Every diligent student in Economics 101 learns how to use supply and demand curves to show that legislating for minimum wage rates tends to reduce total employment. And so these diligent students would imagine that the imposition of higher hourly wage rates is a big factor in the way that US labour costs are rising this year.

What these diligent students don’t know yet is that the real world is often reluctant to behave the way that economic theory says it should. Supply and demand curves are theoretical abstractions, and the straightforward conclusions of economic theory depend on several simplifying assumptions which usually aren’t true in the real world. What is happening to US labour costs this year is a clear illustration of the complexity of the real world versus the simplifications of theory.

In recent earnings guidance from US retailers and restaurant chains, management has suggested that rises in the minimum wage will cut CY2016 profits by 2% to 3% and CY2017 profits by 3% to 4%. Retailers and restaurant chains are on the frontline of wage changes because they employ a lot of unskilled labour and their labour costs typically account for 35% to 40% of their total costs. Companies were also careful to point out, however, that the size of the cost increase depended on their current business strategies and on conditions in the individual labour markets where they operated. Many companies noted that, despite higher labour costs, they were planning to hire more staff in order to cope with rising sales.

The minimum wage laws in the US vary widely from State to State. The Federally mandated minimum is USD7.25 per hour, but only 29 of the 50 States set their minimum wage rate above this level. Fifteen States index their minimum wage rates to cost of living increases, with the result that there are small increases every year. The highest minimum wage rate is currently USD10.00 per hour, not surprisingly in Massachusetts and California. Ten States have increased or will be increasing their minimum wage rates in CY2016, including California.

Thus the effect of rising minimum wages on a company depends on four factors:

  1. How many States are lifting their minimum wage rates, and when;
  2. What size the increase is in each of those States;
  3. Which of those States the company has significant operations in;
  4. How many of the company’s employees are paid less than the new minimum wage.

One of the main contributors to rising labour costs is California, which raised its minimum wage rate from USD8.00 to USD9.00 on 01 July 2014, then to USD10.00 from 01 January 2016. This is a big percentage increase, and California’s 38.8 million people account for 12% of the population of the US.

The core problem facing companies is that labour markets have been getting steadily tighter and tighter in most States (except for the oil, gas, and coal producing areas). National unemployment is now down to 4.9%, the labour participation rate is rising, layoffs are falling, the voluntary separation rate is steadily improving, and the number of job openings is well above pre-GFC levels (see chart below). The statistics are supported by anecdotal evidence: for example, housing starts have been held back by regional shortages of tradesmen and unskilled labour.

In response, many companies have changed their strategy from cutting costs to adding value. Wal-Mart, which is the largest retailer in the US, has been notorious in the past for how little it pays its low-level employees. But it recently announced that it was going to raise its minimum wage to USD10.00 per hour, and in February it said that it would give a pay increase of at least 2% to most of its employees.

It is likely that rising labour costs will crimp corporate profit margins in CY2016 and CY2017. Higher minimum wages are a contributing factor, but by no means the whole story. In the seven years since the GFC, US companies have enjoyed abundant labour at low cost, but this picture is about to change, and the successful companies will be those who use their employees to add value and improve customer satisfaction.

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