gravity-incomeWhen the city of Seattle recently voted to increase the minimum wage to $15 an hour, some critics (like me) snarked that if $15 would help workers why not raise it to $20, $25, or even $30 an hour.

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.

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  • Duke

    You argue the company will fail due to higher wage costs than hypothetical competitor, but if competitor company paid CEO 1 million a year and some employees less labor costs should be a wash.

    • fantasticrice

      Glad I am not the only one scratching my head here.

      If labor costs stay the same, this move does not necessarily doom the company to bankruptcy. Rather it is just a very generous gesture on the part of the CEO, who having taken the risk of starting the company and making the decisions that determine whether it will stay open, has chosen not to reap the monetary compensation of the value he has created. This is a form of charity.

      • Joe Carter

        ***This is a form of charity.***

        Well, yes and know. It is very charitable for Price to give his profits to his employees. So in that sense it is charity he is giving. But employees will soon view the pay increase as their compensation. They’ll start expecting it whether Gravity is making enough profit to cover their increased costs.

        This is why economists refer to wages as “sticky.” Workers hate pay decreases, which is why it is easier for companies to lay off some employees in hard times than it is to implement an across-the-board pay cut.

    • Joe Carter

      It would be if the increased pay was coming solely from the CEO’s pay. But it’s not.

      According to the New York Times, the pay increase will consume 75-80 percent of the current profits. A much more prudent strategy would be to merely promise to give 75-80 percent of the profits to the employees every year. That way when times are tough, the higher minimum pay structure won’t sink the company.

  • Duke

    Either way it will probably pay for itself as a brilliant marketing stunt. Would you have written about them otherwise?

    • il fait soleil

      Agreed – brilliant marketing stunt but eventually this will catch up and implode. The market will not reward his “generosity” for long if this move doesn’t benefit his customers.

      • yamazakineat

        It doesnt need to benefit the customers, only not hurt them. Gravity already has a successful product. What happens internally, as long as it doesn’t affect the quality or price of the product, is of no concern to the customers. In fact, the move could result in additional business simply because new or exisiting customers will want to work with gravity because of shared values.

        • Ahmad Rasheen

          “is of no concern to the customers.”

          Considering that several long term customers have since cut ties with the company, apparently it was.

  • Joseph Tassone

    The CEO is only getting 70k, as well.

  • Hunter Baker

    I think the answer depends on whether the company experiences various benefits from offering such high wages. It is entirely possible that if they attract unusually good employees they will see higher productivity and other improvements. Things like morale, retention of strong employees, and hiring great new ones make a difference. I might be willing to bet you that they will be in business five years now and stronger than ever.

    • SecondJon

      You’re right, and that was my first reaction too: the move to be generous to low earning employees may well end up with them all losing their jobs. To your point, the only way to keep the company afloat may be to hire higher performing employees. They’ve just demolished their profits, so there’s no funds for additional headcount unless they get rid of current employees who add less value.

  • Retired from Visa

    Visa initially paid their workers above market wages and benefits. After 35 years, that $4T+ per year sales company is no where near bankruptcy.

    • DeeWW

      How is that relevant to the situation discussed in this article? That is hardly a comparable scenario.

  • Nerdy Woman

    I agree with you completely, Joe Carter. BTW, you mentioned manager Y’s dissatisfaction at making the same as his/her less productive assistant, but what you didn’t mention are some other unintended consequences:

    The cost of unemployment benefits, wrongful termination lawsuits, and social security taxes…

    SSI taxes are a payroll cost to both employer and employee with each paying 6.2%, to a salary cap of 118,500 for 2015. If the employee makes more than the cap, the tax is not withheld from additional income nor does the company pay 6.2% of salary exceeding the cap. If everyone makes less than $118,500, the company and employees all pay 6.2% of every payroll dollar spent.

    Unemployment benefits. Let’s face it. Every company, no matter how mahvalous the corporate culture may be, has dead wood. Or people with attitudes that managers just hope and pray will resign. Fat chance when they are currently earning 2 to 3 times more than they are worth in the job market. The only way to get rid of them is to plod through the tedious and unpleasant disciplinary, probationary, termination process (better make sure company policies are in good working order). Even if the termination is justified, it will most likely be classified as a “layoff” to avoid a nasty defamation or discrimination lawsuit. Which of course means the company’s unemployment insurance rates will increase.

    You are almost correct, Joe, in identifying this as a social experiment. More accurately, it’s a demonstration in how socialism works.

  • yamazakineat

    This predictice analysis holds true only if the assumptions, of which there are many, are correct. Only time will tell if they are.

