The visible hand in economics

Do we want “productivity growth”?

Posted on: November 18, 2008

CPW has requested that we cover the Standard’s coverage of the National-Act coalition agreement, specifically this section:

National/Act agree to close the ‘income gap’ between Australia and NZ by 2025, requiring ‘3% productivity growth per year’. Which is just economic techno-babble. What ‘income gap’ are they talking about? GDP per capita or wages or what? And how would a faster rate of productivity growth close this gap? Anyone who knows what productivity is (the amount of wealth produced in a unit of work) knows that merely increasing productivity doesn’t necessarily boost GDP or wages. GDP = productivity x work done. So, GDP not only depends on productivity it also depends on how many people are in work. And boosting productivity doesn’t lead automatically to higher wages – wages are determined by supply and demand in the labour market, nothing to do with productivity. In fact, productivity grows faster when employment drops because it’s the low quality workers that lose their jobs first and lower quality capital that sits idle first, but wages don’t go up because there is more slack in the labour market.

After reading it we felt that a non-biased explanation of the “economic techno-babble” was in order.

To start with the discussion does have true points in it – however, it takes examples and paints them as facts. In order to weed through this the first thing we need to do is figure out what productivity is.

If there is an increase in “productivity” we get more outputs for the same inputs – however, this can occur in a number of ways. Now over at the Standard they have painted productivity is only average labour productivity – however, as labour is not the only input to production this does not make sense. There are two other primary types of productivity that we cover in economics:

  1. The productivity of capital,
  2. Multifactor productivity (productivity associated with the combination of inputs – say labour and capital),

Now the ideas of “labour productivity” and “capital productivity” only give us a partial view – as we are only looking at a single input. As a result, it is the multi-factor productivity measure that we should be looking at – a measure that has performed incredibly poorly in New Zealand in recent years.

To get an idea of what multi-factor productivity is we can look at growth accounting in wikipedia:

Q = A (L x K y)

This expression states that the production in the economy is some function of labour and capital (in this case a cobb-douglas production function) multiplied by a “solow residual” – this “residual” is equivalent to “productivity” in the most general sense. This is the fella that National and Act want to increase.

Now, since the focus is on multi-factor productivity very little of the Standard’s argument is actually true, namely:

  • A fall in labour does not increase multifactor productivity – any increase in “average labour productivity” in this sense is captured by the “production function,
  • All other things equal an increase in MFP will increase output – as the cost of making “more” is effectively lower,
  • Furthermore, higher multi-factor productivity does lead to higher REAL wages – as the country can now make more stuff with the same inputs. Saying that productivity and wages are unrelated is COMPLETELY wrong – when you analyse the data, real wages are a lot more heavily related to productivity than they are to the level of unemployment (which tells us about the tightness of the labour market)!

Of course I do have a criticism of the plan – do they really think that government can “increase multifactor productivity”? As Chris Worthington says “governments now have very little influence on the economy in the old-fashioned, Keynesian sense” – there are small areas where a change in government organisation may improve efficiency but governments ability to influence something as broad as productivity (outside of through compliance regulation and taxes, which neither party is interested in fiddling with in any substantial sense) does not exist.

National and Act are right that higher levels of productivity growth would directly help us close the income gap with Australia – a gap that DOES exist (although it may not even be an issue). However, saying that “we will increase productivity” is not useful – it is like saying “we will magically make trade-offs disappear”, as saying that productivity is higher is like saying that we can do more with less! National-Act will need to come out with clear policies about how they will “increase productivity” – then we can discuss those policies. For now it is only empty rhetoric.

Even so, the Standard’s critique of the truism provided by the National-Act agreement was simply wrong, and as a result deserved to be covered here.

Update: Anti-dismal adds to the discussion here, Kiwiblog and Inquiring Mind also both discuss it.

Update 2: Following more discussion from the Standard, Anti-dismal discusses productivity again.

22 Responses to "Do we want “productivity growth”?"

“Of course I do have a criticism of the plan – do they really think that government can “increase multifactor productivity”?”

Maybe they’ll use Plan B (migration)

http://articles.garethmorgan.com/labour-s-third-world-solution_409.html

Although migration is also an increase in the labour input – so it doesn’t lead to an increase in multifactor productivity unless we have increasing returns to scale (and even then only in the long-run). Of course if we do have increasing returns to scale a pro-migration policy makes a lot of sense🙂

[…] National/Act agree to close the ‘income gap’ between Australia and NZ by 2025, requiring ‘3% productivity growth per year’. Which is just economic techno-babble. What ‘income gap’ are they talking about? GDP per capita or wages or what? … Read more here […]

Great explanation.

