Relevant and even prescient commentary on news, politics and the economy.

The Cost of Labor

The standard model of Economic Development is Romer’s (1989, JPE 1990) adaptation* of Solow’s (1956, 1957) Model.  Basically,

Y=AK^aL^{1-a}\,

became

Y = AKα(HL)(1-α)

where the H stands for “human capital,” which multiplies the ability of labor. (Think high-skills labor—construction work, plumbing, teaching—where the worker continually “learns by doing” [op cit., Arrow, 1962]. The additional “human capital” multiples the effect of the labor.

One central question is how much of α is attributable to capital and how much is attributable to labor.  Standard Macroeconomics and Economic Development courses teach varying values for α, ranging from around 25% to about 1/3 (33.3%): that is, the mixture is between 3 and 4 parts of Labor to every one part of Capital.

How does the compensation go?  Well, not quite that way:

 

COE

The banded area is the estimate of actual allocations of capital and labor. The bars show the compensation to labor (and, therefore, the area above that to 100% are the portion of GDP that is being allocated to capital).

Economic theory tells us that if something is receiving excessive rents—as capital is clearly doing in the United States—there is suboptimal growth occurring across the economy. The standard method of adjusting for that is to reduce the excessive rents through either the introduction of competition (preferred if possible) or through taxation and redistribution.  Following are the tax rates on Capital v. Labor:

Labor Tax Bracket

Capital Gains, Short Term

Capital Gains, Long Term

10%

10%

0%

15%

15%

0%

25%

25%

15%

28%

28%

15%

33%

33%

15%

35%

35%

15%

Note also that labor is not necessarily allowed to exclude its “depreciation” above the value of the “standard deduction” ($8,500 for an individual, $11,600 for a married couple). This is clearly a skewed incentive, with preferable tax treatment given to the overvalued resource (capital) at the expense of the undervalued one (labor).

Happy Labor Day!

*NBER subscribers can access paper w3173.  Others can just type “Human Capital and Growth: Theory and Evidence” and probably find an ungated copy somewhere.  The uncurious are referred to Wikipedia.

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Capital, Labor, and Modernization

Many years ago, I had a Cultural Anthropology professor who discussed the glories of the mechanical cherry-picker. The only catch was that (1) it had upfront and maintenance costs and (2) it performs less well than experienced cherry-pickers. In short, it would be useful if you have a shortage of labor and an excess of capital, but not—as is common in cherry-picking areas—the reverse.

Roy Mayall at The London Review of Books blog notes that the same type of conceit is being used by the Royal Mail:

Walk-sequencing machines sort the letters into the order that they are going to be delivered in. The old walk-sorting machines only organised the post into rounds: postal workers had to do the final sorting. Under the old system, all the post was in the delivery office by 7.15 and we were usually out on our rounds by 9.00. Under the new system, the last lorry arrives at 9.15 and sometimes we don’t get out until after 11.00. It’s quite normal for a postal worker to finish work at 3.30 these days, and for posties doing rural rounds still to be delivering letters as late as four in the afternoon. The machines also have a tendency to break down, as we’ve just discovered, so on some days no post is delivered at all. But they are central to the Royal Mail’s ‘modernisation’ programme. [italics mine]

And, as with newspaper deliveries in the United States, the emphasis on capital over labor has collateral costs to both:

The Royal Mail have scrapped all the bikes in Milton Keynes and replaced them with vans. Vans are obviously much more modern than bikes. They are also more expensive. Not only do they cost several thousand pounds to buy, they cost several hundred pounds a year to tax and insure….

Vans are also slower and less versatile than bikes. They are quicker along the road, but once on your round you have to get out and walk, pulling the post behind you on a trolley. It’s awkward. After a while it puts a strain on your back. And you can’t read the envelopes as you’re walking, which slows things down even more. Rounds that used to take three and a half hours to complete are now taking up to five. Whoever devised this method has obviously never delivered a letter in their life.

There’s a possibility that the shift to cars allows you to downsize labor. (It also means you cannot deliver the post without a driver’s licence.) But the cost of labor is virtually never the primary cost in a service industry, and it is unlikely to be cost-saving when you go from spending nothing on petrol to buying a commodity whose cost increased 9.9% in the past year, and which is currently running about 1.30 per litre. When your Fixed Cost of “0” becomes a Variable Cost much larger than zero, those “savings” disappear rather quickly.

As Mr. Mayall summarizes:

‘Modernising’ the Royal Mail means replacing a tried and tested method that’s been good for more than a hundred years with one that is more tiring, more polluting, slower and more expensive.

If the goal were optimal processing, he would be correct. If, instead, the idea is to exploit a difference in net pricing between capital and labor and leave the consequences and externalities to the future, then the Royal Mail becomes just a contemporary example of bad economic policies leading to poor social outcomes.

