Is High Productivity Growth Compatible With Employment Growth?

Is High Productivity Growth Compatible With Employment Growth?

Order Code RS21960
October 26, 2004
CRS Report for Congress
Received through the CRS Web
Is High Productivity Growth Compatible With
Employment Growth?
Marc Labonte
Analyst in Macroeconomics
Government and Finance Division
Summary
There is a popular perception that the recent sluggishness in employment growth
is caused by the acceleration in productivity growth. Annual labor productivity growth
has increased from 1.4% from 1974 to 1995 to 2.5% from 1996 to 2001 and to 4.2%
from 2002 to the present. Neither economic theory nor empirical evidence supports this
perception — there has been virtually no correlation between productivity growth and
employment growth since 1948. Higher productivity growth does change our
perceptions of what comprises a strong economic recovery, however. With higher
productivity growth, what was formerly an economic growth rate consistent with rising
employment is now symptomatic of inadequate aggregate spending.
Productivity growth does not affect all industries equally and may not lead to
employment growth in the same industry in which it has occurred. This has been the
case with manufacturing in recent decades. But while productivity growth changes the
composition of employment, there is no theory or evidence indicating that it changes the
overall level of employment. Thus, productivity-enhancing policies intended to raise
living standards are unlikely to have negative side effects. This report will not be
updated.
A recent puzzle among economists, policymakers, and the general public has been
the sluggishness of the labor market. Employment declined from March 2001 to August
2003, easily the longest (although not nearly the deepest) decline in employment in the
post-World War II era. Since then employment has increased slowly, and as of October
2004 it remains far below its previous peak.1 A popular explanation for the sluggish labor
market has been the recent surge in productivity growth, which measures the change in
output per hour worked.2 For example, a recent Business Week article was subtitled, “The
1 For more information, see CRS Report RL32047, The “Jobless Recovery” From the 2001
Recession, by Marc Labonte and Linda Levine.
2 For more information, see CRS Report RL31428, Productivity Growth: Recent Trends and
Prospects, by Brian Cashell.
Congressional Research Service ˜ The Library of Congress

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drive for productivity gains is the real culprit behind anemic job growth.”3 As a recent
Financial Times article describes it,
Productivity is a simple concept: widgets produced, divided by input. Labour often
dominates the input figure. It is therefore difficult to generate high productivity and
substantial employment increases at the same time. The very phrase ‘jobless
productivity’ is close to a tautology.4
Interestingly, in the late 1990s some observers attributed the rapid increases in
employment to rapid productivity growth.5 From 1974 to1995, labor productivity growth
averaged 1.4% a year. From 1996 to 2001, productivity growth increased to 2.5% a year.
From 2002 to the second quarter of 2004, it has increased further still to an annualized
average of 4.2%. Why have rapid productivity gains occurred both in periods of high and
low employment growth?
A Popular Explanation of Productivity Growth’s Effect
on Employment
The popular story focuses on the link between productivity and employment at the
firm level. Imagine that a firm makes 100 widgets a year with 10 workers. If productivity
were to double and product demand remained the same, the firm would lay off five of its
workers and still be able to produce 100 widgets. Extrapolating the firm’s experience to
the economy as a whole, higher productivity leads to lower employment, according to the
story.
But the popular story is incomplete because it does not explain how the economy
adjusts to the change in productivity. If the firm has now reduced its payroll by 50%, its
net income has risen by that much. That additional net income must accrue to the firm’s
owners/stockholders or workers. As their incomes rise, they will purchase more goods
and services than they were purchasing before.6 This will raise the demand for workers
to produce goods and services in other sectors of the economy.7 Higher productivity
3 James Cooper, “The Price of Efficiency,” Business Week, issue 3875, Mar. 22, 2004, p. 38.
4 Amity Shlaes, “Don’t Be Sentimental, Mr. Bush,” Financial Times, Sept. 23, 2003, p. 23.
5 Council of Economic Advisers, Economic Report of the President, Feb. 2000, p. 90.
6 For the increase in productivity to translate into an immediate increase in income requires that
it be matched by an increase in the money supply by the Federal Reserve. This is a reasonable
assumption since it is consistent with the Federal Reserve’s mandate to keep inflation and the
business cycle stable.
7 If the workers or owners decided to save their additional income instead of spending it on
consumption goods, the total demand for goods and services would still increase. Higher saving
would push down interest rates, and this would stimulate spending on interest-sensitive goods,
such as capital investment, residential investment, and consumer durables (e.g., automobiles and
appliances).
The greater demand for workers in other sectors of the economy may not occur in the same local
area that lost employment to productivity growth. Thus, at the local level, the popular story may
seem accurate initially. But the local experience cannot be extrapolated to the national
(continued...)

