For the New Millennium
Produced by the New Economic Paradigm Associates
(Volume 2003: Issue 2) September 9, 2003
Note: To print a hard copy of this newsletter, click on the following link for a PDF download…
For the past couple of years, a variety of pundits have voiced fears of impending deflation, declaring it vastly more dangerous than inflation. Even the Fed, on a number of occasions, has joined the chorus and fanned the flames. The last time the U.S. economy experienced any serious and prolonged deflation was during the Great Depression of the 1930s. Deflation is the phenomenon in which the weighted-average of prices is falling (Note: this is different than disinflation, which means that while prices are still inflated, the rate of increase in prices is falling). The deflationary period of the 1930s was caused by a collapse in demand and by gluts in many markets; recent deflationary pressures come from a far different source (See Figures 1 & 2). The inflationary bias, marking the post World War II American economy, has gradually subsided and given way to encroaching competition – it is the increasing presence and pervasiveness of competition that has contributed the most to our current experience with deflation.
The essential argument of the New Paradigm in Economics is that as competition in markets increase, the power to control price by firms in those markets decreases. A number of markets in the U.S. have been going through this process since the Second World War, when cartelism had reached its zenith. Over past decade or two, the U.S. economy has experienced a tremendous up-tick in competitive pressure. Among these transformed markets/industries are telecommunications, automotive, computer and steel. In the distant past, as the product markets became less competitive, so did the labor and capital markets that served them. The Big Three in the auto industry saw the rise of the United Auto Workers; Ma Bell saw the growth of the Communication Workers of America; and the cartelization of the steel industry led to formation of the United Steel Workers. The surplus profits realized in the early days of these industries provided incentive for labor unions to organize with the objective to obtain surplus compensation. In the economic literature, surplus reward to productive resources such as labor and capital is termed economic rent: the reward to productive resources in excess of their opportunity costs that which must be paid to bring them into employment from their next best competitive alternative and keep them employed.
…the reader will note from the preceding and following charts that the inflationary bias in the economy resides in sectors such as education and medicine, while the increasingly competitive sectors such as computers and autos exhibit deflationary tendencies.
It must be understood that all resources including the suppliers of debt capital, suppliers of equity capital, as well as suppliers of labor, must all earn their opportunity cost. When the rate of return to equity investors falls below the opportunity cost level (when the investor can realize a better return elsewhere in the equity markets), those firms will either have to raise their prices, restructure to lower costs or gradually shrink in size and exit. In the past, many firms and industries were able to exercise market power such that they were able to raise prices and reduce output in order to increase their profits and their rate of return on equity. As markets become increasingly competitive, the option of raising prices to increase revenue and profits up to at least their opportunity cost profit levels (and correspondingly, required rate of return on investment) no longer works. As competition spreads through markets, price increases become less and less revenue enhancing, eventually these price increases will cause revenue to fall. In economic analysis, the relationship of price, units sold, and revenue is called price elasticity of demand.
As surplus profits disappear and fall below the level affording a reasonable rate of return on investment in equity capital, costs must be lowered through restructuring to return to reasonable profitability. Simply put, equity capital requires a reasonable return on investment; yet another form of opportunity cost. Automation, outsourcing, contract labor, and moving to geographic regions with lower cost structures (labor compensation, taxes, energy costs, etc.,) will occur until profits are restored to a level where they yield a reasonable rate of return to equity investors.
As competitive forces push prices downward, firms, to remain viable, must respond by cutting costs, including labor. A rise in productivity results when the same or fewer labor hours employed produce more output – the increase in labor productivity often cited by the media occurs for this reason. In the case of automation, less labor works with more capital to achieve the increase in productivity (throughput).
Harry V’s contribution due to his effort alone and net of other productive resource contributions, is 20 units per hour. Harry’s total compensation per hour is $ 40. When we divide his hourly compensation by the units he alone produces, it is called the unit labor cost, which in this case is $ 2.00 per unit. If Harry’s productivity rose by 10% to 22 units per hour while his total compensation remained the same ant $ 40 per hour, the unit labor cost will fall to just under $ 1.82 per unit. The firm would be better off and Harry would have more job security. The cause of this increase in labor productivity could come from a variety of sources. Harry may have increased his human capital by attending workshops or additional courses. Harry could be working with more or better physical capital such as CAD/CAM; this latter case would be called automation. Some of Harry’s colleagues could have been laid off permanently and Harry has picked up the tempo. There are many reasons but they all lead to a rise in productivity and a fall in unit labor cost.
Let us go back to the original case where unit labor cost was $ 2.00. Now assume that productivity is constant and Harry’s compensation per hour rises by 10% to $ 44.00 per hour. The unit labor cost will rise to $ 44 divided by 20 units or $ 2.20 per hour. The firm is worse off and while Harry’s compensation per hour rose, he has less job security. If Harry’s firm is in a very competitive industry like autos and the firm has no power to raise the price, profits and return of investment to the equity capitalist will fall. If it falls to a return on investment that is less than the opportunity cost level, the firm will eventually shrink or may exit entirely. To stay in business, the firm must restructure and cut costs – in this case, unit labor costs.
The general rule is that as long as the percentage increase in labor productivity is greater than the increase in labor compensation, unit labor costs fall. When the percent increase in labor compensation exceeds the percent increase in labor productivity, unit labor costs rise. When the percentage increase is the same for both, unit labor costs are constant.
Buying the labor indirectly through outsourcing can effectively reduce unit labor costs. Typically in the auto industry, labor compensation is significantly lower at supplier firms and hence there is much incentive to outsource production rather than make it in house where labor costs can be double that incurred by supplier firms. Many firms have relocated to lower cost areas. It is not always labor costs that cause similar decisions to be made. Energy costs, taxes, and environmental compliance costs can also affect the decision-making process.
When deflation is occurring because increasing competition is putting downward pressure on prices, it tends to force a reduction in economic rent or surplus rewards to productive resources. The lower prices consumers pay increases what economic literature calls…
One of the reasons for publishing this newsletter was to interpret current economic behavior and the data reflecting that behavior through the eyes of the New Paradigm in Economics. Most are painfully aware of the down side of this landscape change in the American economy, namely a very large number of well qualified and experienced workers that are structurally unemployed. Many do not fully realize the reasons for this phenomenon nor do they realize the long-term beneficial effects of this landscape change. This is especially true of the impacts of the New Paradigm on the income distribution and the rate of potential real economic growth. While a complete understanding of these impacts requires knowledge of very difficult economic theory, the next paragraph will attempt to explain the benefits in simpler terms.
The restructuring that has been going on for several years has accelerated in recent years. In fact, since the economy has been in a recovery/expansion phase for over seven quarters, most of the remaining unemployed (plus discouraged) workers no longer looking for work, are structurally unemployed, not cyclically unemployed. (See previous issue of this newsletter for a distinction between various types of unemployment.) These structural layoffs of workers are usually necessary for firms to survive. In the case of automation, e.g. CAD/CAM, labor productivity increases and causes the unit labor costs of this less labor intensive production mode to decrease. For society, however, the productivity dividend is not achieved until the structurally laid off workers are reemployed. Until that occurs, the additional output that would come from the employment of this labor is aborted and no dividend occurs to society. This not only means that a higher rate of real economic growth can be achieved, but that it is in fact required so that the structurally unemployed are re-deployed for us, as a society, to receive this painfully achieved productivity dividend. In simple terms, this restructuring means: a higher per capita standard of living once the structurally unemployed are back to work.
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