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.