Labour share of income (Part 2 – The difficulty of overcoming wage stagnation)

Labour share of income (Part 2 – The difficulty of overcoming wage stagnation)

Phuah Eng Chye (2 June 2018)

In the 1970s, policy makers were concerned by how wage rises were fuelling cost-push inflation. When wage stagnation emerged in Japan following the collapse of its asset markets in 1990, it was greeted as a novelty and elicited comparisons with the 1930s depression. Several economists suggested deflationary conditions in Japan occurred only because the government did not commit to sustaining monetary and fiscal stimulus.

The Japanese wage stagnation malaise seems to have spread to other economies after the global financial crisis. According to the International Labour Organization (ILO), “global real wage growth started to recover in 2010, but has decelerated since 2012, falling from 2.5 per cent to 1.7 per cent in 2015, its lowest level in four years…Among emerging and developing G20 countries real wage growth fell from 6.6 per cent in 2012 to 2.5 per cent in 2015. Among developed G20 countries, real wage growth went from 0.2 per cent in 2012 to 1.7 per cent in 2015, the highest rate of the last ten years.”

Given the lessons from Japan, policy-makers coordinated to sustain aggressive fiscal and monetary stimulus in several economies in an attempt to decisively break the grip of debt deflation. In particular, Japanese stimulus policies explicitly targeted overcoming wage stagnation as the key to reviving its economy. But the aggressive policy stimulus barely nudged the needle on wage increases, even as economic growth recovered.

There are multiple theories to explain why wages won’t go up[1]. Every theory has some element of truth but none brings us closer to solving the mystery of overcoming wage stagnation. We need to be able to distinguish the forest from the trees as erroneous policy beliefs can cause resources to be misdirected and is costly.

In this context, there has been constant exhortations to deploy fiscal and monetary stimulus, boost manufacturing, restrict imports and immigration and rebuild the middle class and trade unions. But even when these policies are implemented, they do not seem to have much impact on wages. In fact, wage stagnation occurs even in economies operating near full employment. Others advocate linking wages to productivity growth but the evidence is that productivity gains have not flowed proportionately into wages.

Maybe the critical question to simply ask is why employers are reluctant to pay more. Daniel Gross points out “one of the big – perhaps the biggest – problem in the labor market today is that employers aren’t willing to pay people enough to fill their open positions…And so crops are rotting in the fields in Florida and California because farmers can’t find people to pick them. (Another way to think about this is that farmers were willing to invest the money to buy seeds, plow the fields, plant the crops, buy water and pesticides – but aren’t willing to bring the stuff they grow to market.) Roofers have been forgoing taking on new jobs because they can’t hire people to schlep the shingles. Bed and breakfasts and restaurants in Maine were slow to open or have operated with reduced hours this year because they can’t find housekeepers and waiters…When you operate in a market, you have to keep raising your price until someone is willing to accept your bid. But for the last several years, American employers have steadfastly refused to raise wages.”

At the moment, the most rigorous tool for analysing wage stagnation is the labor market monopsony framework. This theory postulates landscape changes (e.g. concentration) increased monopsony power and enabled employers to dictate wages and terms. Labour monopsony theory predicts “firms with monopsony power have an incentive to employ fewer workers at a lower wage than they would in a competitive labor market. What the monopsonistic firm loses in reduced output and revenue, it more than makes up in reduced costs by paying lower wages. In other words, by recruiting less aggressively, paying less, and sacrificing some employment, employers with monopsony power can shift some of the benefits of production from wages to profits”[2]. This illustrates a point in my earlier article[3] that price (such as wages) formation tends to reflect the outcome from competitive strategies rather than from economic efficiency.

