Some Observations on the Economics of Productivity and Pay
by Charles Mulvey
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In the course of the last decade, the culture of wage fixing in Australia has absorbed the notion that productivity improvement is the only sound basis for increased pay. The underlying concept which permeates the pay fixing system has thus become one in which pay increases cannot be contemplated without offsetting increases in productivity and increased productivity is a sufficient justification for increased pay. In most cases the link between pay and productivity is encapsulated in the terms of enterprise agreements whereby specific changes in work practices are required to secure specific increases in pay. In other cases, productivity measurement models are being put in place with automatic links between increases in measured productivity and pay. While there is merit in using pay increases to secure changes in work practices which enhance productivity, there is also a danger that productivity increases will be viewed as necessary and sufficient conditions for increases in pay. In this note I examine the economics of the relationship between pay and productivity and show that tying wage increases exclusively to productivity growth at the level of the firm over long periods has the potential to create serious distortions in the structure of pay.

Wage Determination in Conventional Economic Theory

Conventional economic theory postulates that wages are determined by the balance of supply and demand in the labour market.Ê In a competitive market, which is free of major imperfections, the structure of wages, which results from the play of market forces, will allocate labour within the market in a manner which will maximise output.Ê This is the concept of the wage as the mechanism by which allocative efficiency will be achieved.Ê It is a concept of efficiency which is relevant to the whole economy, to occupational or industrial labour markets within it and to individual enterprises.

Conventional economic models, however, assume that units of labour within any occupational category are homogeneous ø that is, each worker is of equal quality to each other worker ø and all workers put in the same effort.Ê Moreover, it is usually assumed that the optimal number of workers are employed in combination with the stock of capital, given the relevant prices of each factor and the state of technology.Ê This situation is called technical efficiency or productive efficiency or X-efficiency. Technical efficiency is a necessary condition for the maximisation of output.

Productivity and Wages at the Economy-Wide Level

Since the behaviour of wages is considered by most governments to be of central importance to the achievement of many of their most sensitive policy objectives, such as inflation and unemployment, economic policy will frequently be directed to achieve moderation in wages growth.Ê It is in this context that a link may be made between wages and productivity growth at the macroeconomic level.Ê The term ÔproductivityÕ is usually taken to mean the ratio of outputs to inputs.Ê Increased ÔproductivityÕ, in this sense, therefore means that more outputs (goods and services) are produced by the same number of inputs (labour, capital, etc.) or that the same number of outputs are produced by fewer inputs.

Productivity and Wages at Macroeconomic Level

At the macroeconomic level, productivity tends to rise from year to year over the economy as a whole, mainly as a result of technological change.Ê Governments, from time to time, have developed wages or incomes policies which relate average wage growth to average productivity growth.Ê As a means of avoiding inflation and permitting the fruits of that productivity growth to be distributed across the workforce as a whole, average wages may be allowed to increase in line with the growth rate in average productivity.Ê Under such a policy, increases in wages will be offset on average by increases in productivity, unit labour costs will remain stable on average and the wage increases ought not then to lead to price increases.

A problem with this policy in practice is that productivity will increase in some individual firms more rapidly than the national average and will increase more slowly than the average in others.Ê If wages rise throughout the labour force at a uniform rate in line with the growth rate of productivity averaged across all firms, the unit labour costs of the former group of firms will tend to fall while they will tend to rise in the latter group.Ê Now, in order for the price level to remain stable on average, other things being equal, prices must fall where unit labour costs fall and rise only where unit labour costs rise.Ê Under this regime, changes in the structure of wages between industries will not occur in such a way as to reallocate labour in an optimal fashion, except under highly restrictive assumptions about price and income elasticities of demand.

It would not be appropriate to base macroeconomic wage policy on a productivity-geared principle for any prolonged period of time and that has not happened in Australia (or any other major country).Ê To do so would be to distort the structure of relative wages such that the wage would fail to perform its role of allocating labour to the areas in which demand was highest and away from the areas in which demand was lowest.Ê The attraction of a productivity-geared wage policy is simply that it satisfies the requirements of anti-inflation policy while still meeting a criterion of appearing to be ÔfairÕ in that it permits wages (and other incomes such as profits) to grow in line with national productivity.Ê From time to time, average productivity growth has been specifically utilised as a criterion of national wages policy in Australia and in other countries such as the UK.

