Productivity and Wages

Productivity and Wages

Order Code RL32563
CRS Report for Congress
Received through the CRS Web
Productivity and Wages
August 30, 2004
Brian W. Cashell
Specialist in Quantitative Economics
Government and Finance Division
Congressional Research Service ˜ The Library of Congress

Productivity and Wages
Summary
Productivity growth is widely understood to be the means to raising living
standards. Higher productivity means that the quantity of goods and services
produced and consumed can rise without having to work more. Beginning in 1995,
productivity growth accelerated, suggesting that living standards could be expected
to rise more rapidly than had been the case since the early 1970s.
In theory, increases in labor productivity make it profitable for firms to hire
more workers, as long as they have a market for increases in their production. Other
things being equal, this increase in demand for labor tends to push wages up. If
conditions are such that labor demand does not increase, in a shrinking market or
because of technological advances, then the productivity gains will either accrue to
consumers in the form of lower prices, or to the owners of the firm in the form of
higher profits.
Most accounts in the popular press regarding labor income refer to wages
specifically. But wages only account for a portion of labor income, and focusing
exclusively on wages can be misleading. Compensation is a more comprehensive
measure of labor income. Compensation includes wages and salaries, employer
contributions for insurance and pensions, profit sharing, and unemployment
compensation. Over the long run, wages and salaries have been declining as a share
of total compensation.
The rate of growth in real compensation rises and falls with the rate productivity
growth, but growth in real compensation lags productivity. And, the gap between the
two increased after 1973. In part, the difference may be because the available
measure of average labor productivity is not the one theory that determines the wage
rate. The increase in the gap between productivity growth and real compensation
growth may also be because of labor’s declining bargaining power as the
unionization rate declines.
But even given that gap, the rate of increase in real compensation increased
significantly along with productivity growth after 1995. Between 1995 and 2003, the
growth rates of both average labor productivity and real compensation rose by 1.6
percentage points over their rates of increase between 1973 and 1995. Given that,
it would be hard to argue that labor has not benefitted from the post-1995
acceleration in productivity growth.
This report will not be updated.

Contents
Productivity and Wages: The Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
Measuring Labor Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
The Labor Share of Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
Labor Income and Productivity Growth . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
List of Figures
Figure 1. Wages and Salaries as a Percentage of Compensation . . . . . . . . . . . . . 4
Figure 2. Fixed Capital per Employee, Private Sector . . . . . . . . . . . . . . . . . . . . . 5
Figure 3. Labor Share of National Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
Figure 4. Real Unit Labor Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
Figure 5. Real Compensation and Productivity Growth . . . . . . . . . . . . . . . . . . . . 9
Figure 6. Ratio of Output Prices to Consumer Prices . . . . . . . . . . . . . . . . . . . . . 10
List of Tables
Table 1. National Income, 2003 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5

Productivity and Wages
Productivity growth is widely understood to be the means to raising living
standards. Higher productivity means that the quantity of goods and services
produced and consumed can rise without having to work more. Beginning in 1995,
productivity growth accelerated, suggesting that living standards could be expected
to rise more rapidly than had been the case since the early 1970s.
At the same time, concern has been widely expressed about the relatively slow
growth in employment during the current economic expansion. Moreover, while
productivity growth has accelerated, many have argued that wages are not keeping
pace and that workers are being squeezed in an effort to boost profits. That seems
to have inspired some doubts regarding the benefits of rising productivity. Public
policy is, of course, concerned both with the rate of economic growth and how the
gains are distributed.
This report explains what economic theory tells us about the relationship
between wages and productivity. The report discusses why wages may be a
misleading measure of labor income, and changes in labor’s share of national
income. Finally, possible reasons for changes in the relationship between growth in
labor income and productivity are examined.
Productivity and Wages: The Theory
It seems simple and intuitive that wages would rise with productivity. But as
is the case for many such intuitions, there are exceptions and qualifications, so it may
be helpful to understand the theoretical connection between growth in wages and
productivity.
In order to understand how productivity growth affects wages, consider the
behavior of an individual firm. A single firm in a competitive economy has little
influence on market conditions and sells its goods at prevailing prices and hires
workers at prevailing wages. Most economic models also make the assumption that
each additional worker hired is less productive than those hired before. In the jargon
of economics, this is referred to as “diminishing marginal productivity.” There are
at least two reasons behind that assumption. One, it is in the best interest of a firm
to hire the most able workers first, meaning that each additional worker is less
productive, and two, without additional investment each new hire reduces the amount
of capital per worker.
As long as the contribution to output produced by the last worker hired (i.e., the
price of the good times the quantity produced) exceeds the cost of his labor (i.e., the
wage rate times hours worked), a profit-maximizing firm will continue to add to its
labor force. If the productivity of each successive hire declines, then the value of the

