Thursday, March 19, 2015

When labor gets more expensive firms don't use as much

Today I had lunch at Applebee's and on the table I saw something that I had never seen before; a small touch screen computer was attached to the top of the table. The computer allows the customer to order food and pay without a waiter/waitress.  Apparently Applebee's announced this back in 2013 (I guess I don't go to Applebee's often enough.)

Now today we still had a waitress, but I imagine that during off peak hours the restaurant can cut back on their staff and simply allow the customers to type in their own order, which is then sent to the kitchen. When the food is ready, a staff of 3 or 4 food runners can deliver the meals to the table for the entire restaurant. The computer also had a credit card reader so no waiter is needed to settle the bill.

Eventually the computer may allow the customer to alert the staff when they need a refill or if something is missing from the meal, etc. This will also cut back on the staff needed, since customers can directly state when they need something rather than wait for an assigned waiter to come to their table. If the servers know exactly what a table needs and when they need it they will not make as many wasted trips to tables and thus be more productive. More productive servers means that a restaurant can get by with less of them.

Capital, such as the on-table computer, makes labor more productive. When labor is more productive less workers can produce the same amount of output. If the price of low-skilled labor increases, perhaps due to a minimum wage hike, there is an incentive for the firm owner to use relatively more capital and less labor. The author of the Slate article above understands that:

"Then again, of course these businesses are saying they won’t use the tablets to replace employees. Announcing layoffs along with the tablet move would be begging for a backlash. The fact is, if the tablets work, they’ll make the ordering process more efficient and cut the amount of human labor that these restaurants require. At that point, do you suppose they’ll keep the extra waiters around out of charity?" (my emphasis)

Also, high minimum wage states can impact low minimum wage states. New capital is likely to be developed and perfected in places with high labor costs. In low wage states it may not make sense economically to spend the fixed costs necessary to develop new machines. But once the costs have been borne by firms in high wage states it may make economic sense to simply adopt the technologies.

If people try to tell you that a higher minimum wage will not impact low-skilled employment simply take a look around. The computers at Applebee's are one more sign of the movement towards less labor and more capital, and higher minimum wages certainly play a role in that process.

Monday, March 9, 2015

Crisis politics

This is from Vincent Ostrom's The Intellectual Crisis in Public Administration (3rd edition p. 110):

"Measures taken to solve problems by the rhetoric of warfare and crisis politics will exacerbate rather than alleviate many problems. Performance will radically diverge from expectations, and the illusion of perpetual crisis will permeate public affairs. If the illusion gives way to skepticism, the credibility gap will become an institutionalized feature of American public life. The rhetoric of warfare, crisis politics, and credibility gaps are unfortunate ingredients in the public life of people living in a potentially dangerous world. The rhetoric of crisis, like the cry of "wolf", will not be heeded if frequently used in inappropriate circumstances."

I think that we have reached this unfortunate point in American politics. Every social ill or foreign concern is described as a crisis of "epic proportions", "the issue of our time", etc. It is difficult to maintain a sense of perspective when pretentious politicians exaggerate nearly every situation they confront.

War and armed conflict are especially effective when it comes to enacting policies that erode liberty in the long run. As Alexander Hamilton noted in Federalist 8:

"Safety from external danger is the most powerful director of national conduct. Even the ardent love of liberty will, after a time, give way to its dictates. The violent destruction of life and property incident in war, the continual effort and alarm attendant on a state of continual danger, will compel nations the most attached to liberty to resort for repose and security in institutions which have the tendency to destroy their civil and political rights. To be more safe, they at length will become willing to run the risk of being less free."

It is not surprising that most government overreach has occurred during times of war. Something to be mindful of the next time the president proposes policies during a time of crisis.

Monday, March 2, 2015

A higher minimum wage does not make society better off or create jobs

I had a discussion today with a friend about the minimum wage and it gave me an idea for a thought experiment. Many pundits insist that a higher minimum wage will create jobs (see here for one example). The argument goes as follows (taken from the article linked to above):

"What critics of a higher minimum wage ignore is that, by putting more money into the pockets of the working poor — a group that necessarily spends nearly all its income on such locally provided basics as rent, food, transport and child care — an adequate minimum wage increases a community’s level of sales and thereby creates more jobs."