“The implications of monopsonistic wage-setting extend beyond the redistribution of wages to profits. First, it can lead to inefficient reductions in employment and output, where some workers who would have been willing to work at the competitive market wage are never hired, and the output they would have produced is produced less efficiently by other firms if at all. Notably, firms are willing to incur this reduction in employment only if it allows them to pay lower wages or to reduce costs through inferior benefits or work conditions. An important implication is that monopsonistic employers can be induced to hire more labor if their ability to set wages below the level in a competitive market is constrained – for example, by a collective bargaining agreement or a minimum wage.”[4]

The Council of Economic Advisers adds another “implication of monopsony is a weakened link between labor productivity and wages. Because firms no longer compete aggressively for workers, monopsony power opens up the possibility that wages can differ – both between and within firms – even among workers with similar skills. Recent evidence suggests that much of the rise in earnings inequality represents an increase in the divergence of earnings between workers in different firms…Further, if employers with monopsony power are able to differentiate among workers’ reservation wages, then they can also set wages that discriminate among their own employees. In the extreme case of perfect wage discrimination, firms can pay each worker the minimum he or she is willing to accept, regardless of the worker’s skills or productivity. More generally, differing degrees of worker bargaining power across different groups of workers—for example by age, race or gender—may lead to varying degrees of wage depression, promoting within-firm wage inequality.”

The logical conclusion from labour monopsony is that wage stagnation can be addressed through improving labour bargaining power. In connection with this, policies are proposed to strengthen labour’s bargaining position[5] or to counteract the bargaining strength of employers such as through labour enforcement, antitrust regulation or the break-up of monopolies[6].

Josh Bivens, Lawrence Mishel and John Schmitt points out theories based on competitive labour market models or concentration may not fully explain wage stagnation or inequality. They note that “assessing the role of market concentration in the growing pay-productivity gap is equivalent to assessing how growing concentration affects increasing compensation inequality and the erosion of labor’s share of income, as these are the two channels through which increased productivity can bypass the pay of typical workers”.

Josh Bivens, Lawrence Mishel and John Schmitt posits “this rise in the relative market power of employers might owe less to growing market concentration or labor market frictions and more to the collapse of policies and institutions that buttressed the relative market power of workers…It may have always been the case that American labor markets are concentrated…this concentration…puts downward pressure on wages…It may also have always been the case that…low-wage labor markets are riven with frictions that…give employers the power to set wages. But in previous decades, these always-and-everywhere sources of employer market power were likely neutralized by institutions and policies that provided countervailing power to workers. In more recent decades, several of these institutions and policies have been eroded or rolled back, with nothing to replace them as sources of countervailing power”.

In this regard, Josh Bivens, Lawrence Mishel and John Schmitt point out “macroeconomic policy has failed to secure full employment for the large majority of these years. This has led to labor markets with too much slack to allow low- and moderate-wage workers to demand and achieve consistent wage gains. The evidence is quite clear that low- and moderate-wage workers need lower rates of unemployment to post wage gains than do their higher-wage peers”.

They add that “other bulwarks of market power for typical workers (labor standards, broadly defined) have also eroded in recent decades. The most prominent example is the federal minimum wage, which in inflation-adjusted terms is now roughly 25 percent lower than it was at its height in 1968, even though productivity has nearly doubled and low-wage workers have become far more educated”. “For middle-wage workers, the key labor standard that has eroded is collective bargaining”. In addition, “growing trade flows from lower-wage nations led to a collapse of worker-side market power” and combined with concentration to result in wage losses.

Josh Bivens, Lawrence Mishel and John Schmitt also note that “given that frictions can reduce workers’ ability to find alternative employment, it is no surprise that some employers strive to create such frictions…employers have pursued an aggressive host of practices meant to limit workers’ bargaining position, and policymakers, particularly through the blessing of case law in the courts, have often ratified these practices. Examples of these employer practices include mandatory forced arbitration agreements, noncompete agreements, and nonpoaching agreements”.

My view is that while there are merits to labour monopsony, it has the drawback of being subconsciously tied to an industrial economy. Therefore, it is unable to take into consideration the dramatic changes in the nature of production, consumption and the organisation of work. In this context, the varying theories on wage stagnation can be interpreted as a manifestation of the information effects[7] altering the relationship between aggregate demand and wages.