    I could offer a contrary analysis with different assumptions, e.g. Gravity has already grown successfully because they offer a good product at competitive rates. The salary increase may increase productivity resulting in further growth.

    In any case it should be noted that the salary increase is to be phased in over three years. So, if employee A is making 40k now, they’ll make 50k in 2016, 60k in 2017, and 70k in 2018.

    Long story short, what I presume is that Dan Price, in consultation with his CFO and other advisors, calculated a minimum growth rate, then calculated a growth rate based on an assumed productivity gain from the salary increases and used that data to structure the raises in their final form. In other words, its a gamble that the raises will result in revenue growth but if they dont, or not at the hoped for rate, the minimum growth rate will cover them over the short term. Even if Gravity only maintains the current revenue and margin Price left himself a 20% cushion.

    Let’s not forget, this guy has ALREADY founded and grown over several years, a multi million dollar medium sized tech company.

  • FD Brian

    We just witnessed a CEO become a humanitarian and I’ve never seen so many people wish for his failure.

    • Ahmad Rasheen

      Not wishing for failure, just being realistic, those who urged caution appear to have been proven correct. Top employees have left the company, some long term customers have cut ties and now the owners brother, who also has a stake in the company, is suing him as well.

      In the end the result could very well be that all these people end up without jobs.

      • FD Brian

        the transition will take time.

  • Terry Dunross

    Obviously, there are more than a few Econ majors on this page. I agree with every bit of theory I’ve read here, but for this specific case I disagree with the conclusion. This is not 21st Century Motors.

    In fact, I think this may be Gravity’s 1984 moment.

    Let’s run some numbers. From the articles I’ve read, the result of this new wage policy is that half of Gravity’s employees are going to get a raise, and thirty of those will see their salaries double. That means that prior to the policy, 30 employees had a wage between 35 and 70k. I’m going to make an assumption here and just use the mean. So when I run the cost of this policy I get .75(60*35k)-930k.

    So, based on my estimates, this stunt will result in a net delta of about -$650k for Gravity. But it would take them six years of saving at that rate to be able to purchase 30 seconds of Super Bowl airtime.

    Keep in mind that Gravity is a payment service that is rapidly expanding beyond it’s Washington home turf. This is an exceptionally low marginal cost industry, dominated by players so ubiquitous that most potential customers don’t even know that they have options.

    So the question: Is national coverage worth $650,000 a year for these guys? I think it can be…

  • Al Del Vecchio

    You could be right. Or you could be wrong. Maybe his action will spur people to think about who they work for and start asking their prospective employers how much the CEO makes and stop applying to companies whose CEOs make 300 times more than an average worker. That idea would create a seismic shift in the way we do business. This is the only way people can take power back from some of the rich unscrupulous.

  • HJ

    Lots of assumptions in your analysis (pay cuts to higher paid employees, same productivity regardless of pay, no effect on quality of hires at the higher paying company). I think it is an interesting experiment and could well succeed. There is some precedent. Google pays more that most other high tech employees and has done quite well. In fact, in high tech there is a fairly direct correlation between better pay and more successful companies.

  • Joseph K. McCall

    There are 120 employees.

    What do these 120 employees actually do? What tasks are the workers performing, and what tasks are they responsible for?

    I’m sure that some of the employees actually are worth that $70,000, but I’m sure many aren’t.

    I also had another thought-

    If I was a janitor, or a receptionist, or held some other position that the market typically doesn’t value at $70,000, and I was making $70,000 a year, would I want to gain more education, and move on to another position? It wouldn’t pay to do so! I would be taking a pay cut- a MAJOR pay cut- by going to another company.

  • Sarah Stanley
  • James

    Very interesting prediction and it seems this article was spot on. Just today all over the news in came that gravity is now facing total bankruptcy due to the silly decision of paying everyone 70K. Not only that, the fact that the office clerks earned almost as much as their managers and web designers caused some employees to get angry and leave. The company has also failed to meet increases demand because they can’t afford to hire more people anymore! Customers are also starting to leave as they expect fees to go up to fund these higher costs.

    And to make things worse the co-founder is now suing this guy for this stupid socialist decision

  • janegudge

    only the small minded selfish money grubbing me me me kind of thinking would be negative of this conduct.. nasty people hating the concept of equality

    • Marc Vander Maas

      Or, conversely, it could be people who acknowledge the good intentions behind the move but recognize that the economics of such a change likely won’t work in the long run. That might be the case too.

  • Sarah Stanley

    “The CEO Paying Everyone $70,000 Salaries Has Something to Hide”