “Industrial Organization in Context,” in a perfectly competitive market, price is equal to marginal cost – giving a Lerner index of 0. A company with market power will be able to set price higher, giving a higher Lerner index (although never exceeding 1). In a competitive market, Ronald would not be able raise the price of his cheeseburgers and expect the same amount of business. As Wong pointed out, if McDonald’s raised their menu prices 25 percent to cover the increase in cost, they would lose customers. Instead cheeseburgers have a price that is set by the market. As McDonald’s marginal cost rises and the market price of cheeseburgers remains the same, the numerator of the Lerner index decreases. Since the denominator (the market price) remains the same, the Lerner index for McDonald’s would decrease. The lower Lerner index would reveal that Ronald does not have a monopoly – rather, that he has little power in the market.

Another way to think of it is the inversely proportional relationship between the Lerner index of market power and price elasticity of demand. A cheeseburger is an elastic good – a consumer will go elsewhere if McDonald’s raises prices. This sensitivity would be denoted with a higher price elasticity of demand. Since the Lerner index is inversely proportional to price elasticity of demand, McDonald’s Lerner index would be very low, which would reflect the not-so-monopolistic market power McDonald’s has for cheeseburgers.

4 thoughts on “What Would Ronald Do?

  1. Ah, but you take 10% profits as a “normal” rate of return. How much do you get on your bank account? And depending on the structure, the owner of a franchise may pay him or herself a wage before that 10%. Yes, there’s also capital invested, but…

    Next, the real minimum wage is far below what it was a decade ago, more since it was last raised. One result is extraordinary turnover – and that is costly but most franchise owners underestimate how much. Costs go up by significantly less than wages if the wage hike cuts turnover (I know of small businesses that “overpay” their workers and believe they make much more money by doing so). Higher wages would also mean that fast food workers would not have to try to balance two jobs, which boosts absenteeism (both on days where the juggling doesn’t work – when you have no free time, you can’t fit in a trip to a doctor or getting your car repaired without missing part of a shift, and then there’s poor health due to stress and exhaustion).

    Third, the empirical evidence tends to back these stories. A famous paper by David Card and Alan Krueger looked at towns along (from memory) the PA-NJ border when PA raised the state-mandated minimum wage. By doing so, they were able to look at towns that had similar income and job structures, controlling for lots of hard-to-observe variables. They found no negative impact, indeed they found very robust evidence that the higher wage increasedemployment.

    From an extended post on the Economists View blog (HERE for the provisos – with search costs a small increase in wages can increase employment, but a huge hike would not have that effect. Given the very, very low real level of the Federal minimum wage – you note that on average the actual wage is higher! – then $15 might have no impact on employment, and certainly would have a small one:

    For example, what does it mean for a firm to have a vacancy? If a firm can readily go to the market and buy a worker, there’s no such thing as a vacancy, or at least not a persistent vacancy. During the early 1990s, when Alan and I were working on minimum wages, it was our perception that many low-wage employers had had vacancies for months on end. Actually many fast-food restaurants had policies that said, “Bring in a friend, get him to work for us for a week or two and we’ll pay you a $100 bonus.” These policies raised the question to us: Why not just increase the wage?

  2. My question is: How would paying fast food workers $15 an hour change opportunity costs of working at other jobs? Also, how would the change in opportunity costs for other jobs alter people’s decisions to work at fast food restaurants over, say, a small local cafe that pays $12 an hour? Would raising the pay of fast food workers leave small restaurants underemployed?

  3. Yes, this could certainly spill over into other sectors, indeed that would be the hope or rather (if a change in the legislation) the intent. However, as you may know, small restaurants don’t have to pay wait staff minimum wage. Well-run ones (the Bistro) may in fact offer OK jobs with wages well above the minimum, and already face very low turnover.

    But if I understand your underlying question, a change in wage levels would not affect all businesses equally, but certainly would affect some. So it would really come down to the wage component of costs and to demand elasticities, all of course in light of initial gross profit margins. Certainly some businesses would find it hard to meet a hike in the minimum wage – but far fewer than the opposition seems to imply. A boost in the minimum would not cause the sky to fall.

  4. The movement to increase wages for employees in the fast food industry might be gaining traction after the release of two studies today. The studies show how the fast food industry’s low salaries affect American taxpayers. One study suggested that fast food employees receive $7 billion a year in public assistance. The study found that 52 percent of families of fast food workers are enrolled in one or more public assistance programs, whereas only 25 percent of the workforce as a whole is enrolled in such programs.
    As Charlotte brought up, the minimum wage rise would affect more than just fast food chains. It would affect other restaurant owners and, as this article suggests, the American taxpayer.

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