  • Several theories[8] are based on behaviours associated with the information effects. The Winner-Take-All (WTA) explains how competitive bidding for talent results in a few highly-paid winners but leaves a large number of workers willing to work for low wages. The fissured workplace explains how new organisational flexibilities and technologies increases the substitutability of labour, eliminates overhead labour costs (benefits, idle time) and allows firms to avoid locking in labour at high costs. The new organisational flexibilities also enable firms to fragment work into smaller pieces at cheaper prices and to contract labour only on a need basis. Zero marginal costs suggest the IoT will lead to a dramatic reduction in marginal costs of production (which implicitly includes labour costs).
  • There are also overlaps with the concentration and superstar firm theories. The existence of industrial-era organisations (with hierarchies and large numbers of employees) is being threatened by the emergence of the information-based business models. Globally-scaled firms with few employees have enjoyed tremendous success while the traditional firms with a large number of permanent employees on high salaries are vulnerable.
  • Organisational flexibility is complemented by financial (information) flexibility. Corporate restructuring or share buybacks are an alternative to headcount expansion. This means management have more ways of increasing their share price without having to raise wages. This has led to a decoupling in the relationships between share prices and wages.
  • The co-existence of wage stagnation with job vacancies, low labour participation and a shrinking labour force reflects labour market frictions increase as economies mature[9]. There are several theoretical approaches to labour market frictions. (1) Search cost theories suggest incomplete information might constrain the ability of employees to search for jobs offering better wages. Price theories might focus on how the pressure to continuously widen profit margins might cause the reservation marginal price of labour or the price at which corporations will expand their use of labour to fall. In contrast, there will be pressure on the reservation wage[10] or the price at which households will expand their supply of labour to rise due to the constant increases in the costs of living[11] (e.g. rentals, transportation costs, education). Labour market inflexibilities will also increase due to discrimination against certain types of occupations, working conditions and locations or due to care responsibilities. A widening in the gap between the labour reservation price and reservation wages will result in labour being rationed or labour participation falling. (2) Michael Farren and Scott Winship suggest the fall in labour participation “is not the result of a lack of available jobs or unreasonably low wages”. Instead, they found that “the lion’s share of increasing inactivity – 47 percent – comes from prime-age men reporting they are disabled or ill.” This “may be connected to the rising accessibility and generosity of government aid programs.” In addition, they note “a disproportionate number of inactive men – 76 percent – live in households that receive support from government aid programs. The number is higher—around 90 percent—for those who report they are disabled or ill. This suggests that even if an inactive man does not receive government assistance directly, he may benefit from being part of a household that receives some other form of benefits, reducing the necessity to rejoin the workforce”. (3) Lastly, Josh Bivens, Lawrence Mishel and John Schmitt note “there is a long history of modelling efficiency wages in which wage levels do not just allocate workers to jobs but also provide motivation and a way for employers to elicit effort. Often wage levels and processes for monitoring workers’ performance (with the threat of dismissal if they are caught shirking) are two substitute strategies for eliciting desired effort in efficiency wage models. This implies that if, for example, the cost of monitoring declines, then employers will be able to elicit the same amount of effort with lower wages. Other models of wage determination invoke workers’ concern with fairness with regard to either relative wages or their wage level (or growth) relative to economywide productivity (or growth). In these models, workers frustrated by perceived lack of fairness can cut back on effort, damaging the firm’s output.”
  • Wage stagnation mostly occurs in matured economies which are high-information environments. Developing economies are subject to cost-push inflation dynamics because of their lower wage base. But the cost-push inflation dynamics seems to have dissipated in matured economies; probably because labour work can easily be sourced from lower-cost locations abroad. In matured economies, economic growth does not automatically lead to higher wages.

Hence, the stubborn resistance of wages to aggressive policy stimulus is likely due to landscape change. When economic activities are increasingly intangible and information driven, it changes the complexion of challenges from one of managing output constraints to one of managing information and of addressing income distribution bottlenecks.

