Does capital deepening reduce labour's share of national income?

The share of wages and other labour remuneration in national income has been declining in most high income countries over the last few decades. I have previously argued that if we are concerned with the well-being of the poor, we should be more concerned about trends in real wages than about trends in the distribution of income between labour and capital. That is still my view, but it hasn’t stopped me trying to understand the reasons why labour’s share has been declining.

My interest has been aroused, in particular, by the claims of some researchers that capital deepening (increases in capital per unit of labour) have contributed to the decline in labour’s share of national income. For example, the OECD’s Employment Outlook 2012 provides the following answer to the question: What explains the decline in labour’s share?

“Total factor productivity (TFP) growth and capital deepening – the key drivers of economic growth – are estimated to jointly account for as much as 80% of the average within-industry decline of the labour share in OECD countries between 1990 and 2007”.

The message that seems to be giving is that if a country or a region has the institutions, people and natural advantages needed to attract substantial additional investment, don’t expect the associated capital deepening (increase in capital to labour ratio) to have a strong positive impact on demand for labour. 

There are some circumstances where that might be a reasonable proposition. For example, as Dean Parham has shown in work for the Productivity Commission, the growth of the capital-intensive mining sector in Australia during the 2000s was strongly associated with the decline in labour’s share of national income over the same period.

However, the circumstances of Australia’s mining boom are somewhat peculiar. If it is generally true that capital deepening doesn’t have a strong positive impact on demand for labour I might need to make some fundamental revisions to my views about how economic systems work.

Dear reader, the next few paragraphs are somewhat abstruse, but please bear with me because I need your practical wisdom about production technology and the elasticity of substitution between capital and labour.

The elasticity of substitution between capital and labour is the critical factor determining the impact of capital deepening on demand for labour. It can be defined as the percentage change in capital deepening for a 1% change in the ratio of the wage rate to the rental price of capital (making the standard assumption that factors are paid the value of their marginal products). The sensitivity of the impact of 1% capital deepening (a 1% change in the capital to labour ratio) on labour’s share of output and real wages is shown below (assuming labour’s share of national income is 62%, the median for OECD countries).

The graph is drawn under the assumption of zero technological change. The underlying equation for percentage change in labour’s share is Equation 3 of Robert Lawrence’s recent working paper for the Peterson Institute on the decline in labour’s share in the US. The equation for the change in real wage is as derived in the end note below.

The OECD’s assertions about capital deepening reducing labour’s share were backed up by what appears to have been a fairly sophisticated econometric study by Samuel Bentolila and Gilles Saint-Paul (published in 2003) subsequently updated by OECD staff. These analyses suggest that capital and labour are gross substitutes (i.e. the elasticity of substitution between them is greater than 1) and attribute the decline in labour’s share to both capital deepening and capital augmenting technological change (i.e. technological change that has an impact similar to adding more capital).  

However, other econometric studies suggest that the elasticity of substitution between capital and labour is less than 1. For example, Robert Lawrence’s recent analysis of the decline in labour’s share of US income provides econometric evidence that it is attributable to technological change being so strongly labour augmenting (labour saving) that it has more than offset the positive impact of capital deepening. His results suggest that as a result of technological change “effective capital-labour ratios have actually fallen in the sectors and industries that account for the largest portion of the decline in labor share in income since 1980”.

I will leave it to others to attempt to unravel the mysteries of these conflicting econometric findings. It probably makes more sense for me to focus here on considering which set of results seems more plausible in terms of what you and I know (or think we know) about production functions at the level of the individual firm.

Think of any firm in any industry. In order to keep the analysis simple, assume that the firm leases the capital equipment that it uses and that the firm is small enough not to have any impact on either the rental price of capital or the prevailing wage rate. In the hypothetical situation I want you to consider there is no potential to change technology, only the potential to vary the amount of equipment or labour that is hired (and to vary other inputs in proportion to output). Now, consider to what extent the ratio of capital to labour is likely to change if the rental price of capital equipment declines by 10%, thus causing an increase in the ratio of the wage rate to the rental price of capital.