Measurement of productivity change at national level has been the subject of some controversy in recent times in Australia.Ê The concept of productivity change as indicated by changes in Average Labour Productivity has been favoured during the 1980s in National Wage Cases by the Commonwealth and by the Australian Council of Trade Unions (ACTU)1.Ê An alternative measure, changes in Total Factor Productivity, has been proposed by the Business Council of Australia (BCA 1986: 6). A discussion of the difference between the two measures and their implications for the economy is to be found in Covick (1990).

Productivity and Wages at the Enterprise Level

More recently, beginning with Accord Mark III with the productivity-related pay criterion known as the Ôsecond-tierÕ, which was included in the National Wage Case of 1987, the focus of productivity-geared pay policy has shifted from the national, macroeconomic level to the level of individual enterprises.Ê How does this concept fit within economic theory ?

Investment, Technical Change, Productivity and Wages

As a general rule increased productivity at the level of the firm should only be reflected in increased pay where some direct contribution from the workforce is the source of the increased productivity.Ê Under macroeconomic wages policies of the kind discussed earlier, a productivity criterion is sometimes employed without making any distinction between capital and labour as the source of the increased productivity.Ê This is because such policies usually have an overriding economic objective, such as preventing inflation or reducing unemployment, which can only be achieved by obtaining the co-operation of unions, employers and other institutions.Ê This cooperation can often only be secured if some seemingly ÔequitableÕ or ÔfairÕ system of distributing increases in productivity is employed.Ê Much of the year-to-year change in economy-wide productivity arises through the process of investment in more and better capital.Ê Where productivity-geared wage policies are applied, it is likely that increases in wages (and profits) across the board will occur in line with the growth of productivity generally, in the interests of ÔfairnessÕ, and the returns to the factors of production will not reflect their relative contributions to the increase in productivity.Ê This will distort relative factor prices and, as a result, cause a misallocation of resources.

However, at the level of the individual enterprise it is not unambiguously clear what the general economic effect of linking pay to productivity increases generated by changes in technology will be.Ê The final effects of such a process will depend on the nature of the technical change (whether it is labour-saving, neutral or capital-saving), the characteristics of the supply of labour concerned and the price and income elasticities of the product or service.Ê It is clear, however, that there is no case on economic grounds for a general rule which links pay to productivity change arising from changes in the quantity or quality of capital in an enterprise.Ê In some cases the application of such a rule would produce quite perverse results.Ê For example, in an industry in which technological change was rapid, but where the technological change was of a kind where machines replace people in the production process and the price and income elasticities of demand for the product of the firm is low, the demand for labour may tend to fall.Ê Labour productivity, measured as output per worker, will rise in this situation but some workers may need to be retrenched.2Ê If wages were linked to productivity growth, the perverse result would be that wages were rising as the demand for labour was falling. Conversely, workers in employments where productivity has risen little, because of the absence of technological change, could experience a fall in relative earnings if their pay was restricted to productivity increases despite the level of demand for their services remaining high or rising.3 In other cases the outcomes may not be perverse, and may meet social or political criteria, but only under the most restrictive assumptions will they be consistent with the outcome which the market would produce.

In his authoritative work on the subject of productivity and technical change, Salter (1966: 115) says that:

.. any direct link between wages and productivity in individual industries would soon lead to a hopelessly distorted wage structure.Ê The only circumstances in which there is any reason to expect such a direct relationship is when the increases in labour productivity are directly attributable to characteristics of the labour itself ø such as greater skill or effort ...

