Productivity and the Minimum Wage

Productivity is a function not only of the qualities of individual workers but also of how they are organised. Subsidising low pay and permitting the exploitation of workers encourages employers to use more low-paid labour. Raising the wages of all low- to middle-earners by aggressively raising the minimum wage would, over time, lead to increased productivity in the economy as labour resources are allocated more efficiently across the economy.

Discussions of economic productivity almost always consider only how individuals could produce more, by improving their education or training, for example. Often investment in automation or other technology is also proposed, but again only as a way to make individual workers or organisations more productive. Transport improvements are usually part of any agenda to improve the productivity of a region, principally because they allow employers to access skilled labour and other inputs more easily or reach more customers more quickly.

But the productivity of an organisation or the economy as a whole is not simply the sum of the productivity of all the individual workers, nor is the productivity of the economy as a whole simply the sum of the productivity of all the organisations making up that economy. Productivity is in fact a function of the productivity of all the individual parts of the economy together with how those parts are organised and how resources – including labour – are allocated.

This misunderstanding is something of a puzzle, since we’re all taught from a young age how the division of labour improves productivity. This is the complete opposite of improving the productivity of individual craftspeople by better education. Such “deskilling” can improve productivity and not just by permitting the use of cheaper labour.

I’m often struck by how only the short-term effects of the obvious measure that might increase productivity – increasing wages of low- to middle earners – are therefore taken into account. Consider the short discussion from 1 hour and 20 minutes into a recent Resolution Foundation (RF) meeting:

Apparently the Low Pay Commission (LPC) found that minimum wage increases didn’t result in “good” productivity gains but “intensification”. Sarah O’Connor (who features in the above RF discussion) wrote this up in the FT (paywall). She writes:

“The idea is that if employers are no longer able to rely on cheap labour, they will have to invest more in capital or increase workforce productivity with better technology or training. It also has some empirical support. One paper has found that Germany’s minimum wage increased productivity after its introduction in 2015, albeit by driving some smaller companies out of business.”

Excerpt from Why a higher UK minimum wage fails to spur productivity, Sarah O’ Connor, FT, 24/5/22

Note the first sentence suggests the goal is “better technology or training”. No it isn’t. The goal is increased productivity, which, in the first instance, may be exactly what it is suggested happened in Germany (the LPC report, The Impact of the National Living Wage on productivity actually notes that: “We… have not carried out an investigation into potential reallocation effects across industries and regions from the NLW.” – if you don’t look for a macroeconomic effect from a macroeconomic policy you probably won’t find one, will you?). The German study cited suggests that more productive enterprises were able to expand because it turned out, in this case, that “some smaller companies” had only been able to stay in business because their wage costs were, in effect, subsidised through the benefit system (or they were allowed to exploit workers). Better “technology and training” may or may not be necessary, but regardless, we’ll all be better off in a more productive economy.

The main beneficial effect of a higher minimum wage in an economy is surely the one that happens over time as, through many individual investment decisions, labour is gradually allocated to more productive enterprises. It may even be that for some industries in some countries (e.g. labour intensive agriculture in the UK) a comparative advantage is lost and products are imported instead.

Another way of thinking about the issue is that low-paid jobs in the UK at least are heavily subsidised. This may occur directly (through tax credits and subsidised housing, for example), but also happens indirectly when such jobs generate insufficient tax revenues to cover costs associated with the workforce (and their dependents).

It’s worth noting that for the effects of a higher minimum wage to be measurable, the increase might need to be steep, sustained, and affect a significant proportion of the workforce (Alan Manning may be right in the RF excerpt that the UK minimum wage has had insufficient bite – the proportion of the workforce affected – to improve productivity significantly) and that change can only be expected over a period of time.

So, if improving productivity is the top priority (which I agree it should be) a large part of the answer is to raise the minimum wage aggressively – pushing up salaries for all low- to middle-earners – for a sustained period. The goal is to significantly reduce the level of subsidy necessary for low-earners (something that perhaps could be measured or at least estimated) because, as all economists know, if you subsidise something people will consume more of it.

This plan may require higher minimum wages in areas where the cost of living is higher, which is the subject of the next post.