The answer that some readers may come up with is that the ratio of capital equipment to labour is fixed by existing technology, so that it will not change even if output changes in response to the lower input costs. For example, there is not much point in having more taxis than drivers or more desk-top computers than staff to use them. That corresponds to Wassily Wassilyevich Leontief’s assumption that the elasticity of substitution between capital and labour is zero.

The assumption of zero substitution possibilities is too extreme in my view, but I can’t think of an industry where it would be reasonable to expect a change in the wage rate to rental price of capital ratio to result in a more than proportionate change in capital deepening. Perhaps the time is approaching when firms will be employing both driverless vehicles and human-driven vehicles, so a decline in rental price of driverless vehicles could easily displace humans. But I don’t think that time has yet arrived. (Of course capital equipment can often be substituted for labour by introducing new technology, but the elasticity of substitution relates to unchanged technology.) Perhaps these comments just reflect the limits of my experience. Please enlighten me if that is so.

My bottom line is that unless I am persuaded otherwise I will cling steadfastly to the belief that capital deepening normally tends to raise real wages and labour’s share of national income, and that the decline in labour’s share of national income in high-income countries is attributable to labour augmenting technological change.

Endnote: some of the math behind the graph

Assume CES technology and that labour and capital are paid their marginal products. The rate of growth in the real wage is given by:

(1)     d log W = [(Ϭ – 1)/Ϭ]g + [1/Ϭ][d log (Y/L)]      

where W is the real wage rate, Ϭ is the elasticity of substitution between capital and labour, g is the rate of labour augmenting technological change, Y is output and L is labour input, so Y/L is average labour productivity.

We also know that the rate of growth of output is given by:

(2)    d log Y = S_L(d log L + g) + (1-S_L)(d log K + h)

where S_L is labour’s share of output, K is capital services, h is capital augmenting technological change, if we assume constant returns to scale and Euler’s theorem.

Substituting (2) into (1) and rearranging terms I obtained:

(3)    d log W = g + (1/Ϭ)(1 – S_L)[d log (K/N) – (g – h)]      (Both times I tried!)

The graph is drawn assuming no technological change i.e. that g and h are both zero. However, it is apparent from (3) that technological change tends to have a positive impact on real wages (assuming g>0). This impact is diminished when technological change has a labour-augmenting bias (g>h) and amplified when it has a capital-augmenting bias (g

Where will the future jobs come from?

This question is almost unanswerable, but it is easy to understand why people ask it. A definitive answer is not possible because future jobs will depend on decisions of large numbers of individual businesses, many of which do not yet exist, responding to demands of even larger numbers of consumers around the world. Some guesses are likely to be better than others, but no-one really knows what new products or new technologies will emerge, or how consumer tastes might change.

It is understandable that people ask where future jobs will come from when existing jobs are being threatened by international competition and automation. In the 1970s, when I worked at the IAC (predecessor to the Productivity Commission) many people were asking where the jobs would come from to replace manufacturing jobs then being lost to import competition. People who know about my work career sometimes still ask the same question today for the same reasons (e.g. in the context of the uncertain future of steel production in Wollongong) but these days there is greater concern about the offshoring of services and the impact of technological change.

I was thinking about the way economists answer the question of where the jobs will come from as I read a recently published report by the Committee for Economic Development of Australia (CEDA) with the uninspiring title: “Australia’s future workforce?” Fortunately, this is a good example of not being able to judge a book by its title. The report contains many fine contributions by people with expertise in technological change and/or the Australian labour market. Some of the contributors provide information highly relevant to considering the nature and extent of job losses that are likely to occur as a result of technological change and the kinds of jobs that might be in demand in future.

Some points that seem to me to be important are summarised below:

