Because most philosophies that frown on reproduction don't survive.

Monday, April 20, 2015

The $70k Minimum Wage and the Difficulty of Generalities

A fairly small business named Gravity Payments became huge national news last week when the founder and CEO announced that he was going to set a $70k/yr minimum wage for his company. The 11-year-old company has 120 employees and offers credit card payment processes services for small businesses. CEO Dan Price founded the company in 2004 when he was 19 years old. After seeing the owner of a coffee shop where he was playing a gig struggle with the coffee shop's payment system, Price thought he could do better. This year he expected to turn a $2.2 million dollar profit and pay himself a salary of $1 million. However, after reading some research on how increases in income up to about the $70k/yr threshold have a much larger impact on happiness and security than increases thereafter, Price decided to cut his salary to $70k and use 75-80% of the anticipated profits for this year to begin a phase in (over several years) of getting all his employees up to the $70k mark. The average wage of his employees is currently $48k and about 70 will be seeing some kind of an increase, with 30 seeing their earnings at least double. Price plans to keep his own salary low until the company has grown enough that its profits return to the pre-wage-increase levels.

Given all the attention to inequality and wages, it's no surprise that this has attracted a fair amount of political commentary. Joe Carter has a piece up at the Acton Institute arguing that this dooms Gravity Payments to go out of business, and thus is of questionable ethical value. He has two arguments. The first is based on competitive pressure:
Imagine a competitor, Anti-Gravity, has both the exact same number of employees and the exact same non-salary costs as Gravity. The only difference is thatAnti-Gravity has decided to pay all of their employees a minimum of $60,000 a year ($72,000 in total compensation). Because of the differences in salary costs, Anti-Gravity would need to bring in $1.4 million less in revenue that Gravity. They could pass that savings along to their customers and completely undercut Gravity.

In reality, though, competing companies willing to pay their own employees competitive market wages, which means if their other costs are similar they’ll always be able to price their services lower than Gravity. Payment processing companies are extremely price sensitive, so Gravity has put themselves at a severe disadvantage in relation to their competitors.
Now, since I work in pricing analytics, I'm always kind of drawn to arguments which put price at the center of driving business, but it seems to me that there's a clear problem with this. Gravity is already making enough money to pay the higher wages and then some, it's just that the money is currently being spent on the CEO's salary and on company profits. (And as a private company, they're fairly free to make a high stakes bet with their profits in a way that a public company would have a harder time doing.)

So a competitor with a product and service of similar value was out there, they could already be making the same price play to attack Gravity by choosing to have lower CEO pay and lower profits. There may well be lower cost competitors out there, but not enough to have significantly hurt Gravity up to this point, given that it's gone from zero to 12,000 business clients in eleven years and currently processes $6.5 billion in total transactions per year for them.

With a business service such at this, you typically do what's called "value based pricing". This means that you assess how much your service is worth compared to those of the most relevant competitors. To create a quick example:

I do payment processing and my key benefit is that I have a really great mobile processing app, while the processor my potential client currently uses provides an app that is always crashing, making it hard for the client to sell his widgets and craft widget shows outdoors. My client estimates that he could increase his sales by $40k per year with better mobile processing, and his profit margins are 30%. This means that, all other things being equal, I can charge up to $12,000 more than my competitor and the potential client will be at least as well off as he is now. If I charge $3,000 more per year, my client realizes an increased profit of $9,000 per year by going with me instead of my competitor.

Okay, so that's value based pricing. But so what? What if a new competitor Anti-Darwin CC Processing shows up and offers a service just as good but with pricing $2,000 lower than me. Well, in that case, he may take money from me. But in the real world, having a service which is "just as good" is not always as easy as it sounds. There are a ton of companies who might see it as their mission to produce smart phones "just as good" as the iPhone while undercutting Apple on price, but with a lot of customers, Apple manages to convince people that they provide the best product for the money and thus they keep their massive profits.

All of which is to say: Yes, if Gravity had an immediate competitor who was clearly offering an equal or better value for the price, they would doubtless be taking customers from Gravity (and since they're a small business are credit card processors go, there are clearly a lot of businesses who do choose a provider other than Gravity) but providing an equal or better product is not always as easy as it sounds, and that is shown by the fact that Gravity is already making a tidy profit and paying its CEO lots of money.

One could argue that Gravity is currently more ready to weather a major competitor threat because it's easier to lower profits or lower CEO wages than it is to lay off employees or reduce the wages of employees you've just excited by giving them higher wages, but by that line of thinking any company with a narrow profit margin is already right at the edge of going bankrupt, and we know that many companies live for long periods with low margins.

Carter's second argument has to do with the productivity of labor versus its cost:
Wages are merely the price of labor. The reason wages differ from job to job is because, in general, higher wages are paid for higher productivity, added value, or to compensate for dangerous or toilsome work.

