TAKING THE MYSTERY FROM LABOR PRODUCTIVITY

The Providence Journal, Money & Business Section, August, 2001

One of the more significant economic statistics to be released of late concerns labor productivity. This is an interesting topic and widely non-understood concept -- very few people understand either what it is or why it really matters. When I ask my introductory economics students to either define productivity or detail what it shows, few are usually able to give correct or even viable responses. All they know is that it is preferable for productivity to be “high” and its growth to be “rapid.”

Simply stated, labor productivity measures the amount (or value) of output generated per hour worked. Why does it matter? Greater labor productivity enables firms to produce a given amount of goods or services with a smaller number of labor hours. And, since payroll cost is related to the number of hours they use, this helps firms control their costs, making their enterprises more profitable. 

Ironically, this concept lies at the heart of a national trend we have become all too accustomed to in the past decade: layoffs and downsizing. Since firms face a great deal of competition (regional, national, and international), which limits their ability to raise prices, how can they raise profits? The answer is to lower costs, generally by finding ways to raise labor productivity. This has taken two forms: use of more modern equipment and machinery (labor-saving technology), and better management methods (horizontal management). So, in times of rising labor productivity, as now, firms are able to produce more output with fewer hours worked (either fewer workers or shorter work weeks). And, strange as it might seem, we shouldn’t attempt to track output by focusing on employment trends in periods when productivity is rising.

Productivity also has an important application concerning Rhode Island’s economy. It provides us a basis with which to solve what many view as a puzzle: since Rhode Island’s hourly manufacturing wages are among the lowest in the US, and certainly far below those in either Massachusetts or Connecticut, why hasn’t our inexpensive manufacturing labor enabled our manufacturing sector to perform much better during this recovery? 

This is an important question, which, unfortunately, is predicated on a false premise. Wages are not the correct measure the cost of labor to a firm. In economics, we don’t just focus on the costs of an activity, such as wages here. We look at both costs and benefits and their relationship to each other. What are the benefits from hiring more labor? The output this labor input creates, in terms of, yep, you guessed it -- labor productivity. So, the correct measure of the cost of labor to firms is what economists refer to as unit labor costs (ULC), or wages adjusted for productivity: the ratio of wages to productivity. If wages are “low,” but productivity is also “low,” these can offset each other in terms of their effects on ULC, potentially making labor “expensive” when wages are “low.” Welcome to Rhode Island!

The table gives productivity values during the present recovery for Rhode Island, Massachusetts, and Connecticut, along with their ULC’s. In 1992, Rhode Island’s manufacturing productivity, or output per hour, was $22.75. This had risen to $26.40 by 1999 (the most recent year for data), a healthy 16.1% growth. That’s the good news. For the bad news, look at productivity in our neighboring states. In 1992, their productivity ranged from $27.48 to $29.60, an advantage of at least 21% over Rhode Island. Furthermore, productivity growth during this recovery was 45.6% for Connecticut versus 49% for Massachusetts. As a result, in 1999, Rhode Island’s manufacturing productivity was only 64.5% of that in Massachusetts and 61.2% of Connecticut’s value.

Now lets talk about whether manufacturing labor is inexpensive here. In 1999, the average hourly manufacturing wage in Rhode Island was $11.98, far below that of either $14.24 in Massachusetts or $15.33 in Connecticut. Does this mean that manufacturing labor here is less expensive than in either of our neighboring states? Guess again! The correct cost of labor is ULC, given in the right columns. While Rhode Island’s manufacturing wage in 1999 was far below that of either of its neighboring states, so too was its productivity. The ratio of the wage to productivity (ULC), or labor cost per dollar of manufacturing output, was $0.454 in Rhode Island. Compare this to Massachusetts, with a ULC of $0.348, and Connecticut whose ULC was $0.356, and it’s not too difficult to see that the state with the lowest manufacturing wage is the one with the most expensive labor! And, if that’s not bad enough, during this recovery, ULC in Rhode Island rose by 4.1% at the same time there were double-digit declines in both Massachusetts   (-21.4%) and Connecticut (-15.5%).

 How can Rhode Island correct this disparity? Obviously (except to our state’s leaders), we must make dramatic improvements in our tax and cost structures, and adequately fund public education – irrespective of the state of the economy. For those not choosing to wait until this happens (the next ice age, I suspect), fundamental economic forces will allow Rhode Island to eventually narrow its productivity gap. How? Whenever the next recession occurs, manufacturing firms that have neither modernized production nor management, the “have nots,” will go out of business. Eliminating these below-average productivity firms will then raise overall manufacturing productivity here. It isn’t pretty, but that’s how it will occur.

by Leonard Lardaro