• The jobs that are disappearing involve routine tasks, not just low-skilled tasks. This is resulting in job polarisation, with computerisation or automation of many middle-level jobs in processing and servicing. See the graph in my post: Is average over? (This point is drawn from the chapter by Jeff Borland and Michael Coelli).
• The jobs that remain are unlikely to be susceptible to automation and will tend to involve perception and manipulation, creative intelligence and/or social intelligence. (Hugh Bradlow).
• Future skills and jobs will most often be concerned with the creative application of technology to solving problems. Everyone will need to be able, at some level, to architect (e.g. to integrate computing and communication resources) design (e.g. to understand problems of customers and propose solutions) and analyse (e.g. to make sense of performance data). (Hugh Durrant-Whyte).
• Large job losses are likely to occur over the next 10 to 15 years. The methodology used by Frey & Osborne for the U.S. suggests that about 40% of jobs have a high probability of being susceptible to technological change in Australia. (Hugh Durrant-Whyte et. al).
• In recent years enough new jobs have been created in Australia at a rate sufficient to replace those that have disappeared. (Phil Ruthven).
• There have been substantial changes in the pattern of employment in Australia including growth in part-time and casual work. Most workers are happy with the hours they work. Job tenure is not always short in casual work – a quarter of casuals have worked in the same job for 10 years or more. (Phil Lewis).
• Employment relationships are becoming more adult: workers desire autonomy and employers are unable to guarantee jobs for life. (Lynda Gratton).
• Digital infrastructure provides potential for greater choice about where work is done, possibly reducing the need for people movement (e.g. commuting) and associated physical infrastructure. (Hugh Bradlow).
• Self-employed people account for about 18 percent of the Australian workforce. There is a gradual trend toward independent contracting, as in many other countries. The supremacy of the large organisation is fading; technology is creating greater economic freedom for the individual. (Ken Phillips).
• There is a significant problem of long term unemployment in Australia, particularly for unskilled people. Over half of the long term unemployed have no post-school education (about 9 percent have degrees). There has also been a substantial increase in people on disability support – numbers on disability support now exceed unemployed social security recipients. (Phil Lewis).
• Education earnings gaps (skill premiums) have been fairly stable in Australia, unlike the U.S. and some countries in Europe. (Michael Coelli).
• Schools and universities face a double challenge: how to embrace new technology; and how to deliver the skills required. This involves more than just increasing the number of STEM graduates. Education institutions will need to be able to encourage students to become creative and agile in applying technology to solving problems. (Hugh Durrant-Whyte).
• Technology is challenging traditional methods of delivering education. Individuals may need to treat their careers as a business - taking more responsibility for their own education and investing in skills to adapt to changing demands throughout their working life. (Sue Beitz).
• MOOCs (massive open online courses) are the iTunes of education. The way MOOCs will change education is likely to be similar to the way iTunes has changed the way people buy music. MOOCs are not likely to replace quality campus-based education. (Jane den Hollander).
• Australian industry has largely been an exploiter of technology rather than an explorer. (This claim is seems to me to be highly questionable in relation to areas of Australia’s comparative advantage.) In terms of Joseph Schumpeter’s distinction, explorers search out new solutions to problems, while exploiters seek to make use of existing solutions (e.g. by imitating). In the new global economy new ideas will be the commodity in scarce supply, so explorers and likely to forge ahead and exploiters are likely to fall further behind. (Steven Callander).
• Australia’s comparative advantage in specific industry sectors can be a driver for technological leadership in key areas of technology and computing. The most obvious industry sectors where this applies are mining and agriculture, but it may also apply to financial services, infrastructure and medical devices. (Hugh Durrant-Whyte).
• Australia is well-placed to benefit from digital disruption because of strength of services industries including education and potential for sale of services to Asian markets. (Sarv Girn; Phil Ruthven).  

My answer to the question posed above is that the future jobs of Australians will be shaped by: 

1. the pattern of economic growth that evolves in this country in response to the changing opportunities that the world economy will provide to people living on the edge of Asia; and 
2. the human, technological and physical resources that Australians develop in the years ahead.

It might seem logical to proceed now to consider the policy proposals contained in the CEDA report. However, there are a few other questions I want to consider before I turn to policy.

Do we face a future of more than ordinary economic disruption?

Change is the most constant element in life. I can remember beginning a report I was drafting with words something like those more than 40 years ago. It was an appropriate thought in the context of the economic changes occurring in Australia during the 1970s and it is just as relevant today. Perhaps it was even relevant when Heraclitus said similar things about 2500 years ago.

During the 1970s I was under the impression that the pace of change was quickening, but in retrospect that was an illusion. The economic disruption occurring in the wake of the first oil price shock and the emergence of stagflation certainly involved a quickening in the rate of change relative to the abnormal stability of the 1950s and 60s. Looking back now, however, economic change over the last 40 years seems to have been less about quickening than about fits and starts. That seems to have also been true to a large extent during the preceding couple of centuries.