But can the minimum wage really create more jobs overall? The answer to this questions is most certainly no and a simple example will explain why.

Suppose there are two parts of a town; the owners of businesses live in one part and the workers live in another. These owners and workers produce widgets and everyone demands 1 widget per day. Owners are wealthier than workers. There are the same number of workers as owners.

In each area of town there is a pizza parlor that is owned by the government and uses no workers (the pizza is completely made by machines and has a perfectly elastic supply). Workers only go to their pizza parlor and owners only go to their pizza parlor. The equilibrium price of pizza is $9/pizza in each area. The equilibrium quantity for owners is 100 pizzas per month, while the equilibrium quantity for workers is 80 pizzas per month. (since owners are wealthier and they each demand the same amount of widgets owners spend the rest of their money on more pizza.) The graphs below represent the markets for pizzas in each part of town.


Now let's suppose the government passes a minimum wage increase in the widget factory. For the purposes of this example I will assume that the minimum wage increase is completely absorbed by the owners i.e. the owners take less money and pay the workers more; prices of widgets do not change (this is the preferred outcome of most minimum wage supporters as well).

This increase in the minimum wage will have an income effect on the demand for pizza for both the owners and workers. Since the workers now earn more money, the demand for pizza in their part of town will increase. The demand curve will shift out as in the following diagram.

The increase in demand will increase the quantity supplied of pizzas in the worker's pizza parlor; there will be a movement along the supply curve to the right.

But where do the inputs for the new pizzas come from? The increase in the minimum wage did not change the supply curves of pizza. There was no technology increase; no new way of making pizzas was created. In order to increase the quantity supplied of pizzas in the workers part of town the raw materials for pizza (dough, cheese, pepperoni, etc.) must come from somewhere.

And that is where the owners come in. Remember they are poorer now. So the demand for pizza in their parlor decreases, as in the graph below.

When the demand for pizza decreases in the owners parlor, the quantity supplied decreases and moves to the left. This frees up resources (dough, cheese, pepperoni) to be used for other things. In this case the pizza inputs that are no longer being used in the owner's parlor can be used in the worker's parlor.

This example illustrates a key point: society can not be made better off overall by moving money from one group of people to another. Wealth is created by more production, by figuring out ways to make more stuff using less resources. The minimum wage does not affect the supply curves of the products that worker's demand. Yes they have more money, but all that does is increase their demand for certain goods while it decreases the demand of other goods that were bought by the people that used to have the money. 

A higher minimum wage does not increase output so it cannot make society better off overall. Increases in the minimum wage simply shift money around, resulting in higher demand for some goods and lower demand for others, just like in this pizza example. The net effect is 0, since the pizza resources freed up by the decrease in demand on the owner's side were the same pizza resources used to increase the quantity supplied on the worker's side. In a more complex economy the increases and decreases in demand will be spread out over more products and it will be hard for any one person to see exactly where the changes are taking place, but the result will still hold. Workers are an input, just like pepperoni, and if more workers are going to be used in one market following a demand increase then less workers must be used somewhere else following a demand decrease.

So the next time someone tells you that the minimum wage will increase jobs by increasing demand, ask them where the new workers are coming from. Just like pepperoni, workers can't appear out of thin air.

Tuesday, February 24, 2015

Sherrod Brown doesn't understand trade

In the most recent email I received from Sherrod Brown he makes a startlingly ignorant statement:

This month I joined my colleagues of both political parties to announce the introduction of the Currency Undervaluation Investigation Act, to stand up to Chinese currency manipulation.

This bipartisan plan could create five million jobs, increase our GDP by as much as $720 billion, and provide a shot in the arm to American manufacturing — all at no cost to taxpayers

(My italics and bold print)

No cost to taxpayers? If taxpayers import goods from China (and they do, check your labels) then this act will certainly cost them.

First let me explain what Mr. Brown means by "currency manipulation". Suppose that a Big Mac costs $2 in the U.S. and an identical Big Mac cost 8 yuan in China. For purchasing power parity to hold, $1 would have to equal 4 yuan. This would be the "correct" exchange rate in Mr. Browns view.

But China may want a different exchange rate, perhaps to maintain high levels of employment in China. So in the currency markets China tries to maintain a ratio of $1 = 5 yuan rather than 4 yuan. So what does this mean for the U.S.?