The Full Bench of the Australian Industrial Relations Commission itself has said:

Wage increases achieved through enterprise bargaining ought, in our view, to be justified by and commensurate with employeesÕ contributions to enterprise efficiency and productivity.Ê In saying this, we are not expressing an opinion that wage earners have no claim to benefit from the growth in productivity due to other causes, such as the general advance of technology and the growth of the capital stock.Ê It should be recognised, however, that distribution of all the benefits of productivity growth at the enterprise level would lead to inequity and, ultimately, to a distorted and unsustainable wage structure.Ê Such a situation is compatible with neither a flexible labour market nor industrial peace.4

Riach and Howard (1973: 45) also point out that:

..it is not the purpose of productivity bargaining to introduce any permanent link between productivity and wages at the enterprise. A productivity agreement involves a specific exchange at a point in time ø in return for the acceptance of a change in work methods and practices some improvement in employee benefits is agreed.

The link between increased productivity due to a direct contribution from the labour force and pay is crucial. Increases in pay resulting from a mechanism linking pay to productivity generated solely by changes in the quantity or quality of capital employed permit employees to make windfall gains.Ê There is neither economic nor moral logic in such an outcome.Ê Better that the costs of providing the service should be allowed to fall as productivity rises and either the services provided expanded or the costs to consumers reduced.

Changes in technology may require that labour adapts in terms of work organisation or acquisition of skills to accommodate the change and make it work.Ê The contributions of employees in making that adaptation are to be seen as a direct contribution of labour to improved productivity by assisting in achieving technical efficiency and it will generally be appropriate to reward these in the form of higher pay.

Wages, Productivity and Technical Efficiency

Recall that economic theory assumes that firms operate in a technically efficient way.Ê In practice, in an environment in which the wage-work contract is the outcome of a bargaining process over many years between unions and employers with intervention by the Industrial Relations Commission, many work practices have grown up which prevent technical efficiency being achieved.Ê Restrictive work practices of various kinds have traditionally been rife in Australian industry and, when coupled with such things as demarcation rules, ensure that many firms will operate at rather less than technical efficiency.Ê Productivity-related pay policies can seek to eliminate or reduce these inefficient practices by offering employees pay increases to abandon them.Ê Increased productivity results from the elimination of the inefficient work practices or the acceptance of new practices and may simultaneously provide for increased pay for employees and increased profit for employers.Ê Such a process is unambiguously desirable from an economic point of view so long as it is based on a genuine buy-out of restrictive practices.Ê However, by definition, it is of limited potential since it cannot continue to underpin pay determination after all of the restrictive practices which employees are willing to trade-off are gone.Ê The sorts of efficiencies which the workforce may contribute to achieving technical efficiency are well illustrated by the productivity improvements which have been negotiated within the enterprise bargaining process nationally since 1993.

Enterprise bargaining is presently one of the main thrusts of reform in the Australian industrial relations system, both federally and in the States.Ê It is commonly the case that pay increases negotiated at enterprise level are expected to be accompanied by improvements in productivity.Ê This emphasis on productivity as a basis for increases in pay stems from an agreement reached between the Federal government and the ACTU in March 1993 known as Accord VII and endorsed in Accord VIII in June 19955.Ê In Accord VII it was agreed that, in enterprise agreements:

¥ Ôwage increases not directly linked to improving the productive performance of enterprises should be limited;

¥ ongoing work organisation and job redesign, and the process of reform should be integral to agreements; and

¥ a broad agenda of change should be pursued.Õ

In order to gain an understanding of the practical meaning of this notion, it is worth considering the kinds of measures which have been undertaken in pursuit of increased productivity within enterprise agreements in order to meet the requirement that wage increases should attempt to link wage increases and improved productivity.Ê These are taken to indicate the spirit in which productivity is to be related to pay in the emerging culture of the new phase of industrial relations.

The report ÔEnterprise Bargaining in AustraliaÕ (Department of Industrial Relations 1995) provides the richest source of examples of the kind of improvements in productivity considered to be legitimate trade-offs for increased pay. The main areas in which changes have been made by the workforce in the Federal jurisdiction in order to improve productivity are Ô.. work organisation, use of capital, employment conditions and training as well as a number of other issues.Ê Ninety-six per cent of Part VIB agreements included at least one of these provisions, and sixty-two per cent included a provision related to work organisation, use of capital or absenteeismÕ (Department of Industrial Relations 1995: 137).