Let’s say Assistant X, who has no degree, has a job at Gravity making copies and getting coffee. They were originally paid $30,000 a year and added $40,000 of extra value to the company. Manager Y has an MBA, works in sales, and is paid $70,000 a year while adding $100,000 in value to the company. After the pay change, both make $70,000 a year. But now, Manager Y is adding no extra value to the company. All his value added is going to make up the deficit of paying Assistant X $30,000 more than he was worth to the company. (For now, we’ll ignore the animosity that would result from Manager Y making the exact same wages as his less educated, less productive assistant.)

Presumably, none of the employees that were previously making less than $70,000 a year were adding $70,000+ in value to the company. So all of them will be operating at a value deficit that will have to be made up by other, higher productivity employees. What would have previously been taken as profit will have to go to compensate for the loss of value.

But the higher wages are based on the current profits of the company. What happens in future years when the company is making less profit because the previous value (previously realized in profits) is going to over-pay for less productive employees? Eventually, the company will start operating at a loss and will have to cut jobs. Guess whose job goes first? Those whose value to the company is now negative because of the pay increase—the people whose labor is worth $40,000 but are being paid $70,000. The people who are cheering today because of the pay increase are likely to be the ones that tomorrow will be lamenting their unemployment.

This one seems kind of odd to me. Let's assume that the two employees described are in fact the only employees at a company.

Year 1: Assistant X and Manager Y produce $140k in value while costing $100k in wages, producing a $40k profit.

Year 2: Assistant X and Manager Y product $140k in value while costing $140k in wages, producing $0 in profit.

Yes, the profit has gone from $40k to $0 because expenses now equal gross sales. Now, if the owner wanted to make the same $40k in profit, this would be a problem, and he would be looking to cut expenses or grow topline revenue while keeping at his new expense structure. However, if the owner expected the profits to be down until he grew out of the current depressed profits (Price's stated expectation, which suggests he thinks he can grow his revenues faster than his expenses) then there's not necessarily a problem here.

Given that the situation described is one in which the company continues to make a (much smaller) profit after the wage increases, and given that the CEO thinks he has a growth plan which will allow him to return profits to prior levels, I'm unclear what mechanism Carter thinks will cause the company to have to conduct layoffs.

Now does all this mean that all businesses can and should go to a $70k minimum wage? No, of course not. It's silly to generalize the situation of this one business out to all businesses. This is a small, closely held company which the owner believes (rightly or wrongly) is able to pay all its employees a higher wage while continuing to charge the same prices and grow. Not all companies can do that. Nor, even given one that can, do I think there's an obligation to have a $70k minimum wage.

The reason I think Carter's analysis falls down is that it works in a sort of Econ 101 world of generalities rather than considering things which may be specific to the business in question. Those who think that all businesses can do the same are falling into the same error. In fact, what we have here is an interestingly novel store about what one business is doing in its specific circumstances. We arguably don't know enough to evaluate well whether this will work out well for them, and the implications for others businesses are not necessarily direct, though the overall approach of the founder/CEO looking out for his employees and trying to make sure they share in his fortunes is admirable.


Brandon said...

The reason I think Carter's analysis falls down is that it works in a sort of Econ 101 world of generalities rather than considering things which may be specific to the business in question. Those who think that all businesses can do the same are falling into the same error.

I've thought something similar (although much less precise) with respect to some of the comments on this move. Economics arguments are (in general) really a kind of statistical argument. But that means that they have difficulty dealing with particular circumstances that can have an effect, and there are a lot of them here: the company in question is (apparently) already in a state of expansion, it's a privately held company, it gets special publicity over it from being a relatively unique case, it can (possibly) pull in a better pool of talent, and so forth. It's hard to say how much each of these weighs in the situation, but a few of them are bound to play some kind of role. General considerations of wage and labor don't really seem sufficient for analysis here.

Lauren said...

Perhaps a little off topic, but I'm curious to know what this company does that's so different from other merchant services companies. My small business gets regular calls from companies wanting to switch us to their merchant services. When we do the math the savings come out to almost nothing when you consider that our current provider (Quickbooks) automatically integrates with our accounting software. That's easily worth the $20 a month savings we'd have with the other companies. But not everyone is in the same boat as us (low number of transitions at higher value each). I'll have to look up the company and find out what makes them so special, because it seems like a very competitive market.

Kate said...

Thank you for this analysis! I've had the same reaction to commentary seeking to generalize from this example, but I don't have the knowledge base to expand on why it was bothering me besides the obvious that not every company is *this* company, and that I'm quite sure that this CEO's decision wasn't made until after he considered all of the factors affecting his company.

Personally, I think this CEO's sense of responsibility to and solidarity with his employees is admirable--and that there are human factors that economic theory simply cannot calculate, value, or capture. Even were this company to fold over the long run, the lives of these individuals may well be forever positively affected by the opportunities, growth, and experience afforded by being part of such a company. I'm not sure you can put a dollar value on that.