McDonald’s, The Heritage Foundation, And Minimum Wage Myths

Corporations don’t spend millions of dollars lobbying against minimum wage increases because they’re worried about you.

Last week, I published a post about the possibility of Ohio and Michigan adopting a $15 hourly minimum wage. A common response I received was that this was an unfortunate development, as the costs of such a wage increase would simply be passed on to consumers, rendering nearly everyone —possibly even the workers themselves— worse off because of the resulting price inflation. This misconception has been incredibly persistent, even among some economists. Today, we’re going to walk through the effects of minimum wage increases by using McDonald’s as a case study and discussing some of the empirical research on the issue.

Some Economic Theory 

This debate marks another chapter in the long crusade against a higher minimum wage. The old argument that minimum wage hikes were inadvisable because they would result in job loss for low-skilled workers has failed to find vindication in economic research. Ever since Card and Kreuger’s famous study of employment changes at fast-food restaurants following a minimum increase, evidence has mounted that a moderate increase in the minimum wage will be met with only a very small change in labor demand among low-wage employers. Even the possible small effect is in question, as some evidence attributes it primarily to publication bias.

With this explanation cast aside, blaming rising wages for inflation appears a logical (and politically expedient) retreat. Maybe employers don’t take part in massive layoffs after minimum wage hikes, but they must be getting their money back somewhere. Right? Well, we’ll get there. From an aggregate perspective, however, this thesis appears unconvincing. Studies from the Economic Policy Institute and The Federal Reserve both found that increased labor costs bear responsibility for a historically small 8% portion of the recent inflation surge, while corporate profits were responsible for roughly half of it. In other words, corporations clearly weren’t just passing on the costs of their rising wage bills to consumers; they were reaping record-breaking profits.

How is the belief that corporations can fully pass costs on to consumers justified in economic terms? In some cases, it simply isn’t. Proponents merely argue that of course corporations wouldn’t just take higher costs on the chin, neglecting to discuss the possibility that they may have to. In this argument, it is presumed that corporations have full price-setting power; one is left to wonder why they wait for wage hikes to fully unleash its might. 

A more theoretically rigorous explanation is that low-wage firms often operate in near perfectly competitive markets. Under perfect competition, firms compete away all of their economic profits, and prices are set equal to the firm’s marginal cost. Under these conditions, firms must pass their higher costs on to consumers. Presumably, they’ve been minimizing costs since before the wage hike, so laying off staff or reorganizing to increase productivity is not viable. (This argument ignores the fact that firms could be bailed out in part by the productivity benefits —reduced turnover and absenteeism— that have been shown to accompany higher wages.) However, this model of perfect competition is far from a reality. Fast food enterprises sell differentiated products and consequently enjoy some degree of market power. This allows them to charge above marginal cost and reap significant profits. It also means they face a variety of choices in the face of rising wages.

To avoid getting bogged down in economic theorizing, let’s now turn our attention to McDonald’s. 

McDonald’s: A Case Study

McDonald’s has recently been garnering a lot of attention for its rising prices. A recent viral news story expressed outrage at a Connecticut McDonald’s charging nearly $18 for a Big Mac combo meal. While this example is extreme it can give us some useful insight into how McDonald's operates. McDonald’s has over 13,500 restaurants in the United States, but roughly 90% of them are franchises — independently operated locations that make their own pricing decisions. Why did a franchisee think she could get away with such an absurd price? Surely they didn’t need to charge $18 to recuperate wage costs.

Well, the answer requires a lesson in economics. Firms, McDonald’s included, are profit-maximizing. That means they try to maximize their revenues and minimize their costs. In fast food, maximizing revenues means selling an optimal quantity of food at an optimal price that maximizes how much money comes in the door. Firms can maximize profit by charging a high price and selling fewer units or charging a lower price and selling many, but their short-term revenue maximization strategy shouldn’t be fundamentally altered by rising costs. Their method should depend on the preferences of customers, the availability of substitutable products, and how consumers’ purchasing decisions change in response to changes in price, i.e. their price elasticity of demand. 

Different consumer preferences explain why the prices of Big Macs vary so greatly across the country and why they are not tightly correlated with prevailing wage levels. For instance, New York State, with its near $15 minimum wage, has cheaper Big Macs on average than notoriously low-wage Mississippi. 

Source: Zippia

McDonald’s executives understand this well, even if their economic apologists do not. Speaking to CNBC a few months ago, McDonald’s CEO Chris Kempczinski explained his company’s pricing strategy:

When we execute where we know we have pricing power, we do quite well, but what we do find as we try to take pricing in the areas that are maybe a little bit more sensitive, the consumer pushes back on it.

Of course, we shouldn’t blindly take the words of corporate executives as gospel for what motivates their behavior. For every relatively dry economic accounting of pricing power, there exists a hysteric cry that price increases are primarily the fault of workers and their unions that’s geared to a more politically-inclined audience. McDonald’s executives are rushing to do this now, blaming a California minimum wage hike for the company’s latest plan to raise prices. (Several frustrated consumers posed a good question: then what were all the other price hikes earlier this year for?) Another example of this phenomenon comes from former McDonald’s CEO Ed Resni who recently spoke to Fox Business:

You got a choice, you go broke by raising prices or you go broke by losing money because you can't raise prices…So I understand the need to perhaps make a public statement that you're going to $15 and I don't quarrel with that aspect of it. But when the rubber meets the road, you've got to look at what are the franchisees going to do because they're 80% to 90% of the system and a lot of them are already there.