References

Council of Economic Advisers (October 2016) “Labor market monopsony: Trends, consequences, and policy responses”. Council of Economic Advisers Issue Brief. https://obamawhitehouse.archives.gov/sites/default/files/page/files/20161025_monopsony_labor_mrkt_cea.pdf

Daniel Gross (13 August 2017) “More Americans would rather not work than take jobs for stingy wages”. Slate. http://www.businessinsider.com/more-americans-would-rather-not-work-than-take-jobs-for-stingy-wages-2017-8

International Labour Organization (2016) “Global Wage Report 2016/17: Wage inequality in the workplace”. http://www.ilo.org/wcmsp5/groups/public/—dgreports/—dcomm/—publ/documents/publication/wcms_537846.pdf

Josh Bivens, Lawrence Mishel, John Schmitt (25 April 2018) “It’s not just monopoly and monopsony: How market power has affected American wages”. Economic Policy Institute. https://www.epi.org/publication/its-not-just-monopoly-and-monopsony-how-market-power-has-affected-american-wages/ or https://www.epi.org/files/pdf/145564.pdf

Marshall Steinbaum (18 December 2017) “How widespread is labor monopsony? Some new results suggest it’s pervasive.” Roosevelt Institute. http://rooseveltinstitute.org/how-widespread-labor-monopsony-some-new-results-suggest-its-pervasive/

Michael Farren, Scott Winship (1 May 2018) “Supply or demand? What’s the story behind men leaving the labor force?” https://www.mercatus.org/essays/men-leaving-labor-force-supply-demand

Phuah Eng Chye (29 July 2017) “The significance of information effects”. Economicsofinformationsociety.com. http://economicsofinformationsociety.com/the-significance-of-information-effects/

Phuah Eng Chye (26 August 2017) “The services economy: Revisiting Baumol’s cost disease.” Economicsofinformationsociety.com.  http://economicsofinformationsociety.com/the-services-economy-revisiting-baumols-cost-disease/

Phuah Eng Chye (16 September 2017) “The services economy: Service sector growth and the information society”. Economicsofinformationsociety.com. http://economicsofinformationsociety.com/the-services-economy-service-sector-growth-and-the-information-society/

Phuah Eng Chye (2 February 2018) “The sharing economy: A futuristic taxi landscape (Part 3: Pricing fares the same way as stocks)”. Economicsofinformationsociety.com. http://economicsofinformationsociety.com/the-sharing-economy-a-futuristic-taxi-landscape-part-3-pricing-fares-the-same-way-as-stocks/

Phuah Eng Chye (17 March 2018) “Organisation of households: Shrinking households, labour market frictions and societal cultures”. Economicsofinformationsociety.com. http://economicsofinformationsociety.com/organisation-of-households-shrinking-households-labour-market-frictions-and-societal-cultures/

Phuah Eng Chye (26 May 2018) “Labour share of income (Part 1: Theories and measurement)”. Economicsofinformationsociety.com. http://economicsofinformationsociety.com/labour-share-of-income-part-1-theories-and-measurement/

[1] Phuah Eng Chye “Organisation of work: Labour share of income – Theories and measurement.”

[2] The Council of Economic Advisers.

[3]Phuah Eng Chye “The sharing economy: A futuristic taxi landscape (Part 3: Pricing fares the same way as stocks)”.

[4] Council of Economic Advisers.

[5] Measures as outlined by the Council of Economic Advisers.

[6] Marshall Steinbaum.

[7] Phuah Eng Chye “The significance of information effects”.

[8] Phuah Eng Chye “Organisation of work: Labour share of income – Theory and measurement”.

[9] Phuah Eng Chye “The services economy: Revisiting Baumol’s cost disease”.

[10] Phuah Eng Chye “Organisation of households: Shrinking households, labour market frictions and societal cultures”.

[11] Phuah Eng Chye “The services economy: Revisiting Baumol’s cost disease”.

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