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might cause other factors to change as well. For instance, higher productivity at the firm
may allow them to reduce the price of their widgets, which may cause sales to rise.
Workers would then be needed to produce the additional widgets.
Productivity Growth and Employment in Mainstream Economics
Perhaps surprisingly, in a mainstream economic model productivity growth has no
effect on employment growth. That is because, in the model, workers’ compensation
matches their marginal product (output), and productivity determines marginal product.8
(Compensation consists of wages and non-cash benefits.) When a worker’s productivity
rises, market forces cause his compensation to rise because there is greater demand for
his services. If a firm did not increase compensation in response to higher productivity,
then another firm would be willing to outbid the firm for the worker’s services, since the
value of output produced by the worker exceeds his compensation.
In this model, changes in employment occur when workers’ compensation demands
become misaligned with their marginal product. For instance, if the demand for a firm’s
product falls, a firm must reduce payroll to remain viable (assuming the firm was not
previously earning excess profits). It can reduce payroll in two ways: by laying off some
workers or maintaining its workforce but reducing compensation. In practice, laying off
workers is more common than reducing compensation — apparently, when their marginal
product falls as a result of the fall in product demand, workers are unwilling to reduce
their compensation.9 In recessions, there is temporarily a widespread reduction in demand
for products, and widespread unemployment results.
Employment has no relation to productivity in this model because it is assumed that
workers and firms can properly identify the workers’ marginal product and workers can
easily switch employers in pursuit of higher compensation. Workers and firms do not
have to actively evaluate their productivity because markets provide that information
through prices: if a firm pays a worker less than his marginal product, the worker will be
able to pursue higher paying alternatives with other firms. The original firm will be
forced to raise compensation to avoid losing its employees. While the model is
undoubtedly a gross simplification of reality, it nevertheless appears to conform fairly
well to actual experience.
Nonetheless, a change in productivity growth does change the relationship between
economic growth and employment growth. In the mainstream model, high unemployment
is typically caused by inadequate aggregate demand (spending). While higher productivity
growth does not cause unemployment in the mainstream model, it may change our
perceptions of adequate demand. The strong productivity gains make demand seem
7 (...continued)
experience.
8 This model is supported by empirical data — over the long run, labor’s share of national
income has stayed virtually constant (although it fluctuates slightly in the short term). See CRS
Report RL32563, Productivity and Wages, by Brian Cashell.
9 Survey research supports this observation. See, for example, Truman Bewley, Why Wages
Don’t Fall During A Recession (Cambridge: Harvard University Press, 1999).

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stronger than it is in a casual comparison to the past. Economic growth is caused by
increases in the labor force, which grows at a fairly steady 1% a year, and increases in
productivity (due to capital investment or efficiency gains). From the mid-1970s to the
mid-1990s, when productivity was growing at about 1.5% a year, the economy could
grow at 2.5% without an increase in the unemployment rate. Now that the productivity
growth rate seems to have increased, a 2.5% economic growth rate is no longer sufficient
to keep the unemployment rate stable, and no longer indicates that demand is growing
quickly enough to keep production at full employment. In the first six quarters of the
current economic expansion, economic growth averaged only 2.1%, although it has since
accelerated.
Is There Evidence that Productivity Reduces Total Employment?
Economic theories should be judged on the basis of how well they describe actual
economic behavior. If the popular story is correct, then we should observe declines in
total employment when productivity rises, and increases in employment when
productivity falls. Alternatively, if the mainstream economic model is correct, then we
should observe no relationship between the two variables. What do the data show?
A cursory glance at the data quickly dismisses the notion that higher productivity
reduces employment. Productivity has risen virtually continuously throughout our
nation’s history. Except during recessions, so has employment. Figure 1 takes a more
sophisticated look at this proposition by comparing employment growth to productivity
growth using annual data from 1948 to 2003. As can be seen, there is no clear
relationship between the two variables. High productivity growth has accompanied both
high and low employment growth, as has low productivity growth. The correlation
between these two variables is -0.01; in other words, there is virtually no relationship
between employment growth and productivity growth, just as mainstream theory
predicts.10 Thus, the high productivity growth and low employment growth of the past
three years is an aberration, and does not reflect a broader trend found in the data over the
past 55 years.
10 If two variables are perfectly correlated, they have a correlation of 1.0 and they always move
in exactly the same direction. If they are perfectly negatively correlated, they have a correlation
of -1.0 and always move in opposite directions. If there is no relationship between them, they
are uncorrelated and have a correlation of zero.
As a test of robustness, correlating the unemployment rate and the productivity growth rate
yielded virtually the same result. The correlation between these two variables over the same time
period is -0.07. Using quarterly data or splitting the data into sub-periods of 1948-1973 and
1974-1995 also failed to yield greater correlation.

