Tag: newsletter (volume 9 issue 1)

Forecasting the Rate of Growth of Real Wages (Productivity)

Posted on By economica

by Christopher Bruce

This article first appeared in the spring 2004 issue of the Expert Witness.

One of the most important determinants of the value of an individual’s lifetime income is the rate
at which that income will grow from one year to the next. The lifetime income of an individual whose earnings grow at 1 percent per year will be dramatically lower than that of an individual whose earnings grow at 5 percent per year. Two major factors determine this growth rate, once the individual has chosen an occupation. First, as workers obtain more experience, their earnings increase due to what is often called
“career progress.” Second, all workers in society tend to benefit equally from the long-term rise in wages across the economy. (If average wages rise by 50 percent over a period two decades, we expect that the wages of labourers and waitresses will increase by 50 percent also, even if the skills required for those two jobs remain unchanged.2)

Furthermore, economy-wide wage increases can be divided into those that are due to changes in the consumer price index – inflationary increases – and those that are due to changes in the “real” purchasing power of wages – real wage increases. (The observed, or “nominal,” rate of increase of wages equals the rate of price inflation plus the rate of increase of real wages.) Unfortunately, despite its importance for the calculation of damages, the forecast of real wage increases proves to be very complex. The purpose of this article will be to report some recent developments in the preparation of that forecast that should prove to be valuable to the courts.

Introduction

Effectively, an increase in the real wage is an increase in the purchasing power of workers’ earnings. But, in the
long run, the average worker will only be able to consume more goods and services if output per worker has increased. Therefore, one would expect there to be a correlation between the long run rate of growth of real wages and the rate of growth of (real) output per worker, or “labour productivity.”

Depending upon the purpose to which it is to be put, a number of different definitions of labour productivity have been proposed. The definition that is most relevant to the determination of real wages is output per hour worked. Changes in this measure are influenced by three factors: increases in the amount of capital goods (machinery, buildings, computers, etc.) per worker, improvements in the technology “embodied” in capital (technological change), and changes in the productivity of workers (usually attributed to improvements in education).

Theory

Because a portion of any change in output per worker is attributable to changes in the quality and quantity of the capital available to workers, some of that increase in output will be paid to the owners of capital. Recently, most economists have come to accept the view that the allocation of gains between capital and labour will be determined in large part by the relative scarcity of those two factors.3 That is, in periods in which labour is in short supply (relative to capital), workers will be able to capture most of the gains from increased productivity and the percentage increase in real wages will equal or exceed the percentage increase in productivity. Conversely, when capital is in short supply relative to labour, it is capital that will capture most of the gains.

One of the attractive features of this theory is that it helps to explain many of the movements in real wages and labour productivity that have been observed over the last five decades. In the 1950s and 1960s, when the economy was growing rapidly and labour was (relatively) in short supply, real wages rose quickly, and at a rate higher than the rate of increase of output per worker. In the 1970s and 1980s, however, when the baby boom generation began to enter the labour market, labour supply increased significantly. Furthermore, because young adults borrow heavily – to purchase homes, cars, furniture, etc. – the influx of young baby boomers drove up interest rates, impeding firms’ ability to borrow for investments in capital. As a result, real wages stagnated even though productivity rose steadily. In the latter half of the 1990s, however, the baby boomers began to approach retirement age. Not only did the supply of labour start to fall, but older workers began to accumulate retirement savings, making funds available for capital investments. The result is that labour has become scarce relative to capital; and economists are now predicting that increases in real wages will begin to match, or exceed, the growth in output per worker.

Empirical evidence

Many economists believe that the reversal in the relative scarcities of labour and capital began in the mid-1990s. Some evidence in support of this conclusion is provided in Table 1. There it is seen that, between 1990 and 1995, the real incomes of Canadian males (25-44 years old, working full-time, full-year) decreased by 0.8 percent per year. (Nominal incomes increased by 1.4 percent per year during that period, while inflation averaged 2.2 percent.) However, between 1995 and 2000, average incomes increased by 3.1 percent while inflation was 1.7 percent, resulting in real income growth of 1.4 percent per year. Table 1 also reports that the real incomes of university graduates grew at 1.7 percent per year in the late 1990s; and that those of high school graduates and holders of trades diplomas and certificates made modest, but positive, gains in that same period.4

Table 1

Most Canadian economists appear to believe that, over the long run, output per worker will increase at between 1.5 and 2.0 percent per year. The 2.0 percent forecast is the consensus prediction of a group of Canada’s leading academic and government economists.5 The lower predictions have been made by forecasting agencies: Global Insight has forecast 1.9 percent per year over 2002-26; Informetrica has forecast 1.6 percent over the same period; and the Conference Board of Canada has forecast 1.46 percent over 2002-15.6Thus, as the model described above suggests that real wages will increase more rapidly than productivity, as the baby boomers age, a conservative estimate would be that real wages will increase by 2 percent per year over the next two decades.

>Conclusion

It is important to note that this means that all workers’ real wages will increase by 2 percent per year. Economy-wide productivity gains are like a rising tide, they carry all workers with them equally. Even the individual who remains in the same job, with no personal increase in productivity and no promotions, can expect, on average, to benefit from real wage increases of 2 percent per year. With inflation predicted also to be 2 percent per year, he or she is predicted to benefit from nominal wage increases of approximately 4 percent per year – a 2 percent inflationary increase plus a 2 percent real increase.

Footnotes:

1. This discussion is taken from Chapter 5 of Christopher Bruce, Assessment of Personal Injury Damages, 4th Edition, Butterworths, 2004.[back to text of article]

2. Evidence that all wages in the economy rise together, regardless of differences in the rate of increase of productivity among industries, was provided by Christopher Bruce in The Connection Between Labour Productivity and Wages (The Expert Witness Vol. 7, No. 2).[back to text of article]

3. See, especially, J. C. Herbert Emery and Ian Rongve, “Much Ado About Nothing? Demographic Bulges, the Productivity Puzzle, and CPP Reform,” Contemporary Economic Policy, 17 January 1999, 68-78; Henning Bohn, “Will social security and Medicare remain viable as the U.S. population is aging?” Carnegie-Rochester Conference Series on Public Policy 50 1999, 1-53; and William Scarth, “Population Aging, Productivity and Living Standards;” in Andrew Sharpe, France St.-Hilaire, and Keith Banting, eds. The Review of Economic Performance and Social Progress 2002, Institute for Research on Public Policy, Montreal, 2002, 145-156.[ back to text of article]

4. U.S. data also suggest that there was a striking switch to a high productivity growth regime in the mid-1990s. See, for example, James Kahn and Robert Rich, “Tracking the New Economy: Using Growth Theory to Detect Changes in Trend Productivity,” Staff Reports, Federal Reserve Bank of New York, No. 159, January 2003.[ back to text of article]

5. Andrew Sharpe,
“Symposium on Future Productivity Growth in Canada: An Introduction,” International Productivity Monitor, 7, Fall 2003, 44-45.[ back to text of article]

6. These figures are taken from Andrew Sharpe, ibid. pp. 44-45.[ back to text of article]

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Christopher Bruce is the President of Economica and a Professor of Economics at the University of Calgary. He is also the author of Assessment of Personal Injury Damages (Butterworths, 2004).

An Alternative Method for Assessing the Value of Housewife Services

Posted on By economica

by Douglas W. Allen

This article first appeared in the spring 2004 issue of the Expert Witness.

Often the simplest questions in life have the most complicated answers. Such is the case in measuring the value of non-market activity like volunteer hours, leisure time, and especially the value of a housewife. How can something so much a part of our everyday experience as “household service” be such an elusive thing to evaluate … especially in court?

Of course, at the heart of the matter is the absence of explicit market pricing for housewives. “If only,” exhorts the expert economic witness, “housewives were bought and sold on an open market like wheat futures, we could have an accurate measure of their worth.” This market oriented predilection for using prices to measure value not only drives the methods currently used, it is the source of the problems in measuring, and perhaps the source of the courts often reluctance to rely on “economic” measures of worth. To paraphrase Oscar Wilde, economists often know the price of everything, but the value of nothing.

To refresh your memory, economists have argued for two different methods to measure the value of a housewife: the opportunity cost method; and the replacement cost method.

The fundamental idea behind the opportunity cost method is “what does the household sacrifice by having the wife stay home to work?” In other words, what is the opportunity cost of the housewife’s time? If a female lawyer is earning $150/hour, and she decides to forgo an hour of work to do the dishes, the cost of that task is $150. The economist then says the $150 measures the value of an hour of housewife service.

The replacement cost approach to the problem asks: “how much would it cost to replace the services of the housewife?” The idea being one could go into the market place, find the wage for nannies, cooks, prostitutes, etc., then use these wages as the value of the housewife services. Sometimes an average is used, sometimes the wage within each specialty is used.

Both of these methods are riddled with well known problems:

  • They measure the value of household services at the margin, and not the total value.
  • The OC approach assumes your hours of work are completely flexible.
  • The RC approach assumes the productivity of the wife and market replacement are the same.
  • Both methods have a hard time dealing with full-time, long-term housewives who have been separated from the labor market for years.
  • Both methods rely on often arbitrary measures of time devoted to household services.
  • Both methods are silent on how to treat housewife services that are not available in the market.
  • Both methods have a difficult time dealing with the commingling of leisure and household services.