Well it means that the stuff we buy from China is cheaper than it otherwise would be. For example, suppose a tube of toothpaste that is made in China sells for 10 yuan. At a ratio of $1 = 5 yuan I would have to use $2 to buy 10 yuan, which I would then give to the Chinese manufacturer for the toothpaste. So the toothpaste would cost me 2 U.S. dollars. If instead the $1 = 4 yuan was the exchange rate, I would need to trade $2.50 for 10 yuan. So at the $1 = 4 yuan the toothpaste would cost me $2.50 instead of $2. If purchasing power parity held, then the tube of toothpaste would be more expensive.

China prefers the exchange rate of $1 = 5 yuan in this example because it makes the things that China produces relatively cheaper compared to their cost in the U.S. Remember, based on purchasing power parity the toothpaste should have cost $2.50, which is what American made toothpaste would cost int this example. But because China "manipulates" the exchange rate the toothpaste only costs $2 to buy from China while it costs $0.50 more to buy from a U.S. manufacturer. (Like any good, currency prices are based on supply and demand. China can affect the exchange rate i.e. price of dollars in yuan by buying and holding dollars, which reduces supply.)

(Note that the higher exchange rate ($1 = 5 yuan) makes American goods more expensive for the people of China than the $1 = 4 yuan rate. When the Chinese producer of the toothpaste trades his 10 yuan in for $2 he cannot buy the American made toothpaste that is priced at $2.50.)

This is a stylized example but it reveals that Mr. Browns policy does indeed COST U.S. taxpayers by making the things we buy from China more expensive. So if you spend $1000 per year on stuff made in China and prices go up by 2% on average than this policy would cost you $20 per year. If 50 million Americans had their costs of Chinese goods go up by $20, then Mr. Browns "no cost" policy would cost Americans in total $1 billion. I would need to do more research to get a better estimate, but I guarantee that the true cost is a number much greater than $0.

So don't let Mr. Brown fool you. If China is indeed manipulating their currency then they are doing U.S. consumers a big favor. Trade is about producers AND consumers and ignoring one of the groups to paint a better picture of a policy is dishonest. But I don't expect much honesty from politicians such as Mr. Brown anyway.

Thursday, February 19, 2015

The minimum wage can increase crime rates

In a 1972 article in the Journal of Political Economy researchers found a strong relationship between youth unemployment and crime rates. Other studies such as Fleisher (1966) and Freeman and Holzer (1986) found similar results. I am sure that there are more recent ones as well but I am not up to date on that literature.

Below is a chart showing the year over year, January unemployment rate for 16 - 19 year olds from 1990 to 2015 by year. (click to enlarge)

The most recent data available is for January 2015 and the rate was 18.8%. The rate increased drastically during the recession and peaked in 2010 at 26.1%.

There are many studies that show that higher minimum wages decrease the employment rate of unskilled, usually young, workers (see here, here, and here). I also showed the relationship between the real value of the minimum wage and white and black youth unemployment in an earlier blog post.

The negative outcome of increased crime rates is not usually brought up when increases in the minimum wage are being debated, but it is a real outcome. People who support a higher minimum wage need to be aware that they are pushing low skilled, often young, workers out of jobs and potentially into a criminal career. This is also consistent with economic theory, since the opportunity cost of committing a crime is lower for unemployed, low skilled people than for people with jobs and higher skilled people.

The U.S. prison system is already overcrowded; politicians don't need to create more criminals by making it harder for young people to find jobs and gain skills. Public policy needs to encourage economic growth so that young people are able to find jobs and gain experience that will help them lead productive lives. Having a job also makes it more costly to commit a crime. The minimum wage is a hindrance to youth employment and needs to be tossed on the scrap heap.

Sunday, February 15, 2015

Why are CEOs paid so much?

Many people today complain about the pay of CEOs. Today's CEOs make 200 - 300 times as much as the average worker, up from 20 or 30 times in the 1970's. Many on the left want the government to reel CEO pay in, either through direct regulation or indirect regulation like a binding say on pay.

But why do CEOs make so much? A model can help us sort through this question. Below is a model showing wage on the vertical axis and effort on the horizontal axis.

