This Chart Is Stupid…

April 29, 2015 2 Comments

I’ve talked about productivity before. I’ve also discussed wages. I’ve tried to avoid placing the two together until it was referenced. Considering that it is election season and the Democratic front is attempting to push the inequality issue, I figured that this chart would make an appearance sooner or later. Although its only one chart, its going to be a long blog entry. However, in order to explain the chart, we need to understand some basic ideas.

Basic economic theory suggest that the wages a worker receives (measured in output) is equal to the output the worker produces. In other words, wages increase with the productivity of the worker. If wages are below productivity, this creates an incentive for firms to hire more workers, placing upward pressure on wages, lowering earnings along with productivity. If wages are above productivity, firms have an incentive to shed their labor force. This puts downward pressure on wages and upward pressure on productivity. The relationship between the two is known and measured as Unit Labor Cost (ULC).

However, what we have seen (depending on who creates the chart) is that productivity has outpaced wages for a significant period of time (usually starting from a base year such as 1970) and it looks like this:

I was certain that this chart was debunked by one economist or another, but the idea of a mismatch between productivity and wages is still perpetuated. Considering that you have economist, pundits and analysis peddling these talking points, no wonder people still reference this chart.

Inaccurate Comparisons Between Wages & Productivity

Not only are comparisons between wages and productivity inaccurate, it’s erroneous on its face value. As mentioned previous, the measurement of the relationship between wages in productivity are Unit Labor Cost, which is measured by the Bureau Labor of Statistics.

Why is this important exactly? Some representations of this chart measures productivity against cash wages, average hourly wages or real median incomes; however, they are all measured incorrectly. The only relevant measurement of wages is total compensation, which is wages and salaries, plus fringe benefits. This includes other forms of employee compensation, such as health care, pensions or any other bonuses the employee may receive in addition to ordinary income. In a time when fringe benefits have become an enormous part of employee compensation, you shouldn’t really expect just wages to keep pace with overall productivity.

How Labor And Productivity Is Calculated Matters

Productivity for the entire economy (or economic sector) is measured by total output divided by the total amount of hours worked. However, as mentioned previously, total productivity measured against average earnings or median wages, which is incorrect. Considering that not everyone has the same economic output, it would make sense to measure total productivity to something like average/median wages.

Instead, average wages should only be compared to the average productivity of employees.

Measuring Inflation Is An Art, As Well As A Science

This is a big one. Not only do people lack the understanding of what is being measured, but they also don’t understand how it is being measured. When measuring the relationship between productivity and compensation overtime, we use a price index. The price index gives you a weighted average of the relative price of a good or service within a given time period. In the case of the chart, usually starting from 1970.

Looking at the original chart again, you can see that the divergence between productivity and wages started in 1970. This is because the year for changes is indexed for 1970. Change that year to 1980 or 1990, and you’ll have a different take on when these discrepancies occurred.

Also, depending upon the deflator (used to adjust for inflation) can also change the rate of which a consumer good or base item is rising over time. For example, consider real average hourly earnings of production and nonsupervisory employees. The go-to metric for adjusting for inflation is usually the Consumer Price Index (CPI). However, we can use many different inflation metrics, which are no more or less respected than the CPI.

If you look at average hourly earnings adjusted for inflation via CPI, you will find that wages have barely budged since 1970. However, measuring the same wages with the GDP and PCE price implicit deflator, you will find that wages have risen significantly more than the CPI adjusted wages. And those are just two of possible inflation adjustments one could use.

Marginal Productivity (For Wonks Only)

One of the reasons productivity may outpace wages is because there are other factors to consider when measuring productivity, such as Capital. The marginal product of labor is the amount of output that a single worker would produce, provided that the amount of capital provided remains constant (or being able to do more with what you already have).

The standard economic calculation of productivity for a long time has been Charles Cobb and Paul Douglas production function, also know as the Cobb-Douglas production function. According to their theory, marginal productivity is equivalent to the measurement of average productivity, Y/L (Y = Total production, L = Labor).

Overall, when it comes to evaluating wages and productivity, there is more to it than people normally let on.

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