Quality, Choice, and Growth

Two articles in the New York Times this week are nicely complementary. Each looks at long-term trends in the U.S. economy, and in particular what Americans have chosen to spend their money on as they became progressively richer over the past few generations. And each argues that quality improvements have been a major force in driving American consumption patterns.

In the first, David Leonhardt argues that Americans face a tradeoff between better health care and other consumption goods. While he states that the health care system is indeed in crisis, he doesn't worry that increases in health care spending outpace inflation. We get what we pay for, in his view; and although Americans now pay, on average, $5,500 more per year on health care than they did in the 1950's, that's a small price to pay for the increased quality of life we now enjoy.

Robert Frank makes a similar point in an article titled "The More We Make, the Better We Want." He points out that we could now afford the lifestyles of our grandparents with only a fraction of our current income, but we choose not to.

Both articles illustrate a central element that drives economic growth: the insatiability of human desires. When Adam Smith wrote The Wealth of Nations, it was an easy argument to suggest that scarcity is a defining principle of life -- for one thing, just getting enough calories to survive was a challenge for a majority of people. But in an era when obesity is a bigger problem for Americans than hunger, it's reasonable to ask why we continue to work so hard. In the words of Keynes (that Frank quotes), "A point may soon be reached, much sooner perhaps than we are all aware of, when these needs are satisfied in the sense that we prefer to devote our further energies to noneconomic purposes." Clearly that point has come and gone, and yet here I am at work. Why?

Frank argues that the answer to this question lies in the understanding of what "basic needs" are. A theme running through much of his work is that people define their needs in relative terms, rather than absolute terms. Thus everyone might want a "good house in a safe neighborhood," but that might mean something very different in Los Angeles than it means in Baghdad. If the rest of society is driving a Camry, then, almost nobody is going to be happy driving a Model T.

Leonhardt argues that the answer to this question lies in the fact that technology--and in particular, medical technology--extends the boundary of what is possible. Living a healthy, full life means something very different in 2006 than it did in 1950, but taking advantage of modern medicine costs money.

1. Suppose you're in the market for a car, and you know that you want something like a Honda Civic. You come upon a brand new 1980 Honda Civic that had never been driven. You could save a lot of money by buying that car rather than a 2006 Civic. You work an hourly job and can choose how many hours you work. Suppose that if you bought a 2006 Civic and worked for 40 hours a week, you could afford to spend $400 per week on other goods. If you bought the 1980 Civic, you could either choose to still spend $400 on other goods and work fewer hours, or you could continue to work a full 40-hour week and spend more than $400 on other goods. Which of these options would you choose?

2. Suppose you meet a genie who offers you a choice: you can live in the 1950's and earn more than 90% of people, or live in the present and earn the average wage. Which would you choose? What if it were the year 1900? Or 1500? (Before you answer, you might want to pause and think a moment about indoor plumbing.)

3. Suppose a medical research project could extend life expectancy from 80 to 100 years. How much should we, as a society, be willing to pay for that project? What about one that extended life expectancy to 120 years? Or 140? Perhaps an easier question to answer might be: how much would you be willing to pay to extend your own life expectancy? What current consumption would you give up to live an additional year?

Real Wages and Productivity

The New York Times reports that real wages, as a percentage of GDP, have fallen to their lowest level in recorded history. The article contains a number of good nuggets that illustrate some basic points in economics.

First, we need to think about what we mean by "wages." A worker's nominal wages are the dollar value of her take-home pay, not including benefits. For example, if a worker earns $20 per hour before taxes, that is her nominal hourly wage. However, a worker's real wages are the wages adjusted for inflation. For example, if a worker's nominal wage rises by 2% and there is 3% inflation, we actually consider her real wages to have dropped by 1%--that is, the value of goods and services she could afford went down by 1%. (In fact, real wages did decrease in 2005: median weekly earnings increased from $631 to $651, an increase of 3.16%, but since inflation was at 3.4%, the $651 in 2005 was actually worth less than the $631 in 2004.)

However, the article doesn't say that real wages have decreased--indeed, with the exception of 2005, real wages have generally increased over the last few years. The article's main point is that as a percentage of GDP, real wages have been steadily declining. In other words, the growth rate of GDP has been steadily greater than the growth rate of wages and salaries.

But that's only part of the story, because wages are just part of workers' overall compensation packages. Health insurance is the other big component. Due to a historical anomaly, employers tend to pay for health insurance for their workers, rather than workers buying it on their own. Therefore, total compensation to workers can be thought of has having two components: wages, which the workers are free to spend as they wish, and a certain amount of money with which they are forced to buy health insurance. In recent years, the price of health insurance has grown at double-digit rates, far outpacing inflation, while wages, as a fraction of the overall compensation package, have been falling.

