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The Productivity Puzzle: Increasing Output in Tight Job Market

The Productivity Puzzle: Increasing
Output Difficult in Tight Job Market

M ary owns a company, TARbars, that makes soap and employs 100 workers. The workers are moderately skilled and, compared to others in the industry, are well paid. Mary has noticed lately, though, that some of her employees are grumbling about their wages. Additionally, in the past few months, Mary has experienced problems finding skilled employees to fill vacancies at TARbars, and she does not want to lose the employees she has.

When she examines the company's books she realizes that, to increase her workers' pay by a modest 3 percent and not lose profit, she has few options. She could either raise the price of the company's soap and possibly lose sales to competitors, or she could increase the amount of soap the company produces and sells without increasing employee overtime by investing in new technology such as computers or machines that allow the company to increase productivity. Mary opts to increase her workers' productivity, allowing TARbars to make and sell more soap while also allowing her to increase workers' pay.

In a nutshell, this is one of the driving forces of productivity gains — that to increase employee salaries without losing profit or raising prices, a company must increase productivity.

A Tight Job Market

In the current job market, companies are increasingly concerned about raising productivity. On a national level, the unemployment rate has not been this low since 1973. This trend has also held in the Sixth Federal Reserve District — Alabama, Florida and Georgia and parts of Louisiana, Mississippi and Tennessee — where the unemployment rate is the lowest in the 20 years that U.S. Bureau of Labor Statistics data are available. The unemployment rate in the region has fallen considerably over the past 15 years, from an average high of 11 percent in 1983 to a low of 5.25 percent in 1997. In fact, the average unemployment rate in each state in the region is currently lower than in 1978.

Lower unemployment has several positive effects. When more people work, more earn income and consume goods and services, thereby often increasing profits for businesses. Additionally, welfare roles fall, new markets are created and government tax revenues rise.

But lower unemployment also comes with its own set of problems. As unemployment has declined, many employers have had difficulty finding and retaining qualified staff. In fact, reports in the Federal Reserve's Beige Book released on June 17 indicate that labor shortages are a concern within the region, as in the nation. Throughout the District, many high-tech jobs are going unfilled and labor shortages are reported in parts of Florida, Georgia and Louisiana. Contacts report that the tight labor market is forcing more companies to attempt to increase productivity by investing in more efficient equipment and ratcheting up training of current employees.

Many companies in the United States are finding that the only way to increase workers' salaries without losing profits or raising prices is to take steps that will increase worker productivity.

A Look at Productivity

In simplest terms, U.S. labor productivity is output per unit of input used in production. Labor productivity for the nation is measured by dividing the value of output, or real gross domestic product (GDP), by total hours worked. The value of output is corrected for inflation using an implicit price deflator compiled primarily from producer prices.

Labor productivity growth occurs if output is growing faster than total hours worked are rising. Productivity lays the groundwork for higher future living standards. Higher productivity growth also signals that firms can raise wages without commensurate increases in prices or declines in profits.

Productivity in Perspective

Productivity has risen more rapidly in some periods than in others. From 1947 to 1973, for example, the average annual growth rate of nonfarm business productivity was 2.81 percent. Then, from 1973 to 1990, the growth rate for nonfarm business productivity slowed to 1.12 percent annual growth. This growth rate increased barely to an average 1.15 percent annual growth from 1990 to 1997. The recent growth rates of 1.9 percent in 1996 and 1.7 percent in 1997 could indicate the beginnings of an upturn in nonfarm business productivity growth (see the chart).

The long-run changes in the growth rate of nonfarm business productivity point to three questions: Why did the growth rate slow during the 1970s? Why has it recently accelerated? And will the recent acceleration continue?

Productivity Slowdown in the '70s

Most observers point to one of three major explanations for the reduced growth rate for nonfarm business productivity in the 1970s:

