Wages and Productivity

One of the major assumptions of many economic models is that workers’ pay and productivity are linked: wages are determined by the marginal product of labor. On the other hand, some economists have pointed out a growing divergence between wages and productivity in the US economy, which suggests the link is not so close. This chart is a common example:


Who’s right? Well, this very topic is the subject of one section of a new AEI book, simply titled ‘The US Labor Market: Questions and Challenges for Public Policy’ (free pdf available). The contributor list is a veritable who’s who of economists whose analyses I find invaluable, and it looks to hit on many themes I’m interested in, so I’m excited to dig into this. But for today I’ll stick with wages and productivity.

One the side of divergence is Dean Baker of the Center for Economic and Policy Research. He argues that the top and bottom of the income distribution exhibit a disconnect between wages and productivity. He starts with the example of CEO pay, which as I noted in my post on inequality in firms, has pulled away from the rest of workers in very large firms. If pay were linked to productivity, this would indicate American CEOs have become an order of magnitude more productive than they were decades ago (as well as more productive than similar CEOs in other rich countries). What this suggests is really going on is that due to poor corporate governance structures, CEOs are commanding wages far out of line with what they would earn in a truly competitive marketplace.

Next Baker turns to the minimum wage, and basically argues that a combination of a wage floor and firms’ desire to have a differentiated wage structure means there is another disconnect between wages and productivity. If the minimum wage increases, there is an incentive to raise other workers’ pay as well to maintain distinctions based on seniority, skills, etc. He also argues this means that these workers are being paid less than their productivity already, using a monopsony model as a base. There’s a decent explanation here, but basically a monopsony is the opposite of a monopoly; i.e. one buyer and many sellers, so the buyer (employer) has power over pricing (wages), and in these models wages are well below what they would be in a competitive marketplace.

I don’t find this particular part of the argument so convincing based on my experience in a city that has raised the minimum wage. Over the last few years, the DC minimum wage has gone from $8.75/hr prior to 2014 to $11.50/hr as of July this year, and will reach $15/hr by 2020. In that time, at the (large) retail company I work for, there have been no raises beyond regular cost of living for workers between cashiers and salaried managers. So now workers employees with decades of experience are at the same level as fresh cashiers, and the wage difference between a supervisor (who is typically hired around $12/hr) and a regular cashier has basically disappeared. It still suggests there is disconnect between wages and productivity, just not the way he envisions it.

Moving on, Robert Lawrence of Harvard argues that looking at charts such as the one above is misleading because the deflators used in measuring compensation and output across time are used improperly. The real compensation series uses the CPI deflator, while the real output series uses an implicit price index for GDP. The CPI has some problems; many believe it overstates the real cost of living, and Lawrence argues that in this context an output price index should be used to deflate compensation. Why? Because using a consumption index includes factors that domestic workers do not produce, such as imports and housing. As such, a ‘product wage’ should be used, and doing so accounts for a significant chunk of the observed gap. Using his estimates of productivity, he find that productivity and compensation track each other closely until about 2001, and it’s not until the Great Recession and its aftermath that a real divergence opens up, though not a massive one.

Something that’s often implicit in arguments in this space is that productivity/pay divergence is the main source of inequality. I think the reason for this is that it implies an easy solution: if we can just control the greed of the top 1% and make companies pay workers more, then everything will be ok. If it turns out that people really are broadly being paid their ‘fair’ share, then solving the problem of inequality becomes much harder (as we’ve seen described in The Wealth of Humans).

Where do I come down on this? While I do think there’s something ‘unfair’ going on with things like CEO compensation, I also just don’t see that playing out at the scale required to explain the levels of inequality in the US. And so we’re left to grapple with far more difficult questions.


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