Now might be a good time to talk about the franchisees who account for a large majority of McDonald’s total revenue and are more naturally sympathetic characters than the corporate executives at the company. By all accounts, the position of franchisees is more precarious, with their profit amounting to roughly six cents on every dollar of revenue with roughly 25% of their costs going toward labor. But even this belies the flexibility of these outfits. Let’s do some simple back-of-the-envelope math. If 94% of McDonald’s revenues are devoted to costs, 25% of which are labor, and wages go up ten percent, then roughly 96.5% of that franchisee’s revenue would go toward costs, while they could still retain 3.5% of revenue as profit without implementing a single price increase, all else equal. In other words, wages could increase by ten percent instantly, and the average franchisee would still have a fairly healthy profit margin.

(94*.25)*(1.10)+75(*.94)= 96.585 which means 3.415% profit (down from 6%)

This is obviously a very rough estimation. Minimum wage increases change not just firms’ costs, but worker productivity and turnover. Besides, just because a firm can raise wages without raising prices doesn’t mean they necessarily will. To explore these complications with rigor, we’d better turn to the empirical evidence.

Empirical Studies

Unfortunately, McDonald’s, like nearly all firms, only releases its internal data as is required by regulations and at its own will, so it is not possible to conduct a granular study of how wage increases affect prices. Instead, we’ll need to look at the fast food industry generally. Still, there’s surprisingly little about the effect of the minimum wage on fast food prices. After a quick search, the first paper I could find was a 2013 publication from The Heritage Foundation called “Higher Fast Food Wages: Higher Fast Food Prices.” by James Sherk, a former special assistant to President Trump on domestic policy. (He’s now at the America First Policy Institute). Sherk begins with fast food industry cost and profit data, which roughly corresponds to the percentages I cited above—except his pre-tax profit rate is only 3%. He then averages several estimates of the price elasticity of demand for fast food, finding that for every 1% increase in fast food prices, sales decline by 0.946%. Then, Sherk explains his model for estimating the size of price increases: 

Heritage used an iterative model in which fast food restaurants first raise their prices to cover the labor cost increase, and then experience falling sales in response to the price increase. The reduced sales cut the food and labor expenses of the restaurant but not its fixed costs. Heritage assumed that food and labor costs fall proportionally to the change in sales. In the model, restaurants then raise their prices by an amount necessary to restore a portion of their previous profits.(Italics added)

Using this model, Sherk finds that increasing the wage of all fast food workers to $15 —wages were then $9.04 on average — would decrease the profits of the average fast food establishment by 77% and result in prices that are 38% higher. Let’s dig into how Sherk arrives at these figures. There are two big issues.

First, Sherk provides six estimates of the price elasticity of demand for fast food and averages them together. You may notice that five of these estimates are quite large, while one is much smaller. The reason for this is that they measure different things. The Okrent and Alston measure of price elasticity “do[es] not separate out the effects of household time constraints and advertising on the demand for fast food, as against the pure effects of price on demand.” In other words, it captures the entirety of a firm’s and consumers’ responses to price increases without attempting to control some of them away, while at least four of the other five estimates work to isolate the effect of the price increase alone while neglecting how it may interact with other factors that affect demand. (I cannot access Brown (1990) to verify its approach.) Both approaches have merit, but in a public policy context, the Okrent and Alston metric probably deserves greater weight. After all, when studying a public policy we should care about its aggregate economic impact, not how it affects the economy through merely one heavily-isolated channel. Applying more weight to the elasticity estimate of Okrent and Alston would significantly reduce the size of profit losses estimated by Sherk, though its effect on his estimated price increase is more ambiguous.

Source: The Heritage Foundation

Second, if you read the quoted section about Sherk’s model again, you’ll notice that he actually doesn’t prove his titular claim that higher wages cause higher prices. In fact, he assumes it as part of his model by taking for granted that firms will pass the entirety of their increased labor costs on to consumers. The entire paper is thus an exercise in circular reasoning.

In his conclusion, Sherk hints at (but does not reflect on) the possibility that reality could be more complicated:

Without major operational changes, fast-food restaurants would have to raise prices by 38 percent while seeing their profits fall by 77 percent. This would cause many restaurants to close and many others to make extensive use of labor-saving technology—eliminating many of the entry-level jobs that inexperienced workers need to get ahead

