Will a Higher Minimum Wage Raise Prices?

Thomas A. Firey Jan 30, 2014

I did a hit on today’s C4 Show (WBAL Radio, 1090AM) discussing my 2013 op-ed on the minimum wage and Earned Income Tax Credit and promoting my new policy analysis on the same subject. During the interview, C4 took a call from a listener who dismissed the idea that a higher minimum wage would lead to higher consumer prices, saying that low-wage employers like McDonalds and Applebee’s have raised their prices several times in recent years.

I didn’t (and still don’t) understand why he thought the recent price increases would mean employers would not raise prices to cover higher wages. If anything, we should expect the opposite, right? Anyway, as a result of my lack of understanding, I didn’t do a good job of responding to his comment. I thought I’d write up this post to give a better response.

I’ll first note that raising the minimum wage has already been linked empirically to subsequent higher prices,[1] and this link has been acknowledged by the prominent political left.[2] So we know that it happens. The question is, why does it happen?

Below, I give three different explanations for this, with each explanation depending on a different conception of the economic power of minimum wage employers. Explanation 1 assumes that minimum wage employers have little economic power to manipulate the wages they pay their labor or the prices they charge their customers. Explanation 2 assumes the employers have considerable power to dictate prices. Explanation 3 is more complex (and in my opinion is more accurate), assuming that some employers have little power to dictate wages and prices while others have more so.

Explanation 1: Highly competitive market

In this view, low-wage employers are both price- and wage-takers, meaning that because there are plenty of other employers that can hire low-skill workers and plenty of other businesses that make similar products, these employers have to both pay competitive wages and charge competitive prices for their products. Such competition squeezes the employers’ profit margins.

If a minimum wage increase occurs, these employers will have to raise their wages. That will further squeeze their profits, making the businesses less worthwhile (if not outright unprofitable). To stay in business, the employers have to raise their prices. However, they don’t have to worry about losing many customers because their competitors, who are also low-wage employers, will also be raising their prices. The result: higher prices.

Explanation 2: Non-competitive market

In this view, low-wage employers are price-makers, meaning they can raise their prices arbitrarily with little fear of losing customers to competitors. These businesses thus have high profit margins.

If a minimum wage increase occurs, these employers will have to raise their wages, which will squeeze their profits. However, the employers can then simply raise their prices to restore their profit margins because, as we’ve stipulated, these firms are price-makers. Indeed, many minimum-wage supporters claim that a higher raise will “put more money in people’s pockets”—so these firms will then happily shake that money back out. The result: higher prices.

Explanation 3: A more sophisticated (and real-world) market

In this view, some businesses are price- and wage-takers while others have some power to set their wages and prices. For simplicity, let’s assume there are only two such businesses: Business A is a taker while Business B is a maker. Business B can charge higher prices and earn higher profits because, for some reason, consumers prefer B to A so much that B can profit from that preference. But there is a limit to this: at some point, B’s prices could get so high that people will settle for the inferior A in order to save money. (Even monopolies have a limit to what prices they should charge.[3])

If a minimum wage increase occurs, Business A will have to raise its prices because it’s bound by the same conditions described in Example 1. Business B is not bound by that condition, but because Business A was forced to raise its price, Business B will have greater freedom to raise its prices—and it will certainly take advantage of that freedom. The result: higher prices.

[1] David Card and Alan B. Krueger. “Minimum Wages and Employment: A Case Study of the Fast-Food Industry in New Jersey and Pennsylvania.” American Economic Review 84(4): 772–793 (September 1994).

[2] Christina Romer. “The Business of the Minimum Wage.” New York Times. March 2, 2013.

[3] That is the point where the monopoly’s Marginal Cost (that is, the cost of making just one more unit of the good it sells) equals the Marginal Revenue of that good (the amount the firm would make for selling that additional item). For an explanation of why this is the monopoly’s best strategy, see the Wikipedia entry for “monopoly profit.”