High Wages and Productivity: Where are the emperor’s Clothes??

So there is a big debate raging in the New Zealand blogosphere about the exodus of labor to Australia. Matt
joined in on the debate and made the very valid point that it’s real wages we need to care about, not the nominal wage and that for this happen we basically need productivity increase so that output increases. The same people with more money buying the same set of goods will just push prices up leaving us where we started.

While I don’t want to wade heavily into the debate, I’m still undecided what the best course to take is as I’m not totally convinced by the arguments from the left or the right. The one thing that does bother me is that strengthening employee power to negotiate higher wages seams to be though of as a magic wand. In line with Matt’s argument, giving workers higher wages doesn’t really do much if there isn’t a corresponding increase in productivity. People seem to have the causality all wrong, in general increases in productivity increase wages not the other way round.

Wages are supposed to reflect the productivity of the worker. If for some reason wages don’t reflect the productivity of the worker then there could be an argument to strengthen bargaining power so that we return to the situation where the marginal productivity of a worker is equal to the marginal cost to the firm of hiring them. No one seams to be making this argument though. (please correct me If I’m wrong). Although The Standard does cite CTU economist Peter Conway who says the wage gap

“will only be closed through more widespread industry wide collective bargaining, supported by ongoing improvements in productivity”

Now I know someone is going to bring out the “Efficiency Wage” trump card and say that paying higher wages does increase productivity, a commenter on our blog even used the Ford motor’s example as proof. Now I don’t really have a problem with efficiency wage theory, i just don’t people really understand how it works. Paying an artificially high wage increases productivity primarily through making workers not want to lose their job since it’s so high paying. People work harder, turnover falls everybody is happy and productivity increases. The problem with applying this argument to the economy as a whole is that if everyone is paid more you don’t have the same incentives because the opportunity cost of losing your job is lower. Efficiency wage theory works really well at the firm level but doesn’t make as much sense at the economy level. If all of Ford’s competitors followed suit and matched ford’s really high wages the incentive for Ford’s employees to work really hard because they get paid so much evaporates.

It’s all about incentives and everything is relative.

Agnitio

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  • I was citing Ford as an aside about the costs of hiring and training. The real reason efficiency is increased (to a point) by higher wages is that higher wages encourage better use of labour and more use of complimentary capital investment. On a more political level I’d say that the substantial increases in profit that we have seen over the last nine years need to be redistributed more evenly. The money is there and we have helped make it. We’re just not seeing it in our wages.

  • “We’re just not seeing it in our wages.”

    Wage growth is at record highs (LCI, QES) and firms’ profit margins have been squeezed tightly over the same period (PPI inputs). As a result, I would disagree with that assertion

  • could you please elaborate on how “higher wages encourage better use of labour and more use of complimentary capital investment” and at what “point” this stops happening and why? so if wages are “too high” this effect stops happening?

    “The money is there and we have helped make it. We’re just not seeing it in our wages.”

    Matt’s comment aside,we deserve it in proportion to our contribution, if our wages don’t reflect the value we create to the firm then I am all for wage increases, but I see no real reason to pay someone more than the the value they create for the firm, it just doesn’t make sense.

  • MN – Ok, I really shouldn’t argue this (it’s starting to reduce my productivity) but the “record highs” you are talking about are based on recent year on year growth – taken over a longer period we are still tracking below Australia and other countries. Again you need to look at the bigger picture.

    A- The simple fact is that if labour costs more there is a incentive to use it more effectively. Better investment in capital is one of the ways this is done.

    Your comment about proportion to our contribution is more complicated as it veers into the idea of how we attribute “value” and this rapidly becomes a relativistic argument. I’m guessing you would argue that the market automatically attributes value (forgive me if I’m wrong) but there are so many real-world examples of this failing that I simply can’t take it seriously. I would say from experience that workers’ contributions are hardly if ever taken into account in wage negotiations – generally the overriding factor is how mush the employer can reduce labour costs or slow wage growth in order to deliver as large a profit as possible.

  • I think it’s also a “simple fact” that the more expensive an input is, the more reluctant you will be to use it, thus forcing wages up will reduce employment.

    I agree that there is probably an imbalance in bargaining power between employers and employees. But workers shouldn’t be given enough bargaining power to to be able to negotiate wages that are greater than the value they create to the firm, that will only create unemployment. In many industries it is very hard to measure an employee’s contribution to the firm I don’t deny that.