However I’m not sure that National and Act just want to increase the productivity multiplier. Obviously increasing labour doesn’t necessarily make us better off because we would be working more. But extra capital due to increased investment is good for us. And policies that increase the profitability of businesses will encourage that investment.

“But extra capital due to increased investment is good for us”

Extra capital still has a cost – it implies that consumption now is lower. Changing the incentive to invest in capital may lead to more consumption in the future – but is the sacrifice now worth it?

[…] Visible Hand in Economics gives a neat lesson in economic literacy on the issue of productivity […]

You’ve missed an apostrophe. It should be “Even so, the Standard’s critique” not “the standards critique”. The apostrophe signals possession i.e. the critique belonging to the standard..

You’ve also missed a few economic points such as –

Productivity, including multifactor productivity, is simply the expression of a ratio. An increase in productivity can come with a decrease in output as long as the inputs (wages/capital) decrease at a proportionately greater level.

When you state higher multi-factor productivity does lead to higher REAL wages you are assuming that higher productivity is the result of higher outputs (see my first point) but even if we assume higher productivity as a result of increased outputs there is no clear reason that leads to higher wages rather than just higher profits. You seem to be taking a leap of faith to assume otherwise given the fact that profits (from increased productivity or otherwise) outstripped wage growth in the last 20 years…

[…] Paul Walker at Anti-Dismal points out some errors in a post at The Standard. As part of his rebuttal he notes a further post by The visible hand in economics. […]

Of course if we do have increasing returns to scale a pro-migration policy makes a lot of sense🙂

In NZ’s case it is Lifestyle we are trading. The people down the bottom get Rat race 😉

Hi Robinsod,

“You’ve missed an apostrophe”

Sure enough, I’ve missed it in a few other places as well – I would term it laziness😛

“Productivity, including multifactor productivity, is simply the expression of a ratio. An increase in productivity can come with a decrease in output as long as the inputs (wages/capital) decrease at a proportionately greater level”

Indeed, the ratio is:

A=Q/f where Q is output and f is the production function that represents the inputs we discussed in the posts. So A can increase if Q falls by less than the measured production function falls – or in other words if we actually have decreasing returns to scale (as the decomposition stems from the assumption of constant returns to scale I believe).

This is a pretty difficult argument to make given the degree of “complementarity” between capital and labour.

“even if we assume higher productivity as a result of increased outputs there is no clear reason that leads to higher wages rather than just higher profits”

Move from one point to the other. If we increase productivity without changing anything else (now it is likely that policies will aim to change other things – which is why I say we need to see the policy before we can discuss it instead of arbitrarily attacking productivity), the value of an individual worker to the firm has gone up. If the worker has ANY bargaining power, this will lead to a higher real wage – as they will get a share of the surplus created.

Not only does this make complete logical sense, but analysing the data shows that productivity growth is strongly related to real wage growth.

“In NZ’s case it is Lifestyle we are trading. The people down the bottom get Rat race”

It depends where the increasing returns stem from methinks. Note that a larger population allows us to introduce technologies that are only feasible with a larger population – in this case I would say that a large number of people “at the bottom” benefit.

I read in a Wall Street Journal Article recently that 70% of productivity gains are captured by the workforce in wage increases.

“I read in a Wall Street Journal Article recently that 70% of productivity gains are captured by the workforce in wage increases.”

Interesting – I am not sure that the employee gains from productivity are necessarily a constant though, 70% seems a bit high, maybe😛

I’m sorry but I fail to see how you have addressed my initial points. Indeed I believe you have obfuscated on several of them so a few thoughts:

Labour and capital can be complimentary but they are by no means a perfect compliment. You have presented this as too strong a relationship in order to justify your argument there are plenty of examples – such as automation – that see capital inputs increase while labour inputs fall.

You argue that productivity is strongly related to wage growth. I am assuming you are using developing nation examples for this because in New Zealand in the last 9 years we have seen record wage growth coupled with low(ish) productivity. In the decade before this we saw similar levels of productivity but real median wages fell.

I would argue that productivity (or any other method of increasing profits) alone does not increase wages. You allude to bargaining power as the method by which productivity gains become manifest as wage rises and you are right but bargaining power is not automatically increased with productivity either.