There are 4 wage levels depicted, W1 through W4. There are also two marginal cost curves, MC1 and MC2. Now suppose you are on the board of directors and you want to make sure that the CEO you hire gives their maximum effort, E*. If their marginal cost of effort is like that of MC1, you could pay them a wage of W3. A marginal cost curve that looks like MC1 means that the cost of an additional unit of effort is increasing at a constant rate. That is, every new unit of effort costs more than the last but the cost goes up by the same amount each time. In a world where MC1 depicts reality the CEO who enjoys spending time with their family will incur a higher cost each hour they work but the rate of increase is constant. So the 40th hour of work might be worth $50, the 41st hour worth $55, the 42nd hour worth $60, etc. with each hour costing an additional $5. In this world a wage of W3 would induce the CEO to give their maximum effort, E*.

But what if the cost of effort is not like MC1, but instead it is like MC2? A marginal cost of effort like MC2 means that each additional hour is not only more costly, but the cost is increasing at an increasing rate. So the 40th hour is worth $50, the 41st hour is worth $57, the 42nd hour is worth $65, etc. Reality is more like MC2 than MC1. The more you work, the more you would rather be doing something else because each additional hour of work is forcing you to give up things that are more and more important to you. Missing family breakfast is costly but many working people, including CEOs, choose to bear this cost. Missing Timmy's baseball game and Mary's recital are costly, but again many working people have made this choice. But what if you had to work 80 hrs per week and miss every baseball game and every recital, in addition to missing breakfast and most dinners? Working hours 60 - 70 are more costly than hours 50 - 60. And hours 70 - 80 are probably a lot more costly than hours 60 - 70 because so much has to be given up in the form of lost time with family, hobbies, and even sleep. I think it is very reasonable to assume that the cost of working the 72nd hour is not only more than the 42nd hour, but a lot more. A marginal cost of effort that increases at an increasing rate is consistent with MC2.

If MC2 is the appropriate cost then it takes a big jump in the wage to induce the CEO to give effort E*. At W3 the CEO will only give effort E1, whereas with MC1 W3 led to E*. With MC2 the CEO will need to be paid W4 to give effort E*.

CEOs often work very long hours. They spend a lot of time traveling and being away from their families. They rarely take vacations. They are under intense pressure from shareholders, government regulators, and their customers to make the perfect decision. One wrong move can result in a hefty fine from some government agency, a decline in the stock price that wipes out billions of dollars in shareholder value, or a bad product that alienates their customers. In a world of 24/7 news and instant financial analysis, CEOs are under the microscope way more than CEOs in the 1970s. Not only that, but competition is international in scope. In 2015 companies from around the world compete with each other. International competition and trade were smaller in the 1970s. CEOs didn't have operations in every time zone that had to be monitored nor did they have 20 sets of government regulations that they had to abide by. CEOs of major companies today are the leaders of global entities and it takes a lot of time and effort to run something so large.

Most CEOs spend time as some other senior level executive before becoming a CEO. Those positions require a lot of time and effort too, but much less than being the face of the company. Anyone who follows the news knows that Jamie Dimon is the CEO of JP Morgan Chase, but who is the COO? Or Treasurer? or SVP of government relations? It takes a relatively big bump in pay to induce someone to move up to the top level from an already high paying position that is much less stressful and time consuming. The increase in stress and time costs are so great that the best people wouldn't do it for a 10% bump in pay.

And if the board thinks that the best CEO can increase the value of the company by $2 billion dollars over 10 years while the second best would only increase it by $1.5 billion it makes sense to pay another $10 million a year to get the best person for the job. That's a cost of $100 million for an increase in value of $500 million. A small % change in the value of a large company means big dollars for investors. CEOs that can increase value by 3%/year are way more valuable than those that can increase it by 2%/year. That marginal change in % means a big change in actual dollars.

So the next time you hear about CEO pay being out of control think about what it takes to be a CEO. There are certainly examples of bad CEOs that turn out to not be worth $10/hour, but there are many more CEOs that make a lot of money for their investors and are responsible for making great products available to consumers. For every bad CEO that harms a company there are 10 more who are helping their investors, employees, and customers achieve great things. Unfortunately those CEOs are the ones we never hear about.