The substitution effect is an idea in economics that can understood pretty intuitively. When the price of some good rises relative to some alternative, people will tend to buy more of the alternative and less of the now more expensive good. If apples and oranges used to be the same price, but apples get more expensive while the price of oranges remains unchanged, people will tend to reduce the amount of apples they buy and get more oranges instead. And it’s worth remembering that this effect occurs with a change in relative prices, too – not merely absolute prices.
If apples used to be $1 and oranges $2, but then the price of apples increases to $1.50 while oranges remain at $2, this can increase the number of oranges sold. Even though the price of oranges hasn’t changed, and its price is still higher than the price of apples in absolute terms, the relative price between the two has changed. Previously, for the price of three oranges you used to be able to get six apples. Now, for the price of three oranges you can only get four apples. Different people will adjust in different ways depending on their own preference between these two, but overall we can expect to see a greater proportion of oranges sold than before.
There is also a substitution effect for labor. As labor becomes more expensive, employers will tend to find substitutes for that labor. One way they can do this is by substituting workers with machines. This tends to happen over time on its own – as technology advances and becomes less expensive, the relative price of using automation as opposed to hiring workers falls, leading to increases in automation. But artificially increasing the price of labor also lowers the relative price of automation, causing more workers to be substituted with automation.
Among the many things one can say about the state of California is that it never fails to provide opportunities to show economics in action. I previously wrote about how the $20 minimum wage for fast food workers was causing fewer people to eat at fast food establishments and instead go to dine-in restaurants:
So why would places that serve more expensive food be seeing their traffic increase, while the still-less-expensive fast food establishments see their traffic decline?
The answer is that even though the price of dine-in chains hasn’t fallen in absolute terms, it has still fallen in relative terms compared to fast food. Fast food and dine-in restaurants differ in terms of price, quality, and convenience. But with fast-food establishments being forced to increase their prices in the face of increased labor costs, the gap in price between fast food and dine-in establishments has gotten smaller without any change in the other two dimensions. As a result, people are seeing what it would cost them to get a basic combo at McDonalds and thinking “Well, if I’m going to have to pay this much just to get some McDonalds, I may as well pay just a little bit more and go to Chili’s instead.”
More recently, another change has been made by a major fast-food chain in California – Chipotle. After this wage increase was put into law, Chipotle has begun replacing employees with machines, as was detailed in this news report:
Chipotle has introduced two robots that can take over tasks normally done by its workers.
The ‘autocado’ can peel, stone and cut an avocado for guacamole in 26 seconds. Meanwhile, a ‘digital makeline’ portions up salads and bowls based on orders on the app.
The machines are part of an automation drive that Chipotle bosses hope will cut down the number of workers needed – slashing rising labor costs.
So, it is no surprise they are being put to use first in two of the Mexican chain’s restaurants in California, the company announced on Monday.
The author of that news article raises the issue of how expensive automation might be:
It is not yet clear how the production costs of using Chipotle’s new machines compares to human labor when making Chipotle menu items.
But this is why it’s important to keep in mind that it’s the relative rather than absolute cost that drives these adjustments. Even if the costs of the new machine are more expensive than human labor in absolute terms, the new minimum wage law has still made the use of machines relatively less expensive compared to human labor than before. And that’s all that needs to happen for the substitution effect to kick in.
As an aside, it’s also worth noting that many restaurants, fast-food and otherwise, have found a different substitute for employee labor than machines. They simply have the customer perform tasks they used to hire employees to do. At one of my favorite local restaurants, they used to have someone who took your order, but they don’t anymore. That person’s job consisted of having customers say what they wanted, then pushing some buttons on a computer to ring up the order. Now, they just have a self-serve kiosk and have the customers push those buttons themselves. When your food is ready, they don’t have servers come and bring the food to your table. They call out your order number, and you pick up the food from the counter and bring it to the table yourself. And when you’re done, you don’t leave your dishes behind to be bussed by an employee anymore. You bus your own tables – they have trays set out for you place your dirty dishes. Restaurants increasingly use customer labor to replace the cashier, the server, and the busser.
I’ve said it before and I’ll say it again – for all its simplifications, the world would benefit from a greater application of Econ 101 than what we have today.
READER COMMENTS
Monte
Sep 26 2024 at 11:51am
The minimum wage, like socialism, is a permanent stain. No matter how much you try rubbing and soaking it out with sound economic reasoning, you still get the proverbial “ring around the collar”. Too much ambiguity remains between the differing perspectives by experts to convince the public that minimum wage legislation is bad policy.
john hare
Sep 26 2024 at 2:49pm
I tend to avoid ordering through the kiosk. I will go elsewhere by preference. Sit down restaurants when feasible.
A local McDonalds has remodeled such that customers don’t pour their own drinks as they used to at that location. It’s hard to believe that they will save more on product than the labor costs of drink handling.
Robert EV
Oct 3 2024 at 12:22pm
Do you know this is why they did it, or are you assuming? There are other reason to move drinks behind the counter, from liability (e.g. Panera) to damage to machinery.
Ahmed Fares
Sep 26 2024 at 4:22pm
First, another excellent article by Kevin Corcoran.
This should read as “substituting machines for workers”.
This article should make it clear as to the correct English usage of the phrase:
Substitute X for Y
Kevin Corcoran
Sep 26 2024 at 5:28pm
Thanks for catching that! Typo fixed.