When people look back in 40 years are they likely to perceive that the first half of the 21^st century was extraordinarily disruptive?  Or will they perceive this to have been a period of fairly normal disruption, with the pace of change being similar to that occurring on average since the beginning of the industrial revolution?

Richard Dobbs, James Manyika and Jonathan Woetzel, the authors of "No Ordinary Disruption: The Four Global Forces Breaking All the Trends” (published this year by McKinsey and Company, the famous management consultancy firm) argue that many of the long standing trends of the 25 year “Great Moderation” prior to the 2008 financial crisis “have broken decisively” and “a radically different world is forming”. The authors give the impression that they think the current bout of creative destruction is by no means ordinary.

According to the authors we need an “intuition reset” because our intuitions have been formed in a world in which changes were incremental and somewhat predictable. We have to re-think our assumptions rather than making decisions on the basis of intuitions built on our experiences.

The authors argue that the world is in the middle of a dramatic transition resulting from four fundamental disruptive forces:

• First, there is the shifting locus of economic activity and dynamism to emerging markets like China and to cities within those markets.
• Second, there is an acceleration in the scope, scale and economic impact of technology.
• Third, the average age of the human population is becoming older as a result of declining fertility and increasing longevity.
• Fourth, there is globalization - the world has become much more connected through trade, movement of people and capital, and information flows.

As discussed in a recent article on this blog it is not clear whether there has actually been an acceleration in technological change. The other three factors are well-known features of the economic environment in which we have been living for the last decade or so.

Some of the implications of those forces are less well known. For example, new classes of consumers are emerging, for example from relatively unknown, middle weight, cities in China. Another example is the extent to which new technologies may enable small nimble firms to compete with large established companies.

The authors argue that the era of low interest rates is coming to an end. Their reasoning seems plausible. Monetary policies are likely to tighten somewhat as America and Europe recover from the great recession and inflation resumes. Population aging is likely to result in lower savings rates, since retired people normally have lower incomes and less capacity to save. And the rebalancing of growth in China is likely to favour consumption rather than saving.

Some of the authors’ proposed “intuition resets” are more controversial. For example, they suggest that a prolonged period of falling and steady prices for natural resources is coming to an end. It already seems as though they have underestimated the supply response brought about by high resource prices. I wonder whether Andrew Mackenzie, the CEO of BHP Billiton, read the section of the book containing that particular intuition reset before providing his glowing endorsement.

My main reason for buying this book was not the endorsement by Andrew Mackenzie (or even the one by Lawrence Summers, former U.S. Treasury Secretary). I was particularly interested to learn what a book that draws upon McKinsey’s extensive work with companies and organisations around the world might have to say on the question of how technological change is likely to affect the job market.

The authors suggest that specialization, globalization and technology are making ‘interaction work’ – the searching, coordinating and monitoring required to exchange ideas, goods and services – a critical element of success in developed economies. Interaction jobs range from low skilled to high skilled and many of them involve services that are not internationally tradable, particularly in health care, education and government services industries. The number of these interaction jobs seem to growing rapidly:

“In the same period when nearly three million production and transaction jobs disappeared, nearly five million new interaction jobs were created in the United States”.

The numbers don’t quite match, but it looks as though this statement might relate to the period 2001-09 and be based on data from the U.S. Bureau of Labor Statistics.

The authors note that technology is increasingly allowing employers to redesign and disaggregate work, with routine tasks being assigned to lower-skill employees. In some instances cross-training is enabling workers to perform a variety of tasks and reduce idle time. Workplaces are also being disaggregated as many interaction jobs can be conducted remotely. New technology is connecting purchasers of services to service providers in new and disruptive ways e.g. Uber and Airbnb.

While some parts of the book are full of examples, I was disappointed that the authors’ comments on the changing nature of work seem to be based mainly on abstract reasoning and aggregate statistics. I had hoped that the book based on McKinsey’s real world experience would harvest insights superior to those of academic economists on a range of questions that are highly relevant in considering the disruption associated with technological change. For example, after reading the book I am still wondering whether any evidence is emerging of a limit to the economic benefits that can be obtained by unbundling jobs into routine and non-routine tasks?  Is there evidence of decline in quality of service when unbundling is extended too far? Is there evidence of ongoing movement in the opposite direction as happened in the 1980s and 90s when PCs replaced typists and many professionals had to learn how to do their own typing?