It’s in the interests of the right to reify the productivity=higher wages belief as it directs attention away from the real method of raising wages which is increasing bargaining power for workers.

Matt is probably going to answer you, but I will point out a few things:

“there are plenty of examples – such as automation – that see capital inputs increase while labour inputs fall.”

And I could name about a billion things that have made worker productivity increase without reducing labour. So what?

Besides, you seem focussed on the small scale; a single production process. Automation did not lead to permanent mass unemployment. It just moved the labour from less productive activities to more productive ones.

“but bargaining power is not automatically increased with productivity either.”

Are you really trying to argue that wage increases from higher productivity can only happen when bargaining power also increases? Really?

Bargaining power does not have to increase to increase wages. It simply has to exist. Even if it fell by half it would still help productivity increases be captured by increased wages.

“it directs attention away from the real method of raising wages which is increasing bargaining power for workers.”

That may increase the share of the pie going to workers, but I doubt it does much to increase the size of the pie. In fact, it could actively retard pie growth, by making entrepreneurship less attractive.

But tell us, how can an increase in the bargaining power of the provider of one input of production lead to more being produced for less total resources?

It is in the interests of the Left to ignore or dismiss productivity as a method of wage increases, as the “plight of labour” is the source of their political power and feeds their delusion of moral superiority and intelligence.

Hi Robinsod,

My explanation was clear and transparent – if you feel that I am mixing things up then potentially you have misunderstood what I am saying.

For example you said “productivity is a ratio” – by itself this statement was worthless, so I took the trouble of actually saying what the ratio was and how it worked.

In the second point you said that higher multifactor productivity does not imply higher output – however, if it happens exogenously it DOES, as it is a shift of the nations supply curve right. It increases output by definition – so your statement was simply, completely, wrong. I also covered that if we do a policy to increase “TFP”, then there is bound to be a trade-off – a trade-off that I will cover whenever National-Act release whatever poorly thought out “productivity policies” they have in mind.

Now to your recent claims. Labour and capital do not need to be “perfect complements” to have increasing returns to scale – they just need to be complementry. Saying that the extreme example does not hold in no way counter-acts the argument. Empirically there is an argument about whether constant or increasing returns actually hold in most countries – and as a result the assumption that one of these holds is not bold in any sense of the word.

Productivity is in every possible way strongly related to wage growth. Of course it is not the only factor that causes wage growth – as the share of the surplus that goes to labour also determines the level of wages. However, there is only so far “increasing the bargaining power of workers” can increase real wages.

If you increase productivity you are fundamentally making more with the same number of inputs – which fundamentally is the same as saying that real income is “higher”. Unless the policy causes a drastic, and I mean drastic, reduction in wage bargaining power then higher productivity will imply higher wages. As a result, it is pointless attacking a goal of “higher productivity” – the attack can only occur if the government says they are going to improve productivity in some way that has costs.

When I said productivity increased wages empirically I WAS talking about New Zealand. I work as an economist and I spend time analysing the household numbers. As I have said on Steve’s post over at the Standard I think it is fair that you guys want some evidence – however, I can’t pull out my work from work as that is there private capital. As a result, when I get a moment I will hunt around for some related evidence and try to make the case – I’ve actually got a few things I would like to test anyway so it could be fun🙂 However, I will try to do this at some point, because the claim I am hearing from you guys that real wages and productivity are unrelated is not right – it is like saying output and income aren’t related.

“I would argue that productivity (or any other method of increasing profits) alone does not increase wages”

You are missing the point – as long as a worker has ANY bargaining power, any at all, even a tiny bit, higher productivity will increase wages. Bargaining theory would say that – as higher productivity implies that the production associated with the worker is higher.

“It’s in the interests of the right to reify the productivity=higher wages belief as it directs attention away from the real method of raising wages which is increasing bargaining power for workers.”

To anyone reading who is a bit unsure I would like to point out that this is completely wrong – you cannot increase peoples real wages forever through “bargaining power”, if the economy does not create more then people can not magically have more.

“That may increase the share of the pie going to workers, but I doubt it does much to increase the size of the pie. In fact, it could actively retard pie growth, by making entrepreneurship less attractive.”