In that context, it’s not even especially noteworthy. Just ask, say, Jaime Dimon.

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Thinking about Performance

My aging Subaru had a problem a while back. Leak of transmission fluid; a seal or another failing, leading to steady dripping out. And with little need to open the hood, no gauge—or even an “idiot light”—on the dashboard, it dripped for quite a while. And then some.

The first repair—call it Quizzical Effort 1—refilled the fluid, but didn’t find the leak. So we started driving it again, but were a bit more alert for signs that it was doing things such as slipping out of gear or having trouble accelerating from a stop.

We took it to another, better shop for Quizzical Effort 2 (QE2). There they found the leak itself. We spent a bit more money, but the leak is gone and the transmission fluid stays where it belongs.

But it was without fluid for quite a while, and fluids go into other parts of the system, “priming the pump,” as it were, for better operation.

Can we say that my car has made a “recovery”?

The question keeps rearing its “ugly” head as the Jobless Recovery moves forward. Even the Optimists (Mark Thoma, Brad DeLong) are hesitating in the face of the evidence*; Thoma’s graphic at the link just previous notes that the current reovery is not just Jobless, it’s still Job-Reducing, while DeLong tries to dance a line between “this time is different, just like the last one” and “we’re going to turn this into Structural Unemployment Any Day Now” while still thinking of rainbows and kittens.

The strongest evidence that the Recovery has begun is the fiat that NBER declared the recovery to have begun. The second-strongest evidence is that there is noticeable growth in the economy** since the date chosen by NBER.

The following graph appears to support NBER’s declaration. But note the yellow area.

If you want to speak of Business Cycles—I don’t; I consider RBC Theory as its proponents describe it to be the silliness idea this side of phlogiston, but there are those who do, and it’s a convenient fiction for purposes here—then surely you should speak of a full Cycle.

The return to the level of Capacity Utilization at the end of the previous recession comes not as the recession ends, but four quarters later, a year into the “recovery.”***

And that’s just the Capital side of the equation. Labor is rather more complicated.

It is as if the machine is running again, but has not received a proper tune-up, or any other (“structural”) work that needs to return it to peak performance. As John Maudlin noted last May, employment rises with income, and income tax receipts were not rising with the “head-fake” recovery—”grass shoots—of that time.

My Subaru used to get around 17-18 mpg (city). Now it’s closer to 15-16. It would require an investment of capital and labor to get it completely repaired. Being liquidity-constrained, I’m not going to make that investment until a couple of other things are cleared up—including, but not limited to, the possibility of upgrading to a model built in this century.

Similarly, capital recovery is a slow process, and incremental labor tends to follow that in productive industries. The gap in capacity at the beginning of the “recovery” took 12-13 months to be filled. Given that it took 55 months for the Employment/Population Ratio to recover after the 2001 recession (or here), it seems not at all unreasonable to expect the current recovery to take 67 or 68 months.

Which would be around January or February of 2015, just after the midterm elections and therefore nearing the end of the first Palin Administration.

It would be rude of me to note that the first “non-recession” period of the Great Depression lasted only fifty (50) months. Or that there hasn’t been a period of growth so long without tax increases since the Vietnam War.

As with my Subaru, some major investment is needed. Whether there will be the liquidity for that to happen in time is left as an exercise.

*Both, in fairness, have declared the current “recovery” “fragile” (Thoma) or filled with “unforced errors,” but persist in calling it a recovery.

**Let us sidebar that much of that growth is in the FI part of FIRE. If you have assumed that the lion’s share of the profits generated by an economy should go to those who are supposed to intermediate, you have to deal with the structure you’ve got, not one that would produce better, or even optimal, growth.

***The monthly series (MCUMFN; not graphed) reaches and passes the start of the previous recovery in July of 2010. NBER official dates the end of the recession to June of 2009, where Capacity Utilization reached its nadir of 65.2. It is perfectly reasonable to say “a recovery” began then, but a “Business Cycle” that ends with nearly 7% of usable capital (a 9.6% decline in capital terms) sitting vestigial is a poor “Cycle” indeed.

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Vague Thoughts on The Theory of the Firm, the Business Cycle and Kurt Vonnegut

Robert Waldmann

Don’t say you weren’t warned. I am trying to understand the effects of the switch from mechanically controlled machine tools to electronically controlled machine tools and then to digitally controlled machine tools. I don’t really know much about machine tools, but, then again, I don’t know much about firms or the business cycle either. My thoughts after the jump.

update: spelling checked

I warn again, don’t trust any claims of fact in this post.

The reference to Kurt Vonnegut is a reference to “player piano” a dystopian vision of mass unemployment due to industrial robots. It seems that Mr Vonnegut never checked how many people are actually employed in manufacturing, since he asserted that there would be massive unemployment even if people demanded services from other people. So I am not going to predict massive unemployment.