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additional production also falls. At some point the value of the output of the last
worker hired will equal the cost of the additional labor. At that point, the profit-
maximizing firm will stop adding to its labor force.
Now suppose that some event, a technological innovation for example, raises
the productivity of all the workers at the firm. If each worker is now able to produce
more than before, that will raise the total value of the output each worker can
produce. In that case the last worker hired, instead of producing just enough to cover
the cost of his labor is now producing more than that.
If the firm is willing to continue hiring as long as the value produced by each
additional worker is greater than the additional labor cost, the increase in productivity
also will increase the firm’s demand for labor. Hiring more labor is again profitable
to the firm. Other things being equal, an increase in the demand for labor will tend
to push up the wage rate. In this way, increases in labor productivity increase labor
income. When the firm again reaches the point where the cost of additional labor is
more than the value of goods one more worker can produce, it will stop hiring.
There are circumstances where an increase in productivity might not necessarily
lead to an increase in employment. Suppose, for example, that worker productivity
rises faster than does demand for the goods those workers produce. Because the
supply of the good being produced rises relative to the demand for it, the price of the
good will tend to fall. The fall in the price of the good will offset the effect of higher
productivity on the value of goods produced by workers. If the drop in price exactly
offsets the increase in productivity, there will be no change in the value of each
worker’s production to the firm, and there will be no increase in the firm’s demand
for labor. In that case the firm will neither hire more workers nor will wages
increase.
In this case, all of the benefits of higher productivity will accrue to consumers.
Because consumers can now buy the same quantity of the good with less of their
income, they have more to spend on all of the other goods (and services) they want.
That increase in demand will tend to push up the price of those other goods. When
those prices rise, the demand for labor at firms producing those goods will increase.
That will tend to push up both employment and wages at those firms.
There is also the possibility that an increase in productivity will simply increase
the profits of the firm. If there is no possibility for the firm to increase sales, and if
wages are inflexible, the firm may reduce the number of workers it employs and thus
reduce its overall labor costs. In that case, higher productivity will increase the
profitability of the firm.
In the short run, prices and wages may be somewhat “sticky” or inflexible.
More so in some markets than in others, but to the extent that they are, one group
may benefit more from increases in productivity than others. To the extent that
prices fall, consumers will benefit. To the extent that wages rise, workers will
benefit. To the extent that neither changes, profits will rise. Over the long run,
however, prices and wages do tend to respond to changes in supply and demand and
the benefits will be shared. How the benefits are distributed is an empirical question.