The authors’ discussion of skill gaps is interesting. They project that around the world by 2020 a shortage of about 40 million high-skilled workers and 45 million medium skilled workers may emerge, alongside a surplus of 95 million low-skilled workers. It is easier to grasp what those big numbers might mean for employment and wages when they are disaggregated. The numbers come from a McKinsey report published in 2012. That report suggests that there might be around 3 percent too few tertiary educated workers in the U.S. and somewhat higher percentages in Europe. They project a surplus of medium and low-skilled workers of around 10 percent for advanced economies in 2020.

Without looking closely at the methodology, those projections do seem to provide grounds for concern that current skill gaps will widen. The authors recognize that the skills gap cannot be met by just increasing the numbers of people with tertiary qualifications. In some fields of study many graduates receive multiple job offers, while in others many end up in unskilled work. Even in the STEM fields (science, technology, engineering and mathematics) a “quick churn in job requirements” is apparently common with workers having to master a new set of tools every few years. The solution proposed by the authors is fairly predictable: governments, companies and individuals need to “reset the way they think about labor markets, where to find workers, and the relationship between technology and work”.

My conclusion: I am not persuaded that current economic disruptions are out of the ordinary when compared with other major disruptions that have occurred in patterns of employment and skill requirements during the last couple of centuries. Nevertheless, there are grounds for concern in many parts of the world about the capacity of educational organisations funded by governments to adjust effectively to help meet changing labour market requirements.

Postscript

1.     Historical perspective

Jim Belshaw has provided a comment below which adds useful historical perspective. I quote:

“Just dealing with the scale of change, and if you work in 40 year increments from 1800s and look at the scale of change and major events in each period, you quickly get the feel that stability is unusual. Then if you look at major technological advances during the period, you can also see that the scale, timing and effects were arguably as fast and significant than anything we have seen in the last forty years. So I would argue that your intuitive feel is correct.

The twenty five year "Great Moderation" is a little unusual, but not excessively so. In the newly formed Australian colonies we had quite a long run of economic advance up the 1848 depression, then another long run into the 1880s. After that economic activity was far more choppy. It was not until the end of the Second World War that we had another long growth period, if one broken by various economic crises, that ended in the 1970s.”

2.      Interaction work in provision of professional services

Noric Dilanchian, a lawyer whose areas of specialisation include protecting, documenting, managing and commercialising intellectual property, has provided some comments on Facebook. Edited excerpts are below:

  “The transaction vs interaction work distinction helps frame some technology developments. Transaction technologies, e.g. for ecommerce, are now maturing after 20 years or more of development. In contrast interaction technologies are less advanced and there are very interesting blips on the horizon.

I'm tracking these developments for professional purposes. They affect the future of the content industries that have been my career's focus. More critical for me, they hold out some promise for reducing the time taken in early stage contract drafting when one is business modelling before one tries to locate suitable resources to cut and paste together templates. This work involves interaction between professions and their clients/patients/public/audiences. Technologies that improve interaction are important at this time when the old form of interaction (meetings in rooms with lawyers) for various reasons (including cost) has declined.

Over the last year or two I've been observing progress in the way interaction work is affecting what computer scientists term ‘deep learning’, ‘machine learning’ and ‘neural networks’. There is also greater use now of visualisation software or visualisation in software. These software technologies are raising excitement as they appear to be producing promising results for product about to be released. In the history of computing artificial intelligence has gone through fits and starts. Right now it’s going through a fit as is being reported regarding augmented reality devices such as the Microsoft HoloLens (less easily in virtual reality devices, e.g. Oculus Rift), Google Photos, and next version of Microsoft's Skype." 