I am partly stimulated by the Nobel Memorial Prize committee which gave the prize to Oliver Williamson for new contributions to the old theory of the firm — that is for trying to figure out the optimal amount of vertical integration. In very brief Williamson argued that vertical integration is efficient when intermediate goods are made with inflexible capital.

IIRC They key example is stamps for bashing metal which shape metal into one form. He noted that arms length market transactions don’t work in this case. Once the parts supplier has sunk money into the specific capital, the final goods manufacture can pay a price equal to marginal cost giving it 0 return on the sunk cost. Thus only a fool will sink money in capital which produces a good for only one possible customer without any guarantees. A long term contract promising to by a fixed amount of the part for a fixed price can make the transaction possible. Similarly things work out fine if the parts are made by the same firm which makes the final product, since the firm has no incentive to take advantage of itself.

(a bit of jargon here. To pay marginal cost to a supplier who has paid a fix cost of building specialized capital is called “to seize the quasi-rent produced by the capital.” I will strikestick with “take advantage of” below.)

Note the example depends on the inflexibility of capital. Once it applied to grinding and assembling as well as stamping. That is, I am changing the subject to equipment which grinds, assembles, welds etc. The specific example of metal stamps still works, but many other productive processes have evolved in a way that protects a parts supplier from ruthless bargaining by their customer, the final goods producer.

Once upon a time, machines which ground and welded and so forth were controlled by the hands of skilled artisans. Also parts were put together by human hands. Then it was noted that a machine could do that on its own with its active bits (drill bits for example) guided by metal guides, by oddly shaped metal parts through which other metal parts slid or by oddly shaped gears.

This made it possible to substitute pieces of metal for people and the pieces of metal demanded no wages. The problem is that the machine could do only one thing. To make the mechanically controlled machine tool do something else, new metal parts had to be designed and made and the mechanically controlled machine tool and to be disassembled and reassembled. This process is called “re-tooling”.

Then technology shifted to analog electronically controlled machine tools (as described by Kurt Vonnegut). The movements were controlled by electronic signals read off a magnetic tape. The machine tool could be, in effect, retooled by leading it through the new motions once. I don’t know how this was done, but I assume that a manual control (like a joystick or something) was plugged in and the tape recorder was set to record. Then someone could try to make the machine tool perform a new task and keep trying and recording over the tape till the controller did it well (via the joystick). Probably frustrating, but quicker than designing, casting disassembling and reassembling.

Then they went digital. Now the motions are described with equations and the new instructions are typed on a keyboard. No one with skilled hands was needed (I mean the equations could be typed in by hunt and peck if necessary). The tragic irrelevance of the artisan in the digital age was made by David Noble (who was allegedly denied tenure at MIT, because he noted that technology is not everyone’s friend).

This made manufacturing much more flexible. This reduced the optimal degree of vertical integration. If suppliers just have to reprogram their machine tools when their current customer tries to take advantage of them, then they don’t neeed to be a long term contracts nor is efficiency enhanced if they merge with their customer.

Why low and behold, large firms are outsourcing more and more in the age of digitally operated machine tools. I’m sure Prof. Williamson has noted this fact which supports his analysis.

I am interested in something else — the business cycle. I think that increased flexibility helps us understand the late great moderation (near absence of the business cycle form 1982 through 2007), the reduction in temporary layoff unemployment, the unprecedented current average duration of unemployment, and the joblessness of recent recoveries.

The point is that it used to be that a rule of manufacturing is that when demand is slack one shuts down and retools. Producing new products and improving efficiency required a fairly long period without production — the period during which the machine tools were disassembled. Relatively few people were employed disassembling, and reassembling the mechanically controlled machine tools. Thus temporary layoffs were a necessary part of innovation. Given that, firms decided to schedule them at a time when demand was slack. If all firms have the same policy, recessions can happen due to a sunspot. In practice they had something to do with monetary policy and/or oil shocks, but the instability of the system made frequent severe recessions possible.

If it takes minutes not weeks or months to digitally retool, then there is no technological need for temporary layoffs. It might be better to deal with slack demand by cutting prices rather than production. Sometimes firms will choose to shut down a factory permanently, but they will have less reason to shut it down for weeks or months but not forever.

In fact, there has been a massive reduction in temporary layoff unemployment, and, in particular, in temporary layoff unemployment during recessions. This implies weaker recoveries — permanently laid off workers need to find new jobs and expanding firms need to find workers. In particular, this implies a less rapid increase in employment in recoveries. Finally it obviously implies longer average spells of unemployment for the same unemployment rate.

Many stylized facts about the changes in the business cycle can be explained by increased flexibility of capital, including, in particular, digitally operated machine tools.

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