I suspect that much of the argument against us here Kimble presumes that the size of the pie does not change – a weird assumption given that productivity growth is by definition increasing the size of the pie🙂

Once again. Productivity growth does not necessarily mean growing the pie. The NZ pie grew considerably in the last 9 years with quite low productivity growth.

And I’m not attacking productivity growth, I’m attacking the notion that productivity growth automatically translates into higher wages without a mechanism and the fixation on the belief that productivity growth alone will grow wages.

I also didn’t say that Labour and Capital have to be perfect compliments just that you overstate their complementarity in order to gloss over my point concerning the growth/productivity relationship without addressing it.

I think the real issue is you are unwilling to address exactly where bargaining power comes from. Here’s a hint – it doesn’t just magically appear because productivity increases. If it did then wages would have risen more in the 90’s than they did in the last 8 years. They didn’t.

Hi again Robinsod,

“Once again. Productivity growth does not necessarily mean growing the pie. The NZ pie grew considerably in the last 9 years with quite low productivity growth.”

Indeed – we borrowed significantly to fund this increase in the “pie”, which means that we now have to pay it back as we aren’t “producing more”.

“I also didn’t say that Labour and Capital have to be perfect compliments just that you overstate their complementarity in order to gloss over my point concerning the growth/productivity relationship without addressing it.”

I said that if we have constant or increasing returns to scale then productivity and growth do not move in opposite directions (in the absense of exogenous factors) – this isn’t overstated at all, it is a common result from endogenous growth theory and the data associated with it:

http://en.wikipedia.org/wiki/Paul_Romer

“I think the real issue is you are unwilling to address exactly where bargaining power comes from”

“Here’s a hint – it doesn’t just magically appear because productivity increases”

Kimble has answered this best:

“Bargaining power does not have to increase to increase wages. It simply has to exist”

If bargaining power is UNCHANGED and productivity increases, then as long as bargaining power is not zero workers incomes will increase. We do NOT need an increase in bargaining power to increase income from productivity – you are muddling two mechanisms.

I have never debated that an increase in bargaining power increases wages – however, you seem to be treating it as the only mechanism, which it is not.

“I have never debated that an increase in bargaining power increases wages – however, you seem to be treating it as the only mechanism, which it is not.”

Even though it can increase wages, this only matters if you have that as your sole objective.

That is the problem with the NZ Left, epitomised by the myopic unionists at the Standard; they are incapable of considering things outside of their single (power base related) issue. EVERYTHING is about labour. EVERYTHING is considered in the context of labour. There are the workers and bad people. It’s Us vs Them on every issue.

This special form of ideological blindness embarrasses them in adult conversation, and prevents them from considering anything other than the deceptively obvious solution.

While I’m no labour economist, even in a monopsony (i.e. when the firm is a monpoloy buyer of the input,i.e. when workers have no bargaining power), if there is an exogenous increase in labour productivity (shift in the labour demand curve as opposed to movement along) the wage paid will increase (or at least for any realistic assumptions I can think of?).

The notion that you would hire less people to increase productivity (i.e. a move along the labour demand curve) ignores the fact that while your labour productivity (by which I mean the marginal product of labour) has increased, the productivity of your capital (marginal product of capital) will fall. It seams bizarre that you would make inefficeint use of your capital to make labour more productive.

Matt N.: “When I said productivity increased wages empirically I WAS talking about New Zealand.”

I can give some US evidence from Martin Feldstein, “Did Wages Reflect Growth in Productivity?” This paper was prepared for presentation at the annual meeting of the American Economic Association on January 5, 2008.

Feldstein writes

“The level of productivity doubled in the U.S. nonfarm business sector between 1970 and 2006. Wages, or more accurately total compensation per hour, increased at approximately the same annual rate during that period if nominal compensation is adjusted for inflation in the same way as the nominal output measure that is used to calculate productivity.

More specifically, the doubling of productivity represented a 1.9 percent annual rate of increase. Real compensation per hour rose at 1.7 percent per year when nominal compensation is deflated using the same nonfarm business sector output price index.

In the period since 2000, productivity rose much more rapidly (2.9 percent a year) and compensation per hour rose nearly as fast (2.5 percent a year).”

And later he says

“The relation between wages and productivity is important because it is a key determinant of the standard of living of the employed population as well as of the distribution of income between labor and capital. If wages rise at the same pace as productivity, labor’s share of national income remains essentially unchanged. This paper presents specific evidence that this has happened: the share of national income going to employees is at approximately the same level now as it was in 1970”

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