3.     The changing relationship between professional firms and their clients

Some comments that Jim Belshaw and Noric Dilanchian provided on an earlier post are relevant to considering problems that arise in attempting to unbundle services to enable the more routine aspects to be computerised. Jim has experience in conducting economic/commercial analysis from an informed legal perspective, while Noric has skills in provision of specific legal skills (described above). The comments are summarised below:

Jim: Two things became apparent. On the client side, there had been a decline in the in-house knowledge that would once have informed the request for legal advice. There was also an increase in impatience: “Just get us that contract”. On the legal side, there was greater reliance on and availability of templates and precedents. Use of templates can be efficient, but not if poorly informed clients are given boiler plate solutions that results in a reduction in the quality of legal advice and large legal bills.

Noric: There are now new ways of working. The platform used to be face to face meetings and work bees, but it is now electronic. Perhaps more important than the change in the platform, however, is the productivity impediment at the client-firm transactions level arising because the world has changed, but perceptions about roles and requirements have barely changed.

Is average over?

This question is prompted by the title of Tyler Cowen’s book, Average is Over. The book has been the subject of several excellent reviews since it was published in 2013, including one by Matt Yglesias and one by Rick Searle.

My aim here is to clarify what Tyler means when he says “average is over” and then attempt to consider the implications for high income countries.

As Tyler sees it, average is over in many aspects of life in America including occupations, earnings, education and where people live. The age of genius machines is arriving. People who have skills that complement those machines have brighter prospects that those who don’t. The people with higher earnings will increasingly have relevant post secondary education. Conscientiousness and self-motivation are likely to be rewarded more highly. People who lack the necessary skills and personal qualities are likely to see an erosion of their economic futures. The labour market problems of young people who lack the right training and attitudes are likely to intensify. People with skills that are becoming redundant or over-supplied are likely to experience falls in real income.

Tyler sees America becoming two nations: a fantastically successful nation working in the technologically dynamic sector, and everyone else. Highly educated people will increasingly gravitate to areas where a relatively high proportion of other individuals have post-secondary degrees e.g. San Francisco, Raleigh (North Carolina) and Stamford (Connecticut). Low-income retirees will face increased economic pressure to move to run-down areas where rents are lower and services are deteriorating and/or to shanty towns in the warmer states.

It is important to understand that Tyler is writing about what he thinks will happen rather than what he thinks ought to happen. The government policy responses that he has factored into his assessment are the responses that he considers to be most likely in the United States – largely a continuation of current policies.

Governments in other countries might respond differently. Nevertheless, it is clear that the underlying forces are common in many high-income countries. As Tyler puts it:

“These trends stem from some fairly basic and hard-to-reverse forces: the increasing productivity of intelligent machines, economic globalization, and the split of modern economies into both very stagnant sectors and some very dynamic sectors”.

After I finished reading the book I was left pondering how the mass of the population will benefit from having technologically dynamic growth sectors in the countries where they live. Tyler’s mention of the dreaded term ‘factor price equalization’ in the context of his discussion of the effects of international trade (outsourcing) and immigration implies that he expects real wages to fall substantially in non-dynamic sectors. Factor price equalization is, of course, a product of theoretical models which assume that all goods are internationally tradable, or that labour can and will flow between countries until wages are equalized. The market for unskilled labour is the last place where we should expect the law of one price to become a global reality.

Standard economic models lead us to expect international trade and immigration to provide net economic benefits to residents, even though they may leave a proportion of the population worse off. With that in mind, I think the emergence of technologically dynamic growth sectors based around development and use of intelligent machines should be viewed as just the latest step in a process of expansion in economic opportunities that has been occurring since the beginning of the industrial revolution. Growth sectors provide expanding opportunities for people in the regions/countries that have them, including unskilled people who benefit from the growth of demand for services and home owners who obtain capital gains. At a national level, citizens benefit from tax revenue generated, even if their careers are disrupted. For example, Tyler expects social security for the elderly in the U.S. to be maintained at around current levels - which are far higher than average earnings of unskilled workers in Mexico.

The best description I have seen of the job polarization occurring in the U.S. is provided by Figure 7 of David Autor’s paper ‘Polanyi’s paradox and the shape of employment growth’, published last year. I had thought of reproducing the graph here, but I want to encourage people to read the whole paper. The graph shows:

• the pace of employment gains in low wage, manual task-intensive jobs has been increasing since the 1980s;
• the occupations experiencing loss in employment are in the middle of the distribution, with the locus of displacement of middle-skill employment moving over time into higher skilled categories;
• the growth of high-skill, high wage occupations decelerated markedly in the 2000s, with only a modest recovery between 2007 and 2012. David Autor suggests that the deceleration of growth of high pay jobs was associated with macroeconomic events which led to a sharp deceleration in computer investment (the bursting of the dot-com bubble, followed by the collapse of the housing market and the ensuing financial crisis).

