VoxEU Column Productivity and Innovation Labour Markets

Towards a high-wage, high-productivity economy

9 Dec 2021

Many commentators have understood the UK government’s proposed ‘high-wage, high-productivity’ model as suggesting that wage increases will themselves lead to innovation and higher productivity. In the November 2021 CfM survey, the panel of UK experts is nearly unanimous that that wage increases generally do not increase productivity in the long run; the consensus is that productivity drives wage increases. A minority thinks that government intervention in wages could lead to higher productivity, but even this minority argues that such policies should be complemented with investments in skills and other productivity-enhancing measures.

Ethan Ilzetzki

Associate Professor of Economics (with Tenure) London School Of Economics And Political Science

Lucile Crumpton

Research assistant London School Of Economics And Political Science; Undergraduate Student University College London

The UK government has begun setting out its plans for a post-Covid economy. During his October speech at the Conservative Party Conference, Prime Minister Boris Johnson vowed to “move [away from] the same old broken model with low wages, low growth, low skills and low productivity”, stressing that increases in wages were allowing the UK to “embark on a change of direction long overdue in the UK economy: […] a move towards a high-wage, high-skill, high-productivity, and low-tax economy”. The Chancellor’s autumn budget also reflects this ambition, calling for higher investments in infrastructure and skills to spur productivity growth. He has also followed recommendations of the Low Pay Commission to “increase the National Living Wage next year by 6.6%, to £9.50 an hour”.

The correlation between productivity and real wages in the data is unquestionable. Textbook economic theory attributes this correlation as reflecting the effects of productivity on wages. In this view, wages are determined by supply and demand and workers’ pay will ultimately reflect their productivity. Productivity growth is then the only sustainable way to obtain higher wages. Teichgräber and Van Reenen (2021) have shown that real wages have indeed tracked productivity in the UK over the past 40 years. However, Ngai and Sevinc (2021) have shown that productivity growth in a specific sector may not lead to wage growth in that sector and economy-wide productivity growth is necessary to guarantee wage growth for all (see Rachel Ngai’s video explainer on the subject here on Vox).

The Prime Minister and Chancellor have been cautious in making causal connections between wage growth and productivity. However, many commentators have understood the government’s ‘high-wage, high-productivity’ model as suggesting that wage increases due to lower immigration and labour shortages will themselves lead to innovation and higher productivity. (See Oulton 2019 on the relationship between the growth in the labour force, productivity, and wages.) This view has received a mixed response from economists and journalists. Most journalists’ responses have reflected the conventional wisdom that wage increases cannot in and of themselves cause productivity growth. Writing in The Independent, Sean O’Grady uses wage increases for lorry drivers as an example: “Lorry drivers, and others, can demand higher pay packets and better conditions because there’s a shortage of them. They all work very hard – and deserve better working conditions – but they’ll be working no harder tomorrow than they do today. Their trucks will be no more efficient, nor their logistics improved, nor working practices transformed.”1

Writing in The Times, David Smith agrees that “pay rises without an accompanying rise in productivity will push up unit wage costs. Stagnant productivity explains why real wages did so badly in the 2010s.”2 These higher labour costs will decrease employment and employers will merely pass them on to consumers. Jill Treanor, also writing in The Times, warns that recent wage increases are no cause for celebration, claiming that “higher wages might force some companies to collapse.”3 She points to “the problems in the supply chain—from importing timber to finding enough lorry drivers” as the main cause for wage hikes and a driver of high inflation. Smith concurs, predicting that “a shortage of HGV drivers may result in higher wages for them, and indeed is doing so. But the more such shortages there are, because of a supply shock, the more costs will rise and, particularly following a huge monetary stimulus, the more inflation will become a problem, squeezing the real wages of everybody else”.

A contrasting view suggests that workers can be motivated through higher wages. In its modern incarnation, this view goes back to the ‘efficiency wages’ theory of Shapiro and Stiglitz (1984), with a macroeconomic stipulation put forth by Yellen (1984) that states that firms will be willing to pay workers wages above the market rate to encourage greater work effort. This view has antecedents going at least as far back as Alfred Marshall’s stipulation that “any change in the distribution of wealth which gives more to the wage receivers and less to the capitalists is likely, other things being equal, to hasten the increase of material production” (Alfred Marshall, cited in Wolfers and Zilinsky 2015).

A survey by Wolfers and Zilinsky (2015) summarises the evidence in support of the high wage to high productivity hypothesis. They cite evidence that wages lead to improved job performance, higher customer service quality, lower turnover rates, and higher quality of hires due to higher wages. Critics of this view have questioned why government intervention is required; firms should benefit from these outcomes and be willing to offer higher wages themselves. Martin Sandbu, writing in the Financial Times, makes a separate argument that higher wages will encourage investment in machinery that allows workers to be more productive.4 However, Acemoglu and Restrepo (2020) have shown that such mechanisation has led to job losses in the US, bringing instead lower wages for the average worker.

This month’s Centre for Macroeconomics (CfM) survey asks the panel whether higher wages could lead to higher productivity. The panel was asked to focus on real wages and long-run productivity growth.

