Companies should experiment with minimum pay raises

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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.”
So far the company’s financial results haven’t suffered — just the opposite; sales are rising.
With stagnant wages one of the hottest topics these days, and calls to raise minimum wages resounding across the country, stories like this one are obviously eye-catching. If raising wages improves worker performance enough to help the bottom line, then there’s no tradeoff between how much companies can afford to pay workers — at least within reason — and how many workers they can afford to employ. Obviously if you raise wages high enough — imagine mandating $1,000 an hour! — a lot of people will be put out of work. But it could be that most American companies are in a safe zone where hiking wages modestly makes economic sense.
But why? If it helps the bottom line to raise wages, why haven’t companies done it already? Many minimum-wage boosters, when asked this question, point to the theory of “efficiency wages.” This just says that paying workers extra may make economic sense, because it will make the employees feel valued and loyal, as well as encouraging them work harder to keep their jobs.
This theory probably does apply to many industries. But it can’t explain experiences like McDonald’s. Efficiency-wage theory says that companies pay employees more than the bare minimum they can afford, but it assumes that companies do, in fact, pay enough to get the productivity and loyalty boost. If employers like McDonald’s aren’t catching on to the benefits of paying workers more, we need to look beyond efficiency-wage theory.
One possibility is that companies simply don’t have a firm idea of the demand for their products. In most economics theories, we assume that companies know how much consumers are willing and able to buy at any given price. But in reality, no company really has this information. A demand curve is a purely hypothetical object — in reality, we only see how much demand exists at the current price, not at all possible prices.
Suppose I sell hamburgers for $4 each. How do I know how many fewer hamburgers I’ll sell if I raise the price to $5? I can do a whole lot of statistics to try and predict the change in demand, based on demographics, income and other factors. I can look at areas where burger prices are higher, and use statistics to try to figure out how those areas might be different from my own. But ithere’s no surefire way — these methods are riddled with uncertainty. So raising or lowering my price is always a risk.
The only alternative may be to try changing prices and see what happens. Some people have studied price experimentation, though interestingly it appears to be more the domain of operations researchers than economists. But the same logic applies with wages. A company usually doesn’t know whether hiking pay would boost productivity enough to improve the bottom like — the only way to find out is to give it a try and see what happens. This could be what we’re seeing in the case of McDonald’s. The company took a risk and raised wages, and the results were good.
This brings us back to the minimum wage. We can think of minimum wages as a policy experiment — we try implementing $15 in Seattle, and if it works, we try it in other cities. But it’s also possible that minimum wages force companies to conduct experiments of their own. Lots of employers might be able to raise wages without being forced to lay off workers. But they don’t know this, because they’re too afraid to try. A big minimum wage hike might force companies to overcome this fear — like throwing a reluctant first-time swimmer into a pool.
Of course, both policy experiments and price experiments carry the same risk. If $15 is too high, then a wave of layoffs could follow, and companies wouldn’t be allowed to pull wages back down — as McDonald’s certainly would have done had their wage hike not worked out. But the idea of price experimentation provides a reason why raises in the minimum wage might not be so harmful.

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Noah Smith is an assistant professor of finance at Stony Brook University and a freelance writer for a number of finance and business publications. He maintains a personal blog, called Noahpinion

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