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Thus far, this discussion has considered only the contribution of labor to the
production of goods and services. Two other factors of production also contribute
to the production of goods and services and they also share in the income yielded by
sales of the goods and services.
Demand for both land and capital are determined in the same way that demand
for labor is. Firms will continue to add capital as long as each new investment yields
more in revenue than it costs the firm to use. The same holds for land.
Suppose there is an innovation that raises the productivity of a firm’s capital
equipment. Just as in the case of an improvement in the productivity of workers, the
value produced by that equipment rises and so it becomes profitable for the firm to
invest in more equipment.
The income of each of the three factors of production is based on the value of
their contribution to the total value of the goods and services produced. But they are
interdependent. An increase in the amount of capital equipment available to the
existing workforce is likely to increase their productivity as well. That would tend
to increase the firm’s demand for labor and push up wages.
Measuring Labor Income
Thus far, the terms “labor income” and “wages” have been used
interchangeably, and most accounts in the popular press regarding labor income refer
to wages specifically. But wages account for only a portion of labor income, and
focusing exclusively on wages can be misleading.1
Compensation is a more comprehensive measure of labor income.
Compensation includes wages and salaries; employer contributions for social
insurance, pensions, and insurance; profit sharing; and unemployment
compensation.2
Over the long run, wages and salaries have been declining as a share of total
compensation. Even in the short run, variations in wages may not be indicative of
variations in compensation, because wages are an incomplete measure of labor
income. Figure 1 shows wage and salary income as a percentage of total
compensation since 1929.
1 Wages and salaries in the national income and product accounts published by the
Commerce Department refers to the monetary remuneration of employees including
commissions, tips, bonuses, and voluntary employee contributions to certain deferred
compensation plans (such as 401(k) plans).
2 This measure of labor income may be more expansive than what some have in mind when
they think of “labor.” Compensation here includes the pay of corporate CEOs getting
million dollar plus salaries. To the extent that is an issue, it is one of the size distribution
of income and not one of the distribution of income among the different factors of
production.

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Figure 1. Wages and Salaries as a Percentage of Compensation
Source: Department of Commerce, Bureau of Economic Analysis.
The Labor Share of Income
Most discussions of income distribution address what is known as the “size”
distribution of income. The size distribution of income describes how the incomes
of individuals or families are distributed. The “functional distribution of income”
describes how income is shared among the different factors of production: labor,
capital, and land. If the argument that companies are increasing profits at the expense
of labor is correct, then that should be reflected in the way income is distributed
among these factors of production.
The income for each of these factors of production is determined by the quantity
employed and the price for their use. Relative income shares may vary either because
of changes in the relative quantities employed or in their prices.
Over the long run, the trend has been for the quantity of capital employed to rise
faster than the quantity of labor. In other words, the capital-labor ratio tends to rise.
To understand why, consider that output growth is determined by growth in
productivity and the labor force. If investment is a fairly stable share of total output,
then the capital stock will grow at the same rate as the economy. Since the economy
is growing faster than the labor force (because of rising labor productivity), the
capital stock will grow more rapidly than the labor force, and the capital-labor ratio
will rise. Figure 2 shows the rise in the capital-labor ratio since 1945.

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Figure 2. Fixed Capital per Employee, Private Sector
Sources: Department of Commerce, Bureau of Economic Analysis; Department of Labor,
Bureau of Labor Statistics.
That the capital stock has increased relative to labor might lead one to presume
that capital’s share of income has also been increasing. In the national income
accounts published by the Bureau of Economic Analysis, income is accounted for as
shown in Table 1.
Table 1. National Income, 2003
billions of dollars
percent of total
Total
8,841.0
100.0
Compensation of employees
6,289.0
71.1
Proprietor’s income
834.1
9.4
Rental income of persons
153.8
1.7
Corporate profits
1,021.1
11.5
Net interest
543.0
6.1
Source: Department of Commerce, Bureau of Economic Analysis.
The amounts in Table 1 account for all of the payments to the three factors of
production: labor, capital, and land. Labor income is measured as compensation.
Profits, rent, and interest measure payments for the use of capital and land.
Proprietor’s income reflects payments to all three factors. Figure 3 shows estimates