David Seltzer
Sep 26 2024 at 5:14pm
Kevin: Nice exposition. Question. If the apple has increased from a buck to a buck-fifty, wouldn’t the increased quantity demanded for oranges increase the price of oranges as well? Cross elasticity would have both apples and oranges increase in price up to the point where the relative price change would approach zero. Of course I could be wrong.
Robert EV
Oct 3 2024 at 12:24pm
There was a bumper orange crop that year. The orange producers are actually very happy that the apple price increased, as it means they can sell their excess product at the original price and increase their profit from the extra oranges sold.
Matthias
Sep 27 2024 at 12:06pm
The self-ordering kiosks are also really common in Singapore, especially at fast food places. There’s also a lot of QR-code-scanning-to-order-via-a-website, even when you are inside the restaurant, and even at places that are a step or two above fast food.
Singapore famously does not have a minimum wage. But we have fairly high wages just purely from market forces. Singapore is rich.
Another effect you see from the minimum wage:
A job is a bundle of some drudgery you have to do, some nice things, and some payment. Workers and companies effectively negotiate efficient packages. (Even if some of that negotiation is implicit: companies set some of their policies, and as a worker you can take it, or leave it, and look for a job with a different company with other policies. Similar to how you don’t get to directly decide as a customer what’s on the menu at McDonald’s, but you can always go to Burger King or the Ritz, if you don’t like it.)
Any amenity that the workers value more than it costs the company to provide will probably go into that package. Because it saves the company money, and makes the workers happier. That could be nicer working conditions, training opportunities, or a less demanding workload, or a myriad of other options.
However, a minimum wage outlaws some of that negotiation space. So workers and companies are forced to find mutually agreeable bundles only amongst those that include at least the minimum wage as monetary payment. Thus our prediction (and observation) that lots of low productivity jobs suck even more than they would without a minimum wage.
Ahmed Fares
Sep 27 2024 at 1:55pm
Capital-labor substitution is actually labor-labor substitution. You gain interesting insights when you see through the capital to the labor embedded in capital. For example, when Musk builds his Teslas in Texas using KUKA robots manufactured in Germany, he’s substituting German labor for US labor. In that sense, US labor competes not with capital but with German labor.
An interesting article I came across recently:
The dissipation of minimum wage gains for workers through labor-labor substitution: evidence from the Los Angeles living wage ordinance
Robert EV
Oct 3 2024 at 12:31pm
A lot of capital started out as seigniorage from government monopoly on minting, and thus represented future labor, not a store of past labor. Have we burned through all of that future labor such that all capital now represents past labor (though not necessarily the labor of the capital controller)?
Thomas L Hutcheson
Sep 27 2024 at 2:29pm
I agree, but this also includes deciding if the substitution is great enough to actually reduce worker earnings. Of course the substitution could be avoided entirely if we just used a more generous EITC as te instrument for raising worker incomes.
Ahmed Fares
Sep 28 2024 at 2:53pm
re: the monetary offset
The rule in economics is that for someone to consume more, someone else must consume less. If workers have increased incomes, they’ll increase their spending, which will be inflationary. Central bankers raise interest rates to offset, which means that while these workers have higher incomes, they’ll also have higher interest rates on their debt, cancelling out the effect of the increased worker incomes.
The Monetary Offset
Jim Glass
Sep 28 2024 at 7:11pm
Possibly related, and interesting in a number of ways anyhow:
Universal Basic Income just received its first significant-scale, high-quality controlled test in the USA — and failed. After receiving $1,000 per month for three years, $36,000 total, participants wound up poorer, their earnings declined. They spent the $36,000 mainly on leisure, using some of it to substitute for earned income, working fewer hours. They also experienced no improvement in mental or physical health due to reduced stress or whatever. They just spent the money, and ended up poorer.
This is interesting for a couple of reasons:
1.) UBI has been a success in poor third-world countries. This suggests a meaningful difference between being *really poor* in those societies, struggling to survive and subsist, in which case UBI is invested to improve life, and “relatively poor” in the USA, with the basics of life and security assured, so people can afford to spend UBI on entertainment and substitute it for working.
2.) The result of the study has been reported as a *success* all over the media. I’ve seen several of these reports myself. This is because the test was organized by Sam Altman and OpenAI with the motivation of proving: “If AI unemploys millions — replacing EVERYBODY with machines — they’ll all be better off for it by getting free money.” So they went through the study results and cherry picked whatever sounded positive, putting it in PR releases fed to the press. Low-level journalists are lazy, ignorant and time-pressed, they’ll always work off a press release instead of reading through and analyzing a long academic paper.
Here’s the full story.
Robert EV
Oct 3 2024 at 12:40pm
Also important to note that UBI succeeded in poorer countries because, in the cited case I was told about, the people pooled their monthly UBI in order to use the much larger sum to purchase a metal roof for a single household. Each month they’d do this for another household. This shows that UBI may have failed for these poorer countries if this pooling hadn’t been voluntarily implemented.
In a richer country such as the US the low-hanging fruit is typically much more expensive. And we also lack the neighborly cohesiveness to pool our funds. So a “successful” UBI in the US would have to be something like a lump sum yearly or bi-yearly (not smaller monthly sums). That is to say, sufficient funds to materially change things in one go for the recipient.
Joe Potts
Sep 30 2024 at 2:09pm
Gawd. The VERY FIRST sentence.
No further, thank you.