Productivity: Economic Magic

If you’ve been reading the economic reports of the past ten years, you’ve read about the gains in worker productivity. In some quarters, the higher productivity gets a bad rap, but we would like to explain why increasing productivity is good, actually, it is economic magic.

Productivity is the amount of goods and services produced for each hour of work. Productivity can increase in a few ways. One, the same amount of workers, through training and technological advances, produce more goods and services. That is the best kind of productivity gain. Two, less workers produce the same amount. The U.S. economy experienced that in 2001 and 2002. During the recession, businesses eliminated positions that were least productive, while output remained about the same. That type of productivity is less favorable, because workers get laid-off.

That aside, increasing worker productivity results in higher corporate earnings, increased wages and lower prices for goods and services. Yes, you get all those benefits from higher productivity.

Let’s say we have PickensPolitics.com Pizza Shop, and we have one worker who has the ability to make 1 pizza per hour, and we are able to sell 1 pizza for $5. We split the sales proceeds, paying our worker $2.50 per hour and the company earns $2.50 per hour. (We are assuming the only cost in the pizza is labor; the ingredients are free.)

Now let’s assume our worker becomes more productive, because we give him an oven that cooks pizzas twice as fast. Now he will be able to make 2 pizzas per hour. If we can sell the two pizzas for a total of $10, we’ll pay the pizza maker $5 an hour and the PickensPolitics.com Pizza Shop will earn $5 an hour. Worker productivity has doubled, so wages doubled and company earnings doubled too.

Going a step further, instead of selling those 2 pizzas for $5, given there is more supply of pizzas on the market, likely we would have to drop the price a bit, to something like $4 per pizza. Then the total revenue per hour would be $8; we’d pay our worker $4 an hour and the company would earn $4 an hour. Actually, this scenario is more realistic.

In sum, when productivity rises, three good things happen -- hourly wages rise from $2.50 to $4, hourly company earnings rise from $2.50 to $4 and the price of each pizza falls from $5 to $4.

Raising productivity is important for healthy and strong economic activity. If you ever read an Alan Greenspan speech, this is the reason the Fed Chairman always talks about productivity, and if it is increasing or not.

Think of the 1990’s -- company earnings rose significantly (and that caused stocks prices to skyrocket), wages rose significantly, and the inflation rate fell. Why? We had a significant increase in worker productivity, because of the computer revolution of the 1990’s. Computers made workers much more productive.

A technological revolution and the explosion in worker productivity, like in the 1990’s, comes along rarely. The previous one occurred in the 1950’s after WWII, when the U.S. took the developed technologies of the war and applied them to the private sector. (For example, the jet flights allowed business travelers to use their time more efficiently.) The technological revolution before that was the assembly line of the 1920’s. Before that was the industrial revolution of the 1880’s, that took people off the farm and made them more productive in factories.

Technological leaps happen about every 30 or 40 years. We just had one in the 1990’s. Therefore, we don’t expect another one for 30 to 40 years. Additionally, the past two years the private sector slimmed down, so the productivity gains that come from corporate top to bottom adjustsments are over as well. What does this mean? We do not expect any huge productivity gains over the next 5, 10 or 20 years.

Productivity gains will be modest. Therefore, wage gains will be modest. Growth in company earnings will be low, and therefore appreciation of stock prices will be modest. The trend of disinflation (when the inflation rate falls) is also ending. We expect the inflation rate to begin to rise from its recent low of about 1.1%. The 1990’s boon of government tax revenues has ended as well. Government needs to get more productive or efficient (i.e., do more with the same amount of tax revenue), or else the in-fighting over the tax revenue pie will get very unfriendly.

The knee jerk response of government has been to avoid top to bottom slimming down that increase productivity/ efficiency. Instead, government usually raises tax rates to keep the revenue pie growing. That is a mistake, because low productivity, means lower economic growth and if tax rates are raised on top of that, it will slow economic growth further.