  • the energy price shocks that occurred in the early 1970s,
  • the fall in the capital-to-labor ratio in the 1970s, or
  • the shift from an industrial economy to a service economy.
Adverse energy price shocks appear to have coincided with the drop in productivity growth in 1973, but they cannot explain the continued low productivity growth rate into the 1980s, when energy prices fell. The slowdown in productivity gains had already begun before the first Organization of Petroleum Exporting Countries (OPEC) price shock occurred and continued after the second ended. Also, other oil-importing countries, like Japan, did not experience the dramatic drop in productivity growth that the United States did.
U.S. Productivity Growth Rate
(Percentage change from previous year quarterly, 1948-97)
U.S. Productivity Growth Rate
Source: Bureau of Labor Statistics
The productivity slowdown is often attributed to lower investment rates during the 1970s. Although capital investment actually grew faster in the 1970s than in the 1950s, labor was also growing faster in the 1970s than in the 1950s. As a result, the growth rate of capital to labor slowed. One set of estimates, from Edward Wolff of New York University, indicates that the capital-to-labor ratio in the United States rose by 2.2 percent annually from 1950 to 1960 but by about 1.9 percent annually from 1960 to 1973 and by 1.5 percent annually from 1973 to 1979. Some economists attribute almost all of the productivity slowdown to reductions in the growth rate of the capital-to-labor ratio.

Another potential culprit often cited for the productivity slowdown is the national shift away from manufacturing. Nonmanufacturing sectors, including business and personal services, wholesale and retail trade, and finance, insurance and real estate, make up an increasingly larger share of output and employment, and measured productivity growth tends to be lower in these sectors than in manufacturing. Some analysts claim that productivity in nonmanufacturing sectors is underestimated, so productivity growth is proportionately underestimated as these sectors compose a larger share of output. Daniel Sichel of the Board of Governors of the Federal Reserve System argues, however, that the most generous estimates of measurement error can explain only about one-sixth of the productivity slowdown.

Recent Increases in Productivity Growth

As difficult to pin down as the causes behind the slowdown in the 1970s and 1980s are, current increases in productivity growth have also sparked debate. Some economists argue that recent high levels of business investment, particularly in computer-related equipment, has finally begun to pay off in higher productivity growth. Most economists agree that it is too early to know why productivity growth has increased in the last two years and acknowledge that the current "trend" may prove to be illusory. There is as yet no clear evidence that the economy has entered a period of strong productivity growth.

Productivity and Wages

If productivity is indeed rising at a faster pace, companies should expect to increase workers' compensation as there is a long-term and economically consistent tendency for wage increases to match productivity gains. In recent years, though, some labor organizations have expressed concern that workers are no longer sharing in returns to productivity gains. By some measures, workers' total compensation has not kept pace with productivity growth (see the table).

Average Annual Growth Rates of Productivity and Real Wages
(Nonfarm business sector, percent per year)
Indicator 1947-97 1947-72 1960-72 1973-97 1996-97

Output per hour (GDP) 2.0 2.7 2.7 1.0 1.7
Hourly compensation (CPI-U) 1.5 2.6 2.2 0.3 1.5
Hourly earnings (CPI-W) 0.9 2.1 1.7 -0.5 1.5
Hourly compensation (GDP) 1.9 2.6 2.6 0.9 2.6
Hourly earnings (GDP) 1.1 2.1 2.1 -0.1 2.0

Parentheses indicate deflator: GDP is the implicit GDP deflator based on producer prices, CPI-U is the CPI for urban consumers, and CPI-W is the CPI for urban workers.

Source: Federal Reserve Bank of Atlanta calculations based on data from the Bureau of Labor Statistics and the Bureau of Economic Analysis

The gap between productivity and hourly compensation gains appears to have increased steadily since the mid-1970s. Some economists argue that the wage-productivity gap is the result of the use of different price indexes to deflate output and compensation. (Output per hour and earnings are usually deflated by different price indexes.)

If compensation is deflated with the same measure used to deflate productivity, then productivity gains appear to have only slightly outpaced increases in real compensation (see the table). Some economists, however, argue that this "quick fix" is wrong because different price indexes should be used to correct output and earnings for inflation since businesses and households use different mixes of goods.

Aside from the price deflator difference argument, it is unclear whether productivity and wages have experienced different growth. Labor's share of output has not declined dramatically. While recent shifts away from unions and changes in wage- setting behavior may account for some of the difference, the actual impact of these changes is not known. It is clear, however, that productivity and wages are linked over the long run.

Exactly how the pieces fit together and what shape the finished puzzle should take are questions for debate. Regardless of how the debate ends and the puzzle is solved, companies will likely continue to respond to tight labor markets and demands for higher wages by seeking to increase productivity.

Editor's note: This article is based on a presentation developed by Madeline Zavodny of the regional research group.