Thus far, this post has largely ignored the issue of automation, as it's generally only considered feasible over longer time horizons and is not seriously studied by any of the empirical papers sourced in this post. However, I should note that the incentives to automate low-skill jobs have been in place for a long time. Whether a worker’s average wage is $7 or $15, of course, it would be much cheaper to adopt technology that would require a single dollar per hour to keep running, though the large fixed costs of adopting such technology could make adoption rates marginally slower for workplaces with lower wages. While some automation has taken place, Aaronson and Phelan (2014) find that it has negligible effects on employment. The robots haven’t come yet, and it’s not clear that wage growth will significantly quicken their arrival. After all, McDonald’s doesn’t manufacture its robots in-house. The technology firms that build these sorts of things already have massive incentives to succeed as quickly as possible. What’s holding them back is not the fact that wage growth is too slow. Our technological abilities have simply not yet advanced far enough to produce functional robots at a reasonable cost. I have a lot more I could say about the prospects of automation, but for now, we better return to the topic at hand. I do find it inconsistent of economists like Sherk, who would surely celebrate all the savings he believes consumers and firms would allegedly receive from the adoption of robots, to pretend to lament their arrival and the consequences they would have for workers. No better time to cosplay as a friend of workers than when you’re trying to keep their wages down, I guess.

We must also note that Sherk’s bad estimates have now been partially refuted by reality itself. In the face of rising wages, profits at McDonald’s are up 18% from their pre-pandemic levels and have gone up every year since 2015 in the face of rising wages. It’s one of several businesses that have raked in record profits in the high-demand post-pandemic economy. This demand likely renders Sherk’s estimates of price elasticity a bit obsolete, but to the extent that this demand is driven by higher real wages, Sherk should have made an effort to account for it. Even before the pandemic, fast food enterprises in some states were paying $15 wages and Sherk’s predicted catastrophe failed to arrive.

Source: Macrotrends

That’s because reality is more complicated and Sherk’s assumptions are a bit crazy when you really think about them. According to Sherk’s estimate, we’re supposed to believe that firms whose total costs increased by “approximately 15%” would raise their prices by a whopping 38%, just to decimate their profits in the process. The high elasticity estimates Sherk uses alone are a powerful incentive for firms not to pass on the costs of higher wages to consumers. If raising prices costs you a lot of customers, you find a different way to offset costs. You could “make extensive use of labor-saving technology” or make “major operational changes” as Sherk suggests, but there is a far greater variety of options available than these opaque phrases suggest.

Many of these possibilities have been scattered throughout this post, but here’s a great summary by Pollin and Wix-Lim (whose findings we’re about to discuss) that brings them all together:

In fact, there are four primary ways for businesses to adjust to cost increases other than reducing employment. First, a minimum wage hike could be paid for, in part, by cost savings from reduced absenteeism, lower turnover and training costs, and higher productivity more generally. Second, firms could possibly cover a share of their increased costs by raising prices. Third, firms could allocate a share of the revenues generated by economic growth to cover these increased costs. Finally, firms could redistribute overall revenues within the firm—from profits to the wages of their lowest-paid workers.

All of these factors are taken into consideration by Pollin and Wix-Lim in their paper on firms’ ability to cope with higher minimum wages. Their model predicts how much prices would need to increase for firms to maintain their current rate of profit, realizing that corporations would only accept a cut to their profits as a last resort. They find that: 

 [T]he fast-food industry could absorb the increase in its overall wage bill without resorting to cuts in their employment levels at any point over… [a] four-year adjustment period. We find that the fast-food industry could fully absorb these wage bill increases through a combination of turnover reductions, trend increases in sales growth, and modest annual price increases over the four-year period. 

However, if productivity gains are exhausted and consumer demand sufficiently inelastic, accepting a modest reduction in profits may be the best option left to some firms. That could be a good thing. After decades of a widening gap between firm productivity and worker pay, such a move could be interpreted as making up for past wage stagnation relative to productivity.

Wrapping Up

Since 2015, when movements for higher wages began to take off in America, McDonald's sales growth has been roughly constant, with price increases that roughly kept pace with inflation and trailed wage growth before the pandemic. Since the pandemic, McDonald’s position has improved further. In the last year, for example, McDonald's net income rose by 18%. That’s nearly twice as fast as its wage growth (10%) and more than twice as fast as its same-store sales growth (8.1%). McDonald’s has credited much of this success to its implementation of strategic price increases through its increased adoption of localized prices at the franchise level.

Source: Axios

In summation, the effects of wage increases are something that must be empirically studied, not dogmatically assumed. Second, the evidence at hand suggests that large, quickly-implemented wage increases can be managed by fast food firms. The time horizons utilized by both Heritage and Pollins and Wix-Lim in their studies of minimum wage hikes are much shorter than the ones typically adopted by policymakers, who prefer to raise the minimum wage more slowly, by a dollar or so annually. Additionally, the transition costs of adopting a $15 wage are much smaller today than they were when these papers were published in the mid-2010s. We’ve already progressed some of the way to $15 and the real value of that wage has been eaten away by inflation. Lastly, while firms often misleadingly blame wage increases for their decisions to raise prices, in their investor calls and in the business press, they often opt for greater honesty. Firms have limited pricing power and cannot endlessly pass their costs on to us. However, they are highly incentivized to propagate that belief. It allows them to frame what’s good for their workers as bad for everyone else. 

But if firms can easily pass the cost of minimum wage increases on to consumers, why do they waste so much time whining about it in the news and spending millions of dollars lobbying to prevent hikes from passing?