The substitution effect is an idea in economics that can be understood quite intuitively. When the price of a good rises relative to an alternative, people will tend to buy more of the alternative good and less of the now more expensive good. If apples and oranges used to have the same price, but apples become more expensive while the price of oranges remains unchanged, people will tend to reduce the amount of apples they buy and buy more oranges instead. And it is worth remembering that this effect also occurs with a change in relative prices – and not just absolute prices.
If apples initially cost $1 and oranges cost $2, but the price of apples rises to $1.50 while oranges remain $2, this could increase the number of oranges sold. Even though the price of oranges has not changed and in absolute terms the price is still higher than the price of apples, the relatively price between the two has changed. In the past, you could get six apples for the price of three oranges. For the price of three oranges you can now only get four apples. Different people will adapt in different ways depending on their own preference between the two, but overall we can expect to see a higher proportion of oranges sold than before.
There is also a substitution effect on labor. As labor becomes more expensive, employers will tend to find alternatives to that labor. One way they can do this is by replacing machines with workers. This happens naturally over time: as technology advances and becomes cheaper, the relative price of using automation versus hiring workers decreases, leading to an increase in automation. But artificially raising the price of labor also lowers the relative price of automation, causing more workers to be replaced by automation.
One of the many things you can say about the state of California is that it always offers opportunities to show the economy in action. I previously wrote about how the $20 minimum wage for fast food workers caused fewer people to eat at fast food restaurants and go to restaurants instead:
So why should places that serve? more expensive food see their traffic increase, while the still cheaper fast food restaurants see their traffic decrease?
The answer is that even though the price of chain restaurants has not fallen in absolute terms, it has still fallen relatively terms compared to fast food. Fast food and dinner restaurants differ in price, quality and convenience. But as fast food restaurants are forced to raise their prices due to increased labor costs, the price difference between fast food restaurants and restaurants has narrowed, without any change in the other two dimensions. As a result, people see what it would cost them to get a basic combo at McDonalds and think, “If I have to pay that much to get some McDonalds, I might as well pay a little bit.” more and go to Chili’s instead.”
More recently, another change was made by a major fast food chain in California: Chipotle. After this wage increase became law, Chipotle began replacing workers with machines, as described in this news item:
Chipotle has introduced two robots that can take over tasks normally done by its employees.
The ‘autocado’ can peel, pit and cut an avocado for guacamole in 26 seconds. Meanwhile, a ‘digital makeline’ serves salads and bowls based on orders via the app.
The machines are part of an automation drive Chipotle bosses hope the number of workers needed will decrease – reducing rising labor costs.
So it’s no surprise that they are the first to be used in two of the Mexican chain’s restaurants Californiathe company announced on Monday.
The author of that news article asks how expensive automation could be:
It’s not yet clear how the production costs of using Chipotle’s new machines compare to the human labor involved in making Chipotle menu items.
But that’s why it’s important to keep in mind that it’s the relatively rather than the absolute costs that drive these adjustments. Even though the cost of the new machine is more expensive than human labor in absolute terms, the new minimum wage law still restricts the use of machines relatively cheaper compared to human labor than before. And that’s all that needs to happen for the substitution effect to kick in.
As a side note, it’s also worth noting that many restaurants, fast food and otherwise, have found an alternative to employee labor other than machines. They simply let the customer perform tasks that they used to hire employees to do. At one of my favorite local restaurants they used to have someone take your order, but that is no longer the case. That person’s job was to get customers to say what they wanted and then press a series of buttons on a computer to place the order. Now they just have a self-service kiosk and let the customers press those buttons themselves. When your food is ready, there are no servers to 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 no longer leave the dishes behind for an employee to deliver. You arrange your own tables – there are trays ready for you to place your dirty dishes. Restaurants are increasingly using customer labor to replace the cashier, server and busser.
I’ve said it before and I’ll say it again: for all its simplifications, the world would benefit from greater adoption of Econ 101 than what we have now.