George Rebane
Actually Baumol’s Effect on the liberal mind is exactly nothing, zilch, zero, … . Self-styled thinkers of the Left are constantly going on about workers not being paid enough as they come forward with all kinds of dodgy arithmetic showing how capitalists are making a greedy killing at the expense of their employees. About fifty years ago a couple of economists – William Baumol and William Bowen – explained what happens when wage levels become disconnected from productivity, and here we’ll take a brief look at the result of that. (This post is really an addendum to ‘The Liberal Mind – Wealth Transfer on Steroids’ and its extended comment stream.)
Before going on I would recommend that readers of the collectivist persuasion (liberal, progressive, socialist, communist, statist, …) give this posting a pass since it will only give rise to additional cognitive dissonance where enough is already in residence. The purpose of this post is to familiarize the reader who already intuitively understands the basics of Baumol’s Effect (also known as Baumol’s Disease) but wishes to know its more quantitative details, and attach a label to it for effective communications. I have been remiss in not having posted this much earlier, and thank a reader for his recent nudge.
Wage levels go up for a number of reasons, only one of which is really warranted and salutary to the general welfare, and that is that the worker so rewarded has become more productive either through experience, training, and/or using more advanced tools and methods (e.g. provided by technology). Worker productivity is simply the number of units of work product (widgets?) the worker can produce for the money he is paid for such production. Productivity may be measured in units per dollar.
But workers who witness the wages of other workers going up will naturally seek to have their wages also increase. And if that doesn’t happen, then many of them who can will change jobs for higher pay. Businesses with static productivity must then increase the wages of their employees in order to keep them, and this causes an increase in costs that lowers profit margins if all other things are kept the same. The usual reaction to such collateral wage impacts (Baumol’s Disease) is that the affected business must either raise prices, lower output, and/or lower quality of output. In short, the customers of the enterprise will in one way or another receive lower value (measured in constant quality units per dollar). And delivering value to its customers is the mainstay of staying alive in a competitive business environment.
So to maintain the value of output in the face of rising wages, the workers must become more productive, else the disease starts taking its inevitable toll on people’s quality of life and the economy in general. In industries such as manufacturing where productivity is positively impacted by advancing technology, raising a worker’s wages is not a problem. But in fields of personal services such as retail, nursing, or the performing arts, the disease is rampant in that value received by the customer, patient, or patron is steadily reduced as the price of, say, healthcare (stand by for Obamacare) or tickets increases with no commensurate increase in the number or quality of product received.
When such inelastic (productivity unchanged) wage increases are forcefully implemented (government mandate, union strike, competition for workers, …), then prices increase, less product is sold (shortages), quality is reduced, companies go out of business, jobs get off-shored, etc. What is even worse is that the causal sequence of such effects is almost entirely invisible to a large and active segment of a nation’s population either because of a cognitive deficit or ideological sclerosis.
The simplistic reaction to wage inequalities by such people is to attack the employer and accuse him of greed in making either excessive profits and/or receiving an outlandish compensation. The reduction of either of these is touted as the remedy that will allow everyone to be paid a more ‘equitable and just wage’. However, these numbers don’t work out, and that is not how the real world works. For the private entrepreneur correctly maintains that it is NOT his responsibility to create jobs for anyone, let alone jobs that conform to someone else’s concept of a ‘living wage’ that reduces value to his customers.
Such people, let’s here call them ‘socialists’ regardless of their collectivist hue, never consider the matter of risk, and that risky ventures are only undertaken for an expectation of reward beyond the anticipated cost of the venture. Moreover, that it is ONLY the taker of risk and bearer of cost who can reasonably and justifiably formulate the reward he expects for success. Such a notion is totally foreign to the socialist who stands aside and insists that he, not the risk taker, is the proper judge of all such matters as levels of risk, appropriate costs, and just rewards.
The predictable results from such ignorance and hubris are long a matter of our sordid history, and may be viewed as part of the broader symptoms of Baumol’s Disease that afflicts an economy by causing the unaccountable wage increases for workers who are no more productive today than they were yesterday.
Nevertheless, the disease continues unabated because it is the staple of populism and populist politicians seeking re/election. Today we see current expressions of it in the discontentious froth of fast food and discount store employees demanding higher wages, not because they produce more, but simply because they can fog a mirror. And under today’s received wisdom of social justice, that foggy mirror qualifies them for enforced redistribution of wealth from the employer and/or his customers.
For the numerate reader who wants to exercise his eighth grade algebra skills, the following set of simplified relations explains the whole matter in a more quantitative manner. Please enter these relations in a spreadsheet, and put in some numbers.
UnitPrice = UnitCost + UnitProfit = UnitCost*(1 + ProfitRate),
UnitCost = VariableCost + FixedCost
= (UnitLaborCost + RawMaterialsCost) + Fixed Cost,
Productivity = Units/Wage or 1/UnitLaborCost,
UnitPrice = constant1*Wage*(1 + ProfitRate),
Value = Unit/UnitPrice = Unit/(constant1*Wage*(1+ProfitRate),
= Unit/(constant1*Unit*(1+ProfitRate)/Productivity), or
Value = constant2*(Productivity/(1+ProfitRate)).
So we see that to maintain Value in the face of falling productivity caused by higher wages, we must reduce profits through the reduction of ProfitRate. But ProfitRate has a natural limit that is above zero before the business will quit operations. For a short term it may use retained earnings or further investment to stay in business, but that is only done when future profits promise an appropriate return for the risk undertaken when making such a decision. And here we see also that ProfitRate may be increased without sacrificing Value to its customers when businesses become more productive. This should illustrate the relationship of wages, productivity, and profits, and explain the motivation of business owners when they trade off wages, investment to increase productivity, and expected profits.
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