Thursday 23 February 2012

Ensuring productivity gains benefit all workers

By Tan Di Song & Guo Jiajing, The Straits Times, 20 Feb 2012

THE most direct mechanism by which productivity gains affect living standards is through higher wages.

As such, the extent to which productivity gains translate into wage growth is a pertinent issue. Broadly, the link between productivity and wages has been strong in Singapore. From 2000 to 2010, productivity in Singapore increased by 1.8 per cent per annum while resident real average monthly earnings grew by 1.3 per cent per annum (Exhibit 1).

However, a brief survey of international data suggests that the translation of productivity gains to real wage growth cannot be taken for granted.

Exhibit 2 shows the productivity and real average wage growth of various countries from 2000 to 2010. Singapore fared relatively well in this comparison, with the ratio of real average wage growth to productivity growth coming in at 0.7. In other countries such as the United States, Japan and Germany, real average wage growth was much lower than the productivity gains over this period.

While productivity growth is a key driver of real wage growth, real wage growth may also be affected by many other factors, especially in the short run. To better understand what these factors may be, we follow the methodology employed by Sharpe et al (2008a) to decompose real average wage growth in the economy into three components:

Productivity growth

BASED on the decomposition framework, productivity growth should lead to a rise in real average wage growth, all other things being equal. Productivity growth can in turn be driven by improvements in the quality of inputs (for example, labour quality can be raised through education and training), increasing capital intensity through capital investments, as well as technological improvements or process innovations leading to growth in Total Factor Productivity (Syverson, 2010).

Relative output price changes

RELATIVE output price change is defined as the difference between the change in output prices and the change in the prices of consumption goods (that is, domestic inflation). The intuition is that the real wages of workers can increase on a sustainable basis only if the average price of the goods and services they produce exceeds the average price of the goods and services they consume. Otherwise, the purchasing power of the value of their labour will gradually decline.

Weak growth in the price of goods and services produced by workers may be driven by several factors.

For instance, externally-oriented sectors may face intense price competition from low-cost competitors or may be producing outdated products for which demand is rapidly declining. Even domestically-oriented sectors may face downward price pressures if the sector is fragmented with many firms competing against one another. However, for the domestically-oriented sectors, while an increase in the price of the goods and services produced tends to raise real wages in the sector, it will also result in inflation, thereby eroding real wage gains for all workers across the economy (for example, strong price growth in retail or food services may raise the cost of living for all workers).

Growth in labour share of output

THE third channel by which real wages can rise is if labour gains a larger share of the value of the output produced by firms. However, in contrast to the former two components, wage growth through a rise in labour share is not likely to be sustainable as this implies a decline in firm profitability. An excessive erosion of profits is likely to lead to business closure and a significant disruption to economic activity.

Factors that can influence labour share include the following:
Market structure. If the labour market is not perfectly competitive in that employers can influence market wages (that is, they have monopsony power), employment and wages are both likely to be lower, leading to a smaller labour share in the firms' value-added (VA).

This may occur if there are labour market rigidities that hinder workers from changing jobs easily (for example, search frictions) or if workers lack skills that are transferable across jobs.
Institutional factors. These include factors that affect workers' bargaining power relative to firms, such as rules on union formation and wage legislations. For instance, unions with strong membership can push for higher wages at the expense of profits even if productivity remains unchanged, while minimum wage legislation can force firms to raise wages.
Labour market conditions. A relatively abundant supply of workers in the labour market can reduce the bargaining position of workers, thus leading to a decline in wages and labour share.
Extent of displacement of labour by capital. The labour share may decline if workers are replaced by capital in the production process (that is, when capital and labour are substitutes).
Outsourcing. If firms outsource to take advantage of cheaper production costs overseas, the cost savings will result in productivity gains. However, as these gains do not arise from the workers, their wages may not increase. Furthermore, there could be a net loss of jobs when firms outsource production. As a result, the labour share of VA is likely to fall.

Link between productivity and real wages

IN THIS section, we examine the link between productivity growth and the real average wage growth of resident workers, as proxied by the real average monthly earnings, at the macro level in Singapore.

As the decomposition framework described above is intended to explain the drivers of overall wage growth (that is, incorporating both resident and foreign wage growth), we have adapted the framework to focus on resident wage growth.

In the adapted framework, the third component of the decomposition identity becomes a residual term that captures both the effect of labour share growth as well as the difference between resident wage growth and overall wage growth.

Analysis at macro level

OUR results are presented in Exhibit 3.

Over the period 1991-2010, real average wage growth for resident workers (3.2 per cent per annum) was faster than productivity growth (2.5 per cent per annum). A closer examination of the data reveals that real average wage growth for resident workers significantly outpaced productivity growth in the earlier decade (1991-2000), coming in at 5.4 per cent per annum and 3.3 per cent per annum respectively. The main cause of the divergence was the positive residual term.

Given that the labour share of output, based on national accounts, grew by only 0.2 per cent over this period, we can surmise that the residual term was driven by the faster growth of resident wages compared to overall wages.

In the more recent decade (2000-2010), real average wage growth of residents (1.3 per cent per annum) was broadly in line with productivity growth (1.8 per cent per annum). The slight divergence between productivity and real wage growth was largely due to a fall in relative output prices, with the gross domestic product deflator (a proxy for the price of goods and services produced by workers) increasing by 0.9 per cent per annum compared to the growth in the consumer price index (a proxy for the price of goods and services consumed by workers) of 1.6 per cent per annum.

One possible reason why output prices failed to keep pace with inflation in the last decade is the intense competition faced by our externally-oriented sectors (which make up a sizeable part of our economy) in global markets, given the rise of low-cost producers like China.

This suggests that there is a need to help sectors restructure and move up the value chain so that they can produce high VA goods and services that can be sold at higher prices in global markets.

It is important to note that the above analysis focuses on real average wages, and does not take into account the distribution of wage growth across worker segments. In reality, if skilled workers are valued over unskilled workers, the wages of skilled workers will grow relative to the wages of unskilled workers. Rising average wages may then not be reflective of the extent to which lower-skilled workers are benefiting from productivity growth. Indeed, if we examine the relationship between productivity and the real median wages of residents in Singapore, we find that it is weaker than that between productivity and the real average wages of residents (Exhibit 4). This suggests that there are distributional concerns in Singapore, and that more effort will be needed to ensure that the fruits of productivity gains do not just benefit the average worker but also workers at the lower end of the income spectrum.

The writers are economists from the Economics Division of the Ministry of Trade and Industry. This is an excerpt from a paper on productivity and wage growth in Singapore published as part of the Economic Survey of Singapore 2011.

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