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Archived Bulletins

June 2004

HIGH PRODUCTIVITY AND HIGH WAGES - WHICH COMES FIRST?

By Dr. Peter Sturm
Visiting Lecturer, Macroeconomics


In a recent ceremony at the University of Cape Coast conveying a doctorate honoris causa to the President of the Republic of Ghana, Mr. Kufuor raised the question of the relationship between high levels and growth rates of (labor) productivity and high levels and growth rates of wages. At an aggregate level, the close correlation between productivity and real wages both between countries and in a single country over time is indeed both striking as well as (almost) self explanatory. And there seems little doubt (at least at the aggregate level) about which way the causality runs: In fact, with well above half of gross domestic product accruing as labor income, it is hard to see how real wages can permanently exceed labor productivity or grow much faster than labor productivity for an extended period of time. Unless the output is actually produced, it cannot be distributed in the form of wages or otherwise. And on a theoretical basis, profit and utility maximizing behavior of producers and households respectively, are consistent with the empirical observation of real wages increasing in step with productivity.

Any hesitation about the obvious primacy of productivity over high real wages is probably based on 'efficiency wage theory': the argument that labor productivity is dependent on the real wage; firms which pay wages above the going market rate will induce their workers to be more productive on account of their increased effort and diligence, due to (at least partly) workers' fear of losing their premium-pay job. However, the efficiency wage argument is couched in terms of wage levels rather than growth rates. For a given level of technology, a wage premium above the market clearing wage will induce higher labor productivity, and there are a number of good empirical and theoretical arguments to support this theory. Whether it is also true that a more rapid increase in real wages entails a more rapid increase in labor productivity seems less obvious, and to the best of my knowledge this question has not yet been analyzed and investigated.

However, the seemingly trivial question of whether labor productivity leads or lags real wages raises a number of important policy issues for emerging economies in the process of economic development and industrialization, a couple of which are briefly highlighted below.

One crucial characteristic of (successful) economic development is the gradual but steady integration of the 'informal' into the 'formal' sector of the economy. Normally the formal sector is characterized by higher real wages, and more standardized working relationships (governed by explicit contracts) than relationships in the informal sector. Rising productivity in the formal sector shifts the labor demand schedule of this sector outward, leading (at the extremes) to either rising employment at constant real wages (if labor supply is perfectly elastic) or rising real wages at constant employment, if labor supply to the formal sector is inelastic (or if access to employment in this sector is restricted for example, by union monopolies or by lack of requisite human capital). The less rising labor productivity translates into real wage increases in the formal sector, the more rapid will be the absorption of the informal labor force into the formal (or "modern") sector. Average labor income in the economy will increase despite stable real wages in the formal sector, because of the shift of labor from the low-productivity (informal) to the high-productivity (formal) sector.

Typically, the labor force in the formal and informal sectors is not homogeneous, and a smooth integration of informal labor into the formal sector requires important concurrent training and skill formation. Much of this can be achieved gradually through learning by doing, but formal education usually also plays an important role, usefully complementing the learning-by-doing process and making the transition more efficient. The spectacular modernization in South East Asia during the second half of the last century was largely characterized by this pattern of development, including heavy initial investment into education and human capital formation more generally.

Another important aspect of the discussion of the relationship between real wages and productivity arises in the realm of productive activities where output, and thus productivity, can not be readily measured. This is the case for all output which is not marketed, i.e. all public goods, and many goods which are treated as if they were public goods (for example much of education, health care, and other merit goods). Since output cannot be easily measured, productivity cannot be measured either and can thus not be related to the real wage. In fact, in these cases the national accounts system assigns the value of output on the basis of production costs (largely real wages), and the real wage paid to civil servants, teachers, and health service employees thereby reflects the social value assigned to these activities by society. Low teacher salaries thus are an expression of society's low value assigned to education, and efficiency wage arguments suggest that low teachers' salaries will also entail poor results of educational activities: a vicious circle of self-fulfilling expectations, which can severely handicap a country's economic development and modernization.

(Comments and queries are welcome and can be addresses to: phsturm@hotmail.com)

*This article represents the writer's personal opinion and should not be interpreted as providing an official view of Ashesi University.

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