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One of the ongoing debates about the state of the U.S. economy is the extent to which the profits from productivity gains are increasingly going to the owners of capital instead of wage earners. These researchers are debating the extent to which the labor share of income, once considered a constant by economists, is on the decline.
But what if the decline of national income going to labor actually affects the measured rate of U.S. productivity growth? In a blog post published last week, University of Houston economist Dietz Vollrath sketches out a model showing just that scenario. Vollrath’s post contains the full math for those who are interested, but his analysis rests on the idea that the labor share of income is declining due to the increased market power of businesses.
Vollrath argues that businesses with more market power are able to charge higher markups on their goods and services, meaning their pricing is higher than the cost of producing an additional goods or services compared to pricing in a perfectly competitive market. So in this situation where markups are high, goods and services are being produced less efficiently, with the increased profits going to the owners of capital.
Vollrath argues that this is how measured productivity growth is affected by the decline of the labor share of income. Market power is important for thinking about measured productivity growth because, as Vollrath says, it “dictates how efficiently we use our inputs.” Remember, productivity growth is measured by the residual—or the part unexplained by additional workers or capital—of economic growth. Impeding the most efficient use of capital and labor via marked-up prices will reduce measured productivity.
But let’s be clear: Vollrath’s point is about measured productivity. In his model, the decline of the share of income going to wage earners in the U.S. economy wouldn’t necessarily affect the true underlying pace of innovation in the economy that is not captured by current measures of productivity. So it could be that innovation is happening, but companies’ increased market power means these innovations aren’t showing up as an increasingly better usage of capital and labor in producing gross domestic product. Perhaps this could explain some of the reason why measured productivity growth looks so meager in the seeming age of innovation in Silicon Valley.
But Vollrath’s story isn’t a complete explanation of the fall in measured productivity, as he acknowledges.. For example he cites research by University of Chicago economists Loukas Karabarbounis and Brent Neiman, which points to the falling price of investment goods as the main reason for the decline in share of income going to wage earners. Put another way, the declining price of computers is resulting in a higher share of income going to profits.
Another potential reason is a change in the kind of technological growth the U.S. economy is experiencing, an argument put forth by Harvard University economist Robert Z. Lawrence. He argues that technology is increasingly tilted toward labor instead of capital, which actually reduces labor’s share of income.
And of course there’s economist Thomas Piketty’s version of events, where capital deepening is at the center of his argument in “Capital in the 21st Century.” The Paris School of Economics professor contends that the historically constant rate of return will allow capital to gain more of income as economic growth slows down.
But Vollrath’s market power explanation for falling productivity growth, alongside the falling share of national income going to wage earners, is supported by some evidence. Work by Massachusetts Institute of Technology graduate student Matt Rognlie, for example, found evidence of higher markups.
Whether and how the decline of the labor share of income affects productivity growth is obviously a topic far too large for a couple of blog posts. But Vollrath’s model is especially interesting for connecting two important trends in recent years: the slowdown in productivity growth and the declining labor share. It’s worth, at the very least, a bit more investigation.