Efficiency Wage Theory

The concept of efficiency wages is relevant here also. Efficiency wage theory postulates that high wages, above the market rate, will bring about high productivity since the effort workers put into their work is held to be a function of the wage rate.Ê Four reasons are usually advanced to explain why it is that workers will put more effort into their work when they are paid wages above the market rate;

¥ since workers earn more in the firm paying the efficiency wage than they could in the external market they will work as efficiently as possible in order to avoid the high costs which would be incurred if they were dismissed for shirking or poor work;

¥ high wages discourage voluntary quits ø which economises on turnover costs and thereby raises productivity; high wages attract high quality recruits into the firm and high quality workers are the most productive;

¥ psychological and sociological theories hold that high wages will generate high morale amongst workers and that this will lead to high productivity.

Efficiency wage theory is consistent with the conventional market model of wage determination.Ê Hence, the payment of above-market wages which brings about high productivity will still lead to profit maximisation.Ê It is a wage strategy which is particularly suited to large companies where individual monitoring of worker effort is either not feasible or very costly and to situations characterised by a requirement for teamwork and where high morale is therefore especially important.

Conclusions

At enterprise level, increases in wages in reflection of increased productivity may be justified on economic grounds where:

¥ the employees concerned take action to eliminate restrictive work practices or adopt new practices or methods of working which directly contribute to the increase in productivity;

¥ a policy of relatively high pay attracts a matching increase in productivity from the workforce along the lines of the efficiency wages model;

¥ productivity-related pay increases are restricted to changes in productivity resulting directly from some contribution on the part of the employees concerned and do not permit employees to capture increases in productivity generated by changes in technology with no contribution from labour.

¥ productivity change may be measured through some agreed mechanism, such as a continuous performance measurement mechanism, or may be explicitly agreed to in the form of future targets or milestones in a productivity agreement.

There is no inherent economic or moral reason why employees should be rewarded for productivity improvements. If productivity change takes place without the need of inducements such as increased pay, there is no particular reason for retrospectively rewarding it. However, if productivity improvements in pursuit of technical efficiency can only be achieved through the inducement of a wage increase, it will generally be worthwhile to trade increased pay for increased efficiency. Measurement issues are very difficult to resolve and it seems to me that the only sure way of proceeding to a pay increase based on productivity improvement is to bargain over particular changes in the work arrangements of staff which are designed to lead to specific increases in productivity and/or to rely on some agreed measurement mechanism. Moreover, pay for productivity schemes must be tuned to discriminate between changes in productivity arising directly from a contribution due to labour and changes due to investments in new and better capital.

Finally, it is important to ensure that our system of wage fixation does not become locked into a rigid pay for productivity formula. In particular, pay must be capable of adjusting to reflect changes in the balance of supply and demand in the market and disequilibrating price changes.

References

Australian Council of Trade Unions (ACTU) 1986, Submission to March 1986 National Wage Case [Exhibit ACTU 251], ÔMeasurement of ProductivityÕ.

Business Council of Australia (BCA) 1986, Submission to March 1986 National Wage Case [Exhibit CAI 65], ÔProductivity Case: Productivity and National CapacityÕ.

Commonwealth of Australia 1986, National Wage Case, February-May 1986, Submission of the Commonwealth Government, AGPS, Canberra.

Covick, O. 1990, ÔTotal Factor Productivity and Wages PolicyÕ, Journal of Industrial Relations, 32(4): 488-512.

Department of Industrial Relations 1995, Enterprise Bargaining in Australia, AGPS.

Riach, P.A. and W.A. Howard 1973, Productivity Agreements and Australian Wage Determination, John Wiley, Sydney.

Salter, W.E.G. 1966, Productivity and Technical Change, Cambridge University Press, Cambridge.

About the Authors

Charles Mulvey is the Dean of the Faculty of Economics and Commerce and Professor of Labour Economics at the Department of Organisational and Labour Studies at the University of Western Australia.

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