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of the labor share of income since 1945. This measure assumes that two-thirds of
proprietor income is attributable to labor. Income attributable to proprietorships has
declined relative to total national income over the long run. Because of that,
neglecting to consider the labor income of proprietors would give an upward bias to
the trend in labor’s income share.
Figure 3. Labor Share of National Income
Source: Department of Commerce, Bureau of Economic Analysis.
If there is a discernable trend in these data, it is one of modest increase since the
late 1940s, although there has been substantial variation and the share has declined
from relatively high levels in the mid-1970s. That may seem counterintuitive given
the increase in the capital-labor ratio. One reason this may have occurred is that, as
was assumed in the case of labor, there generally are also diminishing returns to each
addition to the capital stock. That would tend to reduce the value of the output
produced by each increment to the capital stock and so push down its share of
income.
A second reason why labor’s share might be rising over time is that the
characteristics of the labor force are changing. Education, training, and other labor
skills, what economists refer to as “human capital,” are continually improving.3 If
this human capital per worker rises more rapidly than the physical capital per worker,
3 Daniel Aaronson, “Growth in Worker Quality,” Chicago Fed Letter, Feb. 2002, 4 pp.

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that could explain an increase in the labor share of income.4 As long as wages keep
pace with the productivity of labor, and the return to capital keeps pace with the
productivity of capital, the relative income shares of labor and capital will depend on
changes in the relative growth in labor and capital productivity. If labor productivity
rises faster than capital productivity, then the labor share of income will tend to rise,
other things being equal.
Unit labor costs. Another way to assess whether or not labor is reaping the
benefits of increasing productivity is to examine unit labor costs. Unit labor cost
measures the cost of labor required to produce a “unit” of output. It can be expressed
mathematically as:
W × L
W
ULC =
=
y
y
L
This equation says that unit labor cost is simply the rate of compensation (W) times
the quantity of labor (L, measured in hours) divided by total output (y). Dividing
both the top and bottom of the ratio by the quantity of labor shows that the per unit
labor cost is also equal to the rate of compensation divided by productivity. That
being the case, as long as compensation increases at the same rate as productivity,
unit labor costs, as well as the labor share of income, should remain constant. Figure
4 shows unit labor costs adjusted for inflation since 1948.
4Daniel S. Hamermesh and Albert Rees, The Economics of Work and Pay, 3rd edition, Harper
and Row, 1984, pp. 356-360.

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Figure 4. Real Unit Labor Costs
Sources: Department of Commerce, Bureau of Economic Analysis; Department of Labor, Bureau
of Labor Statistics.
As the figure shows, real unit labor costs have fallen significantly since the mid-
1970s. That corresponds with the period of decline in labor’s share of income, and
shows that labor income has not been keeping pace with productivity growth over
that period.
Labor Income and Productivity Growth
Productivity growth varies considerably over short periods of time, and in more
or less predictable ways over the course of the business cycle, but more important are
changes in its long run trends. Economists have identified two shifts in the long-term
trend rate of growth in productivity. In 1973, productivity growth slowed
significantly, and in 1995, it appears to have accelerated somewhat. The 1973
slowdown is still poorly understood, while the post-1995 improvement has been
attributed, at least in part, to investments in computers and other information
technology.5
Compensation growth trends reflect those shifts in productivity growth. Figure
5 compares annual rates of change in inflation-adjusted hourly compensation with
annual rates of growth in productivity for the intervals identified above.
5 For a discussion of productivity growth see, CRS Report RL32456, Productivity: Will the
Faster Growth Continue?, by Brian W. Cashell.

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Figure 5. Real Compensation and Productivity Growth
Sources: Department of Commerce, Bureau of Economic Analysis; Department of Labor, Bureau
of Labor Statistics.
The figure shows that productivity growth fell by more than half after 1973 and
that it accelerated after 1995 approaching its pre-1973 rate of growth. It also shows
that growth in real compensation, perhaps not surprisingly, followed the same
pattern. The chart also indicates that compensation did not grow as rapidly as
productivity in any of the periods shown and, further, that the gap between
compensation growth and productivity growth increased after 1973. The gap
remained the same in both post-1973 intervals shown. The increase in the growth
rate of real compensation after 1995 was the same as for productivity.
One reason for the gap between productivity and compensation growth might
be that, in theory at least, the rate of compensation is based on the contribution to
productivity of the last worker added to the labor force. The data in Figure 5 are
based on average labor productivity. It may be that the average productivity growth
is not representative of growth in marginal productivity. But that does not make for
a very satisfactory explanation, and economists often presume that the two measures
behave similarly.
One reason why compensation seems to lag productivity growth may be the
result of changes in labor’s “terms of trade.” In this context, labor’s terms of trade
refers to the difference between the rate of change in the prices of those things
workers buy and the rate of change in the prices of the things workers make. In other
words, worker pay is based on the prices of the goods they produce, not on the prices
of the goods they consume. The compensation growth rates shown here are adjusted
for inflation using a price index for consumer goods and services. The measure of
real output used to calculate productivity is adjusted for inflation using a more