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Figure 1: Annual Employment Growth and Productivity Growth, 1948-2003
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productivity grow th (% change)
Source: Bureau of Labor Statistics
Has Productivity Growth Reduced Manufacturing Employment?
As discussed above, productivity growth should not reduce employment because it
expands the overall purchasing power of the economy, thereby creating new employment
opportunities in the overall economy. However, there is nothing in this mainstream
model that suggests that productivity growth will create employment opportunities in the
same industries in which it occurs. This has been the case in the manufacturing sector.
As can be seen in Figure 2, manufacturing productivity growth has consistently
outpaced productivity growth in the overall economy in the 25 years for which data are
available. (The figure actually understates the difference in growth rates since the non-
farm business sector includes manufacturing.) With productivity in manufacturing
growing consistently faster than the rest of the economy, manufacturing employment
would keep steady only if the demand for manufactured goods also grew consistently
faster than the demand for other goods and services. Since the demand for manufacturing
goods has not kept pace with manufacturing productivity gains, manufacturing
employment has declined from about 25% of total employment in 1970 to about 14% in
2000 (the change in absolute employment has been much smaller). The manufacturing
experience is strong evidence in favor of the mainstream model, because the decline in
manufacturing employment was not accompanied by a decline in total employment.
Rather, it was more than offset by rising service sector employment, so that total
employment maintained an upward trend.

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Figure 2: Annual Productivity Growth, 1988-2003
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oduc
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(%
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1
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4
5
6
7
8
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1
2
3
198 198 199 199 199 199 199 199 199 199 199 199 200 200 200 200
m aunfacturing
non-farm business
Source: Bureau of Labor Statistics
The relative decline in manufacturing employment has not been due solely to
productivity gains; the business cycle and trade have also played a role. Nevertheless,
CRS estimates that productivity gains have been the single largest factor in the decline of
manufacturing employment, responsible for about 60% of the decline, from 2000 - 2003.11
Conclusion
It is not unusual for economic analysis to conflict with common sense explanations
of the world. This is the case with the relationship between productivity and employment.
Although it may seem obvious that higher productivity means fewer workers are needed
to fill an economy’s production needs, both economic theory and empirical evidence
reject the notion that higher productivity leads to lower overall employment, even in the
short run. On the contrary, higher productivity frees up workers to produce more goods
and services than the economy had previously been capable of producing, and this is the
key to rising living standards. This suggests that policies conducive to high productivity
are unlikely to have negative short-term consequences for employment, and thereby
national welfare. On the contrary, high productivity is compatible with improved national
welfare because it is the primary means by which living standards can be raised over the
long run.
Productivity growth, like any change brought about by market forces, will not
necessarily lead to new jobs being created in the same industry or local economy where
it caused old jobs to be lost. This can be seen in the example of the manufacturing sector,
where productivity growth outpaced demand, leading to a shift in jobs from
manufacturing to the service sector. A challenge for policymakers is to find the right
balance between ameliorating the hardship experienced by those harmed by market forces
and allowing society as a whole to reap the benefits of those same forces.
11 See CRS Report RL32350, Deindustrialization: The Roles of Trade, Productivity, and
Recession, by Craig Elwell.