Wednesday, May 14, 2008

Wages Aren't Everything

In today's online version of the Wall Street Journal, Thomas Frank (the author or "What's the Matter with Kansas") declares that we are in the midst of an economic catastrophe. The evidence? "Real hourly wages for most workers have risen only 1% since 1979." That sounds bad. And it's often cited as a seemingly powerful argument used against the New, global economy. Nobody questions the fact that the US has become more productive (see chart below, data from BLS). But if workers are not compensated for it, we have a problem.

How do we evaluate the validity of Frank's claim?

[Skip the bordered section if bored by math...]

Classical economics teaches us that the profit maximizing firm employs workers until the wage rate is equal to the marginal revenue product of labor (MRP,l). That is, a rational firm will hire labor until the extra revenue earned by an additional unit of labor is equal to its cost:


where P is price, L is labor and f represents the production function. Production functions map the output achieved given any mix of available inputs. The marginal physical product of labor, the additional output achieved with an another unit of labor, is given by df/dL.

Stating the decision rule for the for a profit maximizer mathematically (remember, the marginal revenue product of labor is equal to the wage rate):


Assuming a constant price, if productivity (df/dL) increases, the wage rate must also increase to maintain the equality.


So, we should be concerned if wages are stagnant while productivity is increasing. But wages don't tell the whole story. Employers provide a package of benefits to their employees, and these should not be left out of the discussion. Common benefits include those paid for health care, medicare, and social security.

Real compensation combines both real wages and real benefits, and represents the totality of employee earnings. [Tying up loose ends, we should redefine "w" in the section above to represent full compensation]. The following graph (data from BLS) displays the trend in real wages and real compensation. Both series are represented as indices, so even though real compensation is always greater than real wages, each series equals 100 in 2008.

The chart agrees that inflation adjusted wages have not increased over the last thirty years. On the other hand, real compensation has grown steadily over the same period. Further, the rate of increase is steeper since the late 1990's, the beginning of the New Economy. What does that mean? Basically that pundits who cite stagnant wage statistics are only telling part of the story. Is Frank sorry about the "economic catastrophe" thing?

It's true that employer provided benefits are not necessarily fungible; it's difficult to transform them into cash. However, they do represent an opportunity benefit--cash that would otherwise be spent on health care can be turned into a shiny new iPhone. While it's interesting that wages haven't increased over time, it's hardly grounds for alarmist predictions.

Unfortunately, Thomas Frank seems prone to those. Just read his book.

Copyright © 2008 TCE.

No comments: