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Economics: It's not just whats' in your wallet

Productivity Growth and Cost Disease of the Service Sector

Paul Krugman in his book, The Age of Diminished Expectations, states: "Productivity isn't everything, but in the long run it is almost everything." The basis for Krugman's position that productivity is an essential feature of economic growth can be seen with the aid of a simple example. We begin by assuming that the price (P) of a product (Q) is equal to its per unit cost of production which is equal to the wage rate (W) times the number of laborers used per unit of output (L/Q) [equation 1]. This latter term is actually the reciprocal of the productivity of labor - the amount of output that can be produced per unit of labor (Q/L). If we were talking about the service industry, productivity would be measured by the number of individuals 'served' per worker.

(1) P = W*(L/Q)

With a little bit of algebra, we can convert equation 1 into two equations that explain the interrelationship between growth rate in wages (w), the growth rate in prices (p), and the growth rate in labor productivity [equation 2]. The growth rate in wages (w) is equal to the growth rate in prices (p) plus the growth in productivity (%D (Q/L )[equation 2]. If production per unit of labor can be expanded, then the price of labor (wage rate) can rise faster than inflation and we will see growth in real wages. Stated somewhat differently, real wages can rise only if there is an increase in labor productivity which is why so much effort has been exerted to explain the productivity slowdown.

(2) w = p + %D (Q/L)

The cost disease of the service sector, a concept that has been around for quite some time but which has gained in importance in recent years, is closely related to the above analysis. The relationship can be seen if we simply rewrite equation (2) in the following way.

(3) p = w - %D (Q/L)

In this form we can see that the growth rate in prices (p) is directly related to the growth rate in wages (w) minus the growth rate in productivity (%D (Q/L). The pronounced move out of manufacturing and agriculture toward services that has taken place in the post WW II era has, however, created a problem for the economy. The problem is that productivity gains in services are more difficult to realize than the gains in the manufacturing and agricultural sectors. This is a problem that is at the core of the move to rein in health care, education, and defense expenses as well as having been cited as one of the potential causes of the productivity decline after 1973. When we talk about a service like education or health care, productivity advances may be difficult to obtain since this would tend to mean higher customer/worker ratios. In the absence of these productivity gains, any wage increases would be translated directly into higher prices and it will be more difficult to obtain the growth rate in real wages that were an important feature of the pre 1973 period.

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