Question 1: Which of the following statements most closely reflects your understanding of the relationship between productivity and wages?

Twenty-three panel members answered this question. Ninety-one percent of panel members support the proposition that wage increases generally do not increase productivity in the long run; the consensus is that productivity drives wage increases. However, a majority (51%) of the panel agrees that wage increases can contribute to long-term productivity. The remaining 40% believe that wage increases cannot increase productivity in and of themselves.

Many respondents argue that there is no causal relationship through which higher wages augment productivity in the long run. Roger Farmer (University of Warwick) writes that while wage increases could yield a one-off boost to workers’ effort, there is “no plausible causal chain that would lead… to continual improvements on an ongoing basis – as would be needed to explain continual productivity growth”. Michael Wickens supports Farmer’s stipulation and further highlights that government measures to artificially increase wages may cut into firms’ profits. In his words, this would lead to “a fall in the demand for labour and increased unemployment”. In a similar vein, Martin Ellison (University of Oxford) states that while there are “models in which low wages discourage effort”, the reverse would “look like falling into the fallacy of reverse causality”, adding that “history is unlikely to look kindly on such initiatives”.

Fifty-one percent of respondents nevertheless believe that wage increases may, in some cases, lead to improved productivity. According to David Miles (Imperial College London), “effort and morale may might rise with remuneration”. While conceding that “productivity developments are the major source of sustained increases in real wages”, James Smith (Resolution Foundation) points to evidence (Dustman et al. 2021) that “setting a floor on wages can incentivise firms to adopt productivity-increasing changes in technology”. For Morten Ravn (University College London), supporting labour productivity through higher wages can only be effective when accompanied by investment in workers’ skills and new technologies: “increasing real wages by themselves may not do much apart from exporting jobs and motivating firms to invest in labour saving technologies. A high wage economy without investment in skills will force individuals with lower skills out of the workforce. There might be shorter-run motivating factors of higher wages but they cannot sustain longer-run productivity enhancements, Britain's main problem.”

Question 2: What is your evaluation of the following statement: “A well-designed government-stipulated wage increase can lead to higher productivity”?

Twenty-five panel members answered this question. Fifty-six percent of panellists either “strongly disagree” or “disagree” with the proposition that the UK government can raise productivity through a wage increase. Ricardo Reis (London School of Economics) and Martin Ellison argue that the state of our knowledge on the causal effect of wages on productivity would lead to poor design of government policy attempting to exploit this relationship. Ellison writes that “it is uncertain whether any government-stipulated wage increase can lead to higher productivity, however well designed, and it’s certain that any attempt to exploit such a possibility will be badly designed. We simply do not understand enough about how a government-mandated wage increase affects productivity to start exploiting that relationship.” Moreover, Gino Gancia (Queen Mary University) warns that “higher wages will lead to more automation with adverse re-distributional implications”.

James Smith, arguing for the minority view that the government could boost productivity through wage regulation, writes that “in some circumstances, there is evidence that Government policies which increase wages can prompt behavioural changes which are associated with higher measured productivity”. But like most panel members espousing this opinion, he adds the proviso that “longer-term increases in wages will need to be driven by sustained improvement increases in productivity”. Similarly, Paul Mortimer-Lee (National Institute of Economic and Social Research), while agreeing that government wage support could be effective, posits that “average productivity will increase because workers whose real productivity falls below the new real wage level… will cease to be workers. Low-productivity jobs will go, to be replaced by unemployed workers with a productivity of zero.”

Finally, few panellists wholeheartedly support the notion that wage increases could support productivity growth. Nicholas Oulton (London School of Economics) concurs with the stipulation that restricting migration flows towards the UK might further aggregate productivity levels. Arguing that “[the UK’s] higher growth rate of labour explains [its] poor productivity performance relative to countries which by one means or another control immigration”, he writes that “reducing immigration can raise both the level and growth rate of productivity, and so raise the level and growth rate of wages”.

References

Acemoglu, D and P Restrepo (2020), “Robots and Jobs: Evidence from US Labor Markets,” Journal of Political Economy 128(6): 2188-2244.

Dustmann, C, A Lindner, U Schönberg, M Umkehrer and P vom Berge (2021), “Reallocation Effects of the Minimum Wage”, The Quarterly Journal of Economics.

Ngai, R and O Sevinc (2021), “A Multisector Perspective on Wage Stagnation,” mimeo, London School of Economics

Oulton, N (2019), “The UK and Western productivity puzzle: does Arthur Lewis hold the key?” International Productivity Monitor 36, pp. 110-141.

Shapiro, C and J E Stiglitz (1984), “Equilibrium Unemployment as a Worker Discipline Device”, American Economic Review 74(3): 433–444.

Teichgräber, A and J Van Reenen (2021), “Have productivity and pay decoupled in the UK?”, POID Working Paper No. 21

Wolfers, J and J Zilinsky (2015), “Higher Wages for Low-Income Workers Lead to Higher Productivity”, Peterson Institute for International Economics.

Yellen, J L (1984), “Efficiency Wage Models of Unemployment,” American Economic Review 74(2): 200–205.