  • “MN – Ok, I really shouldn’t argue this (it’s starting to reduce my productivity)”

    I know what you’re saying 😉

    ““record highs” you are talking about are based on recent year on year growth – taken over a longer period we are still tracking below Australia and other countries”

    Yes, as labour markets have also been tight in Australia, and productivity is higher, and they have had one hell of a big terms of trade increase (dry commodities have outperformed soft commodities). All these factors play a important part. However, 6% wage growth when productivity growth was near 0% – employees are getting a pretty damn good deal in that case.

    “The simple fact is that if labour costs more there is a incentive to use it more effectively”

    Firms’ already have an incentive to use labour more effectively – it’s called profit maximisation. Firms might not do it immediately, but they do it over time. Industries are dynamic, things such as ‘creative destruction’ and firms constantly reinventing themselves help increase labour efficiency far more than ad hoc regulation.

    Government has a huge role to play in the education section of the labour force, however when it comes to employer-employee relationships the governments only role should be one of fairness, not efficiency.

    “I would say from experience that workers’ contributions are hardly if ever taken into account in wage negotiations”

    This depends on market power ultimately. If workers do not have market power, they have trouble negotiating themselves a fair wage. Again that is a equity argument for intervention, not an efficiency one. It is definitely valid, just not in the case of labour productivity. Furthermore, productivity growth actually has significant explanatory power in explaining wage growth – implying that workers probably do get some of that value they create back.

    “generally the overriding factor is how mush the employer can reduce labour costs or slow wage growth in order to deliver as large a profit as possible”

    I agree that the target is profit, however firms are entities made up of large divergent groups. Those at the top do realise that they have to incentivise workers, that is why they spend so much money on consultants to help them. There is a lot more focus on building the firm as an organic entity nowadays, rather than just trying to achieve bottom-line – that is because this type of firm structure is more efficient.

  • dracotb

    if our wages don’t reflect the value we create to the firm then I am all for wage increases, but I see no real reason to pay someone more than the the value they create for the firm, it just doesn’t make sense.

    You do realise that if all the people at the firm were paid the value they actually created for the firm the firm wouldn’t have any profits don’t you?

    Wage growth is at record highs (LCI, QES) and firms’ profit margins have been squeezed tightly over the same period (PPI inputs). As a result, I would disagree with that assertion.

    Recenlty – yes. Between 1982 and 2001 the majority of the population saw a decrease in market income (Prosperity for All?, Brian Roper, p. 35, figure 2.1). There is nothing to suggest that this decrease has yet been corrected.

    On top of that, firms in NZ are still reporting profit increases far above the wage increases so it still seems that productivity in NZ is not being adequately rewarded.

  • “You do realise that if all the people at the firm were paid the value they actually created for the firm the firm wouldn’t have any profits don’t you?”

    That comes from taking capital and entrepreneurship as a stock and labour as a flow. I could assume that at a given wage labour is a stock and additional capital is a flow – this would tell me that all the surplus should go to those that own capital. Ultimately both models are wrong – the surplus is divided based on the relative bargaining power of workers to capital owners.

    “Recenlty – yes. Between 1982 and 2001 the majority of the population saw a decrease in market income ”

    That is a random time period to choose! I know you will say it was during ‘free market reforms’ (except the last two years and the first two years). However, over this period we had a collapse in the terms of trade, a tumble in the exchange rate – which hurt importers of goods and inputs (it would have helped exporters, but of course they were having subsidies taken off them, so they were hardly in a position to hand out this surplus), income inequality also rose as some policies were implemented that were either inappropriate or badly timed. So why should it be corrected, wage growth and firms profit margins eased.

    “On top of that, firms in NZ are still reporting profit increases far above the wage increases so it still seems that productivity in NZ is not being adequately rewarded.”

    I don’t think I’ll take a search for profit increase in the NZ herald as an objective measure of firms’ profit margins 😉 – after all, firms aren’t reporting their real profit, its nominal, and this is a biased sample of firms (as they are more likely to push a story about them doing well than badly). Ultimately, firms’ profit margins are squeezed, productivity growth has sucked, and labour has managed to get some real wage increases – this implies to me that productivity is being more than rewarded, and it is currently at the cost of the firm.

    So why are firms willing to take on these costs for now? Well they expect productivity and margins to improve. Between 2002 and 2005 they invested heavily in capital, they are just waiting for labour productivity to rise as a result – and for some of this improvement in the terms of trade to trickle through.