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Today, I encountered what I would consider to be a rather misguided article by Business Insider writer and CEO Henry Blodget.  Blodget’s writes:  “Dear Wal-Mart, Starbucks, and McDonald’s:  How Do You Feel About Paying Your Employees So Little that Most of them are Poor?”   He argues that the firms are wildly profitable and can afford to “share the wealth” by paying their employees more.

There’s an emotional appeal to Blodgett’s argument.  Unfortunately, we know from the science of economics that it’s not that simple in reality.  In fact, such a scheme would not achieve its objectives.

Let’s start with Starbucks.  I have no idea how much a Starbucks barista is paid, but let’s say for simplicity’s sake it’s $10 per hour (and no tips).  Starbucks decided to graciously raise the wage to $20 per hour.  Baristas become wealthier as a result, right?  Well, the answer is, “it depends.”

Actually, the most notable result of this wage increase is that the demand for jobs at Starbucks increases dramatically.  This is simple to understand — people are more likely to want a higher-paying job.  Now that Starbucks is willing to pay $20 per hour instead of $10, a data entry worker making $12 per hour, or a secretary making $18 per hour might suddenly become interested in the Starbucks job.

Meanwhile  the supply of Starbucks jobs is likely to decrease.  This comes from the fact that Starbucks will have to raise prices in order to increase wages.  As a result, fewer customers will demand Starbucks coffee and fewer baristas will be needed.  We could, of course, argue that Starbucks decides to absorb the massive hit in profits voluntary; thereby, not increasing prices.  I’ll get to that alternative argument later, but for now, let’s stick with the more logical explanation that they are required to increase prices.

Now, the question becomes, has anything improved?  On the face of it, the answer is yes, because Starbucks employees make more money.  In reality, the answer is no, because Starbucks merely lowered the supply of jobs and temporarily increased market labor wages.  The latter might initially sound desirable, until we realize who it actually harms.  Since other businesses have to compete with Starbucks for labor, they will have to raise wages to compete.  For instance, our $18 per hour secretary might demand an increase to $22 per hour, if she had an alternative of working at Starbucks for $20.  In a simple example, since secretarial work likely has a higher level of skill required, she would be able demand more than $20 per hour.

Higher wages for everybody — it’s great, right?  Well, maybe not.  Let’s say the firm that hired the secretary was having a rough go of it.  Now that they have to pay their secretary (and other lower-level employees) higher wages to compete, they might decide it’s not worth it to continue, and shut down the business. So not only does Starbucks reduce the number of jobs at its own stores (via lower demand for their coffee at higher prices), but it actually results in jobs being eliminated at other businesses.

In other words, all Starbucks did by raising wages was destroy jobs.  No economic wealth was created.  It merely arbitrarily rewarded those who were able to get the limited number of barista positions and arbitrarily punished those who lost their jobs as a result.

So a few people became somewhat wealthier, while a larger number of people became poorer; sometimes much poorer.  While the $20 per hour employees would be happy, the unemployed former baristas probably would not be.  Eventually, Starbucks overpaying for its employees would probably result in competitors like Caribou Coffee gaining more market share and driving Starbucks locations out of business; thereby, driving the market wage for baristas back down towards $10 over time, regardless.  So nothing was actually achieved by this entire endeavor, except for a temporary increase in unemployment and a somewhat arbitrary redistribution of wealth between lower-wage workers.

None of this is to suggest that employers should be stingy with wages and there are some legitimate reasons to pay more than necessary.   But it’s merely to say that wages, to a great extent, are determined by the market for labor.  If the market for one position pays $9 – $11 generally, an employer might benefit from paying at the end of that range at $11 — maybe even $12 if they’re lucky, but raising wages to $15 is essentially like digging their own grave.  Conversely, it’s likely in our scenario that if an employer tried to pay $7 or $8 per hour, they would also suffer, because the quality of worker they would attract t at that rate would be so low as to be uncompetitive.