The list goes on. Such problems are a source of income for an expert economic witness, but there must be a better way – especially for the case of the long-term, full-time housewife where using market measures is inappropriate.

The fundamental problem with both methods is that they are based on market oriented economic theory, and as a result they ignore the institutional aspect of marriage. Marriage, as an institution, is designed to produce a set of goods that the market does not produce. Certainly some market goods get jointly produced in the marriage, but these are secondary to the main purpose of marriage. Marriage restricts the behavior of both the husband and wife such that they have an incentive over their life-cycle to cooperate in procreation and the successful rearing of the next generation. To confuse the value of a housewife with the services of domestic service misses the point entirely. The market based procedures are only crude, unreliable, and biased under-estimates of the true value of a housewife.

Within the past 25 years economists have started to move away from this purely market based way of thinking, and have started to consider the institutional aspects of exchange. This work leads to an interesting method of evaluating a housewife – one that works best in the case where the market approach does poorly. This method is simple to use, and is based on the revealed spouse choice at the time of marriage as an indicator of the value of a spouse’s contribution to a marriage.

Marriage is a sharing arrangement. A husband does not hire his wife, nor does the wife hire her husband. When the marriage is doing well both benefit, and in hard times both suffer: “for better or for worse.” Some shares are better than others. A spouse who gets a small share of the pie has little incentive to work within the marriage. The gains from an increased share to this person will more than offset the disincentives caused by reducing the share to the other spouse. Economists have shown that for a given man and woman there is an “optimal share” which creates the best incentives for the husband and wife to contribute to the marriage.

The interesting thing about the optimal share is that, with one exception, it never pays the average contribution of each spouse. For example, if one spouse were contributing 90% of the marriage value and the other spouse was contributing 10%, the optimal share turns out to always be lower than 90% for the more productive spouse. This is a good deal for the low productive spouse, but a bad deal for the partner. The only time this is not true is when each spouse is equally productive and they share 50-50.

In a marriage of unequals then, to have the optimal share means that one of the spouses is unhappy. On the other hand, to share in proportion to unequal contributions means the share is not optimal and the incentives are not right: the marriage will be low valued. In either case, there is a problem.

Couples do not marry in a vacuum. Individuals compete with one another for mates. This competition for spouses, along with the optimal sharing rule above, forces people to marry individuals they expect will make an equal contribution to the marriage. A person will always do better marrying someone of equal quality and sharing equally, rather than marry someone with of a lower quality, even though their share is higher in the latter case. The result is that in equilibrium husbands match with wives who are expected to contribute equally over the life of the marriage.

This does not mean the type of contributions are the same. The husband may be expected to work in the labor force, the wife may work in the home full time. Nor does it mean the contributions actually end up equal. It simply means that the couple believes at the time of marriage that the two different streams of services are of equal value – otherwise they wouldn’t marry. Thus this approach recognizes the most valuable contribution of a full-time housewife – giving birth and raising children. The other methods, by focusing on simple household chores, ignore the most important contribution of the wife.

Recognizing the incentives of sharing within a marriage explains why marriages have a hard time surviving large unexpected shocks like infertility or long spells of unemployment. An option to divorce is to renegotiate the share. However, renegotiation, ex post, will always imply a sub-optimal share. The spouse who ends up, ex post, more productive will always be better off finding a new mate of similar productivity.

Recognizing the incentives of sharing explains why full time working wives still tend to do more than half of the housework in a marriage. Women still earn 70% of men, on average. Since total contributions must be equal in successful marriages, women who contribute less market value to the marriage must contribute more household services.

The idea that people tend to marry equals is in our popular culture. The expression “what does she see in him?” indicates that some hidden redeeming feature must be present to compensate for an observable shortcoming.

If we accept the argument that individuals marry others of equal expected value, then we have a simple, but better, method of measuring the value of household services for marriages that remain intact. If a marriage is on-going, the partners must feel that on average they are getting out of the marriage what they are putting in, and that this marriage provides a higher value than marriages to other people. The condition for this is that the partners are making approximately equal contributions and are sharing 50-50. Thus, to determine the value of household services we need only look at the market earnings of the husband and adjust for the market earnings of the wife, and the household services of the husband. Or:

Value of housewife = Husband’s income – Wife’s income + value of husband’s household services.

Suppose the wife does not work outside the home, and the husband never does any work around the house. Then the value of the wife’s household service is simply equal to the husband’s income. This methodology is not only easier than the standard ones, it is better in that it is a true measure of value, rather than just cost. It is better because it does not have any of the ad hoc aspects of the market measures since it relies on the revealed behavior of the individuals to assess their own value.

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Douglas W. Allen is the Burnaby Mountain Endowed Professor of Economics, Department of Economics, Simon Fraser University