June 29, 2022

The Divergence Between Wages and Productivity. Mirage or Reality?

Fortunately, market forces tend to ensure that wages and productivity never diverge too much.

The famed English author Charles Dickens wrote A Tale of Two Cities. Today, we are going to consider “a tale of two theories.”

One theory of wage determination, believed by all too many people, is that pay greatly depends upon employer generosity. The CEOs of major corporations and sports stars such as LeBron James earn annually in the tens of millions. Why? They are fortunate enough to work for generous companies (interestingly, our progressive friends object, strenuously, to CEO pay being so high, but not to that of top athletes, singers, movie stars who gross in the same neighborhood). Many lawyers, doctors, accountants, professors, journalists, engineers take home at the six-figure level because their firms are moderately kind. And those who ask if you “want fries with that?” or push a broom are unfortunate in their choice of employer and thus compensation: they work for a bunch of skinflints and cheapskates.

Economists tend to adhere to a very different theory: productivity (actually, discounted marginal revenue productivity, but we need not go into all of that). What is this? Take Joe Blow for example. He is a semi-skilled worker. Joe can do all sorts of things for many companies. Right now, one of them produces $10,000 hourly. If Mr. Blow is added to its workforce, receipts rise to $10,020. We attribute all the difference to him; ceteris paribus (all else equal) conditions hold. His marginal productivity is thus $20 per hour.

What will his wage tend to be? Well, there are only three choices. First, it could be below that amount. Suppose it is $3 (something like that would be the offer expected by the average “progressive”). The employer would profit to the extent of $17. Would matters end there? Not bloody likely. Nature abhors a vacuum and economics does so with profits: they serve as blood in the water does for a shark. Many other companies would like to have Joe’s services at $3. The only way they can entice him away from his present employer is to offer him more money. How much more? At $4, there would still be profits of $16 to be garnered. At $12, the employer would still “exploit” the employee, but now to the tune of $8. Joe’s wage would rise to as close to $20 as possible, given that there are transaction costs of finding such people, bidding for them, etc. It is for this reason that California growers go down to Mexico to seek crop pickers (the lure of profits) and in effect bid up their low wages in that country.

Second choice: Joe Blow is paid $30. But this would be a disaster since the business firm would lose $10 on this decision, and there are lots of Joe Blows out there. So we can scratch that option.

The third is that he will see a pay packet of exactly $20. This would be an equilibrium situation. This may or may not ever actually occur, at least not to the penny. However, there are strong market forces (profit seeking, something we can rely upon) pushing wages back to that point whenever they deviate in either direction. It is for that reason that economists believe that there is a tendency for wages to equal productivity rates. This is the productivity theory of wage rates.

This important economic insight has come under attack by the Economic Policy Institute, a left-wing outfit. According to their research, wages and productivity kept pace with one another up until about 1980. But, between then and 2020, wages rose by about 14 percent, while productivity escalated by roughly 60 percent.

Even if true, this finding would not overturn the economic law. Remember, it only states that there is a tendency for wages to equal productivity levels; this only obtains under full equilibrium which is never attained, since there are continuous changes throughout the economy.

Still, if true, this would indeed cast aspersions on this primordial economic insight. However, there are reasons to doubt the veracity of this EPI study. First of all, other economists have measured wage increases, and have found them much higher than 14 percent for the last four decades. For example, according to one statistic, the wage index in 1980 was $12,513.46; as of 2019, this had jumped to $54,099.99.

A far more serious problem with the Economic Policy Institute critique of basic economic theory has to do with productivity. How did we come to posit Joe’s productivity at $20? We just assumed it for illustration purposes. But out there in the real world, people do not come equipped with productivity levels printed on placards. How, then, does the employer estimate this? Plain and simple, he just guesses!

That seems to be a weak reed upon which to place an economic theory. However, it is more powerful than first appears. For those who guess correctly tend to prosper; those who don’t, fail. The market weeds out those who cannot accurately assess worker productivity. If they guess too low, they can’t keep a workforce; too high, and bankruptcy beckons. It is often very difficult to measure productivity. The Jeremy Lin example—a former NBA player who played for the Knicks, Rockets, and Nets, among other teams—is a famous case in point. The contribution of this basketball star was for several years vastly underestimated by professional scouts who were paid big bucks to make such assessments.

How did the Economic Policy Institute, hardly an outfit of profit-risking entrepreneurs, measure this will ‘o the wisp, productivity? Simple: they divided GDP by the number of hours worked. But to do this is to give credit, only, to labor. However, there are other factors of production that also contribute to the GDP, preeminent amongst them land and capital goods. Only those operating under the fallacious the Marxist labor theory of value would calculate this phenomenon in any such manner.

Secondly, sorry to pull technical economic jargon on you, gentle reader, but this calculation will only render average productivity. However, the mainstream economic theory of wages is in terms of marginal, not average productivity. This is something drummed into all students in Economics 101. The EPI economists must have missed that lesson.

No, the best estimate of workers’ productivity is the wage they are pulling down. Market forces tend to ensure these two cannot diverge too much. There is no valid case to be made for their radical dispersion.

This article, The Divergence Between Wages and Productivity. Mirage or Reality?, was originally published by the Foundation for Economic Education and appears here with permission.  Please support their mission.