Apparently, one CEO in Seattle didn’t realize we were joking. Dan Price of Gravity Payments recently announced that every one of his 120 employees would soon be making a minimum of $70,000 a year—a minimum wage of $33.65 an hour.
The media reaction to the story has been about as fawning and uncritical as you would expect. While Price is rightfully being praised for his generosity (he’s cutting his own pay from $1 million to $70,000 a year to fund the pay increase), few people have—so far—pointed out how his largess may soon put his employees out of a job. Here’s why.
For the average worker, non-salary benefits and taxes usually add about 20 percent to an employee’s compensation. That means that Gravity Payments will be paying a minimum of $84,000 per employee. If we assume that all 120 employees made the same amount (they won’t), the company will have a minimum fixed salary cost of $10,080,000 a year. Gravity will need to bring in 10 million dollars in revenues just to pay the salary.
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.
But there is another reason Gravity’s CEO is setting the company on a path toward bankruptcy.
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.
We should look at this story not a rational business decision but as a peculiar social experiment being played by a rich guy. Gravity Payments is essentially turning into a non-profit that will stay in business only as long as the CEO can fund the experiment out of his own pocket.
While the employees of Gravity Payments are cheering now, so are the company’s competitors. Competing firms know that Gravity is setting itself up for failure. Gravity will either have to change the policy in the future (thereby destroying company morale), lay off their least-productive employees (thereby destroying company morale), or go out of business when Mr. Grant runs out of money.
Because unemployment is a moral issue, actions that lead to unnecessary forced unemployment—such as inflated wages, whether voluntary or government mandated—should also be considered a moral issue. Inflating wages far past the value of labor may sound generous but it can lead to disastrous consequences.
Of course, pointing this out is likely to be unpopular. Today, I’ll be called a scrooge for saying the pay increase is foolish. But in five years, when Gravity is bankrupt and 120 jobs have been destroyed, the same scoffers will say how unfortunate it is that such a generous company went out of business.
Those with no economic foresight will be unable to see that, based on basic economic concepts applied to wages. the unfortunate outcome was exactly what we should expect to happen. Increased unemployment at Gravity will certainly be unintended—but it should not be an unforeseen.
Update: I should clarify that I think Mr. Price’s charity is noble and laudable. But I think a better strategy would be to merely give the employees a cut of the profits rather than increased pay (the higher pay structure will reportedly consume 75-80 percent of the profits). If you give employees a bonus from the profits, then if there are no profits there is no problem. But if you promise employees higher compensation based on profits, they’ll still expect the higher wages even when the profits dry up. So it’s the compensation structure, not the charity, that makes Mr. Price’s decision imprudent.