David Autor’s paper also contains some comparable data on job polarization in Europe. Some comparable data for Australia is shown in the chart below, which is based on data in the chapter on information technology and the Australian labour market by Jeff Borland and Michael Coelli in Australia’s Future Workforce recently published by CEDA (see Table 1, p136). CEDA’s report is worth considering at some length in a later post.

The picture of job polarization in Australia and Europe seems to differ substantially from that in America. It seems that there have been lower increases in employment in the lowest paid occupations in Australia and Europe than in the U.S. I can’t explain why. There are several possible explanations including differences in social security systems providing options other than low-paid employment in Europe and Australia, and differences in migration patterns.

The chart also suggests that in Australia, the rate of decline in the middle pay occupations and growth in the higher pay occupations have been higher during the 1970s and 80s than during the last couple of decades.

David Autor argues that employment polarization is unlikely to continue indefinitely because many middle skill jobs demand a mixture of skills that cannot readily be unbundled into routine tasks that intelligent machines can do and non-routine tasks that only humans can do, or because unbundling would involve a substantial drop in quality. Workers will maintain a comparative advantage in tasks involving interpersonal interaction, flexibility, adaptability and problem solving. Examples include medical support occupations, a wide range of skilled trade and repair occupations, e.g. plumbers and electricians, marketing, and clerical occupations that involve coordination and decision-making.

I conclude with another point emphasized by David Autor. In considering the future of the labour market it is worth remembering the long history - since the beginning of the industrial revolution - of leading thinkers overestimating the potential of new technologies to substitute for human labour and underestimating their potential to complement it.

Will paying for internet content raise productivity growth?

Productivity growth is important because the opportunities available to our children and grandchildren depend on it. As I write that I can almost hear some people saying: “Oh yeah, who needs more stuff?” It would be great if people who are satisfied with their current living standards didn’t have to worry about productivity growth. Unfortunately, even those people need productivity growth because their governments have already spent some of their future income on their behalf. Material living standards will depend on the income that remains after governments have taken away a slice (via reduced welfare payments and services or higher taxes) in order to service the public debts that continue to accumulate.

Some economists are worrying that the rate of productivity growth in high-income countries has declined since the turn of the century and is hampering recovery from the great recession in Europe and North America. In an article published by the Australian Treasury in 2013, Christine Carmody suggested that the substantial decline in productivity growth that has occurred in Australia might be related to a more general decline in productivity growth in other high-income countries. However, when I went looking for more recent OECD data on productivity to illustrate the slowdown I started to doubt whether it is a general phenomenon. The Figure below shows that in only about half of the countries covered by the OECD data was the rate of multifactor productivity (MFP) growth during the 2001 to 2007 lower than that in 1995 to 2001.

(Please click on graph for a better view.)

Multifactor productivity (MFP) measures the growth in value added output per unit of labour and capital input used. Labour productivity is sometimes still used in such comparisons but if we are interested in productive efficiency it makes sense to remove the impact of capital deepening (i.e. increasing capital per unit of labour).

After I saw the ambiguous OECD data I decided to take another look at Tyler Cowen’s book, The Great Stagnation, because that was where I had first come across the idea that all the low hanging fruit has been picked. As it happens Tyler’s book was about America and he did not rely on national productivity data to make his point. In fact he was highly critical of national productivity data. (Tyler relied heavily on data on median family incomes, which have growth slowly since the mid-1970s. Some analysis by Scott Winship suggests to me that there may also be problems in using that data to measure trends in productivity and earnings.)

Robert Gordon’s view that there has been a secular decline in productivity growth that is likely to continue is based on an examination of longer term trends in productivity growth in the United States. He notes that in the eight decades before 1972 labour productivity growth in the U.S grew 0.8 percent per year faster than in the four decades since then. He is sceptical of claims by techno-optimists such as Erik Brynjolfsson and Andrew McAfee that the global economy is on the cusp of a dramatic growth spurt driven by smart machines taking advantage of advances in computer processing, artificial intelligence, networked communication etc.