Note that the increase in health care spending might very well have had the same effect if workers received all of their compensation in cash, and then paid for health insurance out of their own pockets. Since health care is widely viewed as a necessity rather than a luxury, demand for it is relatively inelastic; therefore, as its price goes up, people might very well decrease their expenditures on other goods and services. In other words, the effect of an increase in the price of healthcare means a decrease in consumers' real income, and the fact that wages and salaries don't include benefits serves to highlight this effect.

However, even if we take into account both wages and benefits, overall compensation has still been falling in recent years as a fraction of GDP, while corporate profits have been increasing. Why? Workers have been more productive--that is, creating more output per hour of labor--which has meant higher revenues for firms. Those revenues accrue to different factors of production: wages to workers, rent to capital, and profits to shareholders. The article's main point is that the gains in worker productivity have not accrued to workers, but instead have gone largely to shareholders.

Describing how wages, benefits, and profits have changed over past years is the province of positive analysis. The article raises an important normative question as well: is it fair that wages have not kept pace with productivity? Or that the top 1% of earners received over 11% of all wage income, up from 6% three decades ago? These are important questions as well, but economic analysis is less helpful in answering them.

1. Suppose the U.S. government provided national health insurance for everyone. Do you think wages and salaries would still be falling? What about after-tax wages?

2. The divvying up of the economic pie appears to be a zero-sum game: there is a certain amount of economic surplus out there to be divided between profits and wages, and more of it has been going to profits. Jared Bernstein, a senior economist at the Economic Policy Institute, lays the blame for lower real wages on workers' lack of bargaining power. Would a greater rate of unionization help to achieve greater equity? Would it do so at the expense of efficiency? What about using government taxes and transfers to achieve greater redistribution of income from rich to poor households? Would economic policies aimed at a more equitable division of the economic pie mean a decrease in the size of the pie?

3. If labor markets were perfectly competitive, wages would increase directly with productivity. (For a simulation of how this works, see this demonstration of an interactive experiment based on the classical theory of the labor market.) What about the real labor market is a departure from this model?

Update: This has been a hot topic on the blogosphere. Greg Mankiw, Russell Roberts, and David Altig have posted comments on the article (and others' comments on it). More to follow, I'm sure, and we'll keep you updated.

Mexico Fights Back

The U.S. House of Representatives passed a bill last month that included provisions to build a 700-mile wall along the U.S.-Mexico border. The following news articles describe both the political and economic dimensions in this debate.

Mexico Fights Back as U.S. Proposes More Wall to Bar Immigrants
House Approves Immigration Bill

The falling wages of low-skilled workers in the United States is often attributed to an increase in the number of low-skilled immigrants to the United States. However, there are alternative explanations for the fall in low-skilled wages that have nothing to do with immigration.
A simple supply-and-demand model can provide us with valuable insight on the labor market and its relationship to immigration and capital. Consider the labor market for low-skilled workers. An increase in low-skilled immigrants would increase the supply of low-skilled labor and lower the wage of low-skilled workers in the United States. (Graph I)

However, suppose immigration has no effect on low-skilled wages. Is it still possible to observe a decline in low-skilled wages? Yes. The demand side of the labor market has as much, if not more, impact on wages than the supply side. Capital and technology can be substitutes for low-skilled labor. As the U.S. economy accumulates more labor-saving capital and technologies, the marginal product of low-skilled labor decreases. This causes the demand for low-skilled labor to fall and wages for low-skilled labor to fall as well. (Graph II)

At the same time, capital accumulation and technological innovation raise the marginal product of labor for high-skilled labor to operate and maintain the new machines and ideas. Hence, we expect wages for high-skilled workers to rise in the United States.

Discussion Questions

1. What effect would building a wall along the U.S.-Mexico border have on wages in the United States?

2. If low-skilled workers are displaced by capital (rather than immigration), then what policies should the government pursue?

3. Economists often use cost-benefit analysis to determine whether a policy is worth implementing. What are the costs of immigration imposed on taxpayers, households, and firms? What are the benefits?

4. Economists generally agree that the free trade of goods and services benefits both trading countries. If the free trade of output makes the world better off, does the free trade of inputs (labor) also make the world better off?

For more information on the economic analysis of immigration, you might want to check out the work of George Borjas, from Harvard University, and David Card, from University of California at Berkeley.