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comprehensive price index which reflects not only consumer goods and services but
also the goods and services purchased by government, as well as business
investment. If the prices of the goods workers produce rise more slowly than the
prices of the goods they consume, then it is unlikely that labor income, in real terms,
will keep pace with rising productivity.
Bosworth and Perry suggest that is enough to account for both the difference
between compensation and productivity growth and the increase in the gap between
the two.6 They constructed a measure of real compensation based on the same price
index used to calculate productivity and found that measure to follow productivity
much more closely.
Figure 6 presents the ratio of the chain-weighted price indexes for total gross
domestic product and for personal consumption expenditures. It is clear that between
1948 and the mid-1970s prices for all goods and services rose relative to those for
just consumption goods and services. As a result, workers’ terms of trade improved,
and labor’s share of income rose over that period.
Figure 6. Ratio of Output Prices to Consumer Prices
Source: Department of Commerce, Bureau of Economic Analysis.
After the mid-1970s, consumer prices rose relative to overall prices. One reason
the more comprehensive measure of prices fell relative to the consumption price
index is that since the early 1980s computer prices have fallen significantly.
Computers account for a very small portion of consumer spending. As a result of the
6 Barry Bosworth and George L. Perry, “Productivity and Real Wages: Is There a Puzzle?,”
Brookings Papers on Economic Activity, 1994/1, pp. 317-335.

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relative price change, real labor income did not rise as much as total labor
productivity.
The gap between productivity and compensation growth might also be affected
by changes in how competitive the labor market is. For example, if something alters
the relative bargaining power of either employers or employees, that could affect the
rate of compensation.
A study published by the Federal Reserve Bank of Atlanta investigated the
connection between unionization and the gap between compensation growth and the
rate of productivity growth.7 The study found that industries with relatively high
rates of unionization had relatively small gaps between compensation and
productivity growth. The study also found weak evidence that industries
experiencing relatively larger declines in unionization experienced relatively larger
increases in the gap between compensation and productivity growth.
Conclusion
There is no doubt that productivity growth is the source of rising living
standards. From a nationwide perspective that is certain. But how the gains from
rising productivity are distributed may be an issue. The benefits of productivity
growth may accrue to workers whose pay increases, to consumers in the form of
lower prices, or to the owners of capital.
The labor share of income has fallen since the mid-1970s, but is actually above
what it was in the 1950s and 1960s, in spite of the fact that the capital stock has
grown more rapidly than the labor force.
It is clear that the rate of growth in real compensation rises and falls with the
rate productivity growth, but growth in real compensation lags productivity, and the
gap between the two increased after 1973. In part, the difference may be because the
available measure of average labor productivity is not the one theory that determines
the wage rate. The increase in the gap between productivity growth and real
compensation growth may also be because of labor’s declining bargaining power as
the unionization rate declines.
But even given that gap, the rate of increase in real compensation increased
significantly along with productivity growth after 1995. Between 1995 and 2003, the
growth rates of both average labor productivity and real compensation rose by 1.6
percentage points over their rates of increase between 1973 and 1995. Given that,
it would be hard to argue that labor has not benefitted from the post-1995
acceleration in productivity growth
7 Madeline Zavodny, “Unions and the Wage-Productivity Gap,” Federal Reserve Bank of
Atlanta Economic Review, Second Quarter 1999, pp. 44-53.