But What About Shifting Profits Over?

Now, let’s shift back to Blodgett’s likely counter-response that he’s merely advocating that more of Starbucks profits go to employees, so a price increase would be unnecessary.  Unfortunately, this is not a convincing argument, either.  The problem is that all the investors in Starbucks stock would begin selling off their holdings. Since Starbucks’ profitability would plummet, the value of the stock would fall significantly.  By the way, this doesn’t only harm the wealthy; it also harms a lot of middle class workers who depends on pension fund, 401(k)s, or various other retirement products to plan for their future.

Over the past three fiscal years, Starbucks’ profit margins have fluctuated from 4.0% to about 11.0%.  In my example above, I doubled Starbucks’ wages and it’s probable that the company would lose money in this scenario.  But even if we moderated the example, so that Starbucks’ profit margins fell to 0.0% to 7.0%, the implied value of the stock could fall over 50%!  Suddenly, Starbucks’ seemingly manageable debt burden starts to seem much, much larger with fewer cash flows to service it. Moreover, fewer people want to invest in Starbucks’ equity, so the company has a lesser ability to tap the capital markets.

As a result, Starbucks’ costs of capital would increase significantly, making it more difficult to finance their own investments.  This includes the opening of new stores internationally, as well as capital improvements to their existing US stores. This makes Starbucks less competitive with Caribou, Peet’s, and other chains; and their stores become less attractive to patrons.  This results in a likely downward spiral for Starbucks, which still ends up with the same result as above:  competitors eventually drive the market wages for baristas back down to $10.

To use two cliches in the same sentence, there’s a reason economics is “the dismal science” and it’s because “there’s no such thing as a free lunch.”  What Blodgett fails to understand is that there’s a reason that Starbucks’ employees make the wages that they do and it largely has to do with supply and demand.  A Starbucks barista is a relatively unskilled occupation, so much of the American populace is capable of performing the duties of the job with little to no training.  This means that wages stay relatively low.  Wages tend to only be high for skilled occupations where there’s a much lesser supply of labor and there’s more value created.

Blodgett’s proposed solution does not change the supply and demand dynamics; nor does it create more wealth through innovation.  It merely tries to redistribute wealth; but the redistribution fails to achieve its desired objective because the market will simply push back towards the supply-demand equilibrium.

How to Increase Wages

There are only a few noteworthy ways to increase real wages in this scenario:

(1) Starbucks innovates, thereby lowering capital costs, and increasing employee productivity. This results in higher wages for Starbucks employees, (However, it might also result in fewer jobs at Starbucks, since the innovation could require less labor.)

(2) Starbucks offers its employees equity compensation.  Since equity is higher risk, this form of wage tends to have a higher return over time, but it’s also less stable and many entry-level laborers (of the type that work at Starbucks) can not afford this risk.

(3) Technological innovations and productivity improvements in other areas of the economy increase the overall wealth in the United States, thereby creating higher-wage jobs, which “lifts all boats”; including Starbucks’ wages. This is probably the most realistic.

There are of course ways that individual employees could showcase their value and demand higher wages.  At Starbucks, that might include upselling other items, or convincing customers to move into higher-margin selections.  Or maybe a barista shows a knack for management, and moves “up the ladder”, therefore demanding higher wages.  Moreover, there’s an argument for slightly “paying up” in order to gain employee loyalty, which would result in lower employee turnover and lower hiring costs.  (Starbucks, btw, adopts this philosophy already.)

Overall, however, the basic lesson here is that redistribution of wealth in ways that violates market principles never achieves the desire objective.  If Starbucks tried to pay higher wages, it would simply become less competitive and the “invisible hand” would tug things back towards their natural equilibrium.  That’s why Starbucks can’t pay its employees more.

Of course, if one is really concerned about the low wages of Starbucks baristas, there is one easy solution to this problem that only requires a small sacrifice on your part:  the next time you go to Starbucks, you can tip your barista more.