Tyler Cowen seems to be in broad agreement with what Bob Gordon writes about the past, but tends to agree with the techno-optimists about productivity growth in the future. There are other important contributors to this debate, including Joel Mokyr who makes the point that that the indirect effects of science on productivity through the tools it provides scientific research – such as searchable databanks, quantum chemistry simulation and highly complex statistical analysis - may, in the long run, dwarf the direct effects. The views of various contributors to the discussion have been summarised by Andrew Flowers in EconSouth.

In a recent article in the New York Times Paul Krugman made a useful contribution by suggesting that the productivity numbers are missing the benefits of new products and services. He wrote: “I get a lot of pleasure from technology that lets me watch streamed performances by my favourite musicians, but that doesn’t get counted in GDP”.

That point is, of course, not new. Australia’s Productivity Commission (with which I am still proud to claim past links) has recognized the problem of measuring the outputs of the information and communications technologies (ICT) industries - for example, see the staff paper on productivity concepts and measurement by Jenny Gordon, Shiji Zhao, Paul Gretton. The problems of measuring productivity of the internet were discussed at some length by Tyler Cowen in Chapter 3 of The Great Stagnation.

In order to answer the question I posed above I had hoped to point to some concrete evidence that content providers are finding effective ways to charge the users of their products. It seems all too obvious that it is happening with respect to a great deal of music, video and news, but I have not been able to find a summary of relevant information on the extent to which this is happening. Information such as that is usually easy to find on the Internet, but when I type in the words ‘revenue’, ‘internet’ and ‘content’ into search engines what comes up is a lot of information on models that firms can use to charge for content. Perhaps that is a sign of the times! The success of major sporting organisations in obtaining revenue from the entertainment they provide via all communications media seems to point toward a future in which consumers will pay for content directly and/or expose themselves to greater, and more personalised, advertising.

As people have to pay for more internet content it seems likely that will,of itself, make the productivity numbers for ICT industries look better, even though underlying productivity will not have improved and well-being of consumers may have declined. The potential upside of this return to old style capitalism is that as people pay for content there will be an increased incentive for firms to invest in providing content and to employ more people to produce content. 

Postscript 1:

Jim Belshaw has some related comments on his blog raising some questions about education, on-the-job learning and retention of corporate knowledge. My discussion with Jim in the comments section below has introduced me to the concept of productisation, which involves combining suitable elements to form something that is standardized, repeatable and comprehendible as product (a longer definition is provided in this abstract).  It has also prompted me to think more about the implications for productivity of ICT investment at the firm level.

The Productivity Commission’s research report "ICT Use and Productivity: A Synthesis from Studies of Australian Firms" published over a decade ago indicates that the rate of ICT uptake and effects on performance differ substantially across firms, even in similar circumstances. The differences were attributed to: differing technology and innovation strategies; availability of complementary skills; and differences in capacity to ‘learn-by-doing’. The Commission also suggests that differences between firms in their accumulation of organisational capital sets them apart from each other in their effective use of technology and in related innovation. 

A report by Ben Miller and Robert Atkinson entitled “Raising European Productivity Growth Through ICT” (prepared for the Information Technology and Innovation Foundation and published in June 2014) also draws heavily on firm-level productivity studies. The report cites many recent studies suggesting that investment in ICT has continued to have a strongly positive impact on productivity at firm level. The report argues that the regulatory environment in Europe has hindered the ICT investment needed to close Europe's increasing productivity gap with America.  

Postscript 2:
Noric Dilanchian has drawn my attention to a post by Timothy Taylor, the Conversable Economist, on a new OECD report entitled "The Future of Productivity". The OECD report seems to cover some similar ground to the report by Ben Miller and Robert Atkinson referred to above. I will read it properly and write more about it later. 

Will robots replace human labour and reduce real wage levels?

The potential impact of technological change on real wage levels in high-income countries seems to me to be more important than some other questions about the future that attract more public attention. In particular, the future of real wages must be much more important than income distribution, since there is not much evidence that income distribution has a significant impact on the well-being of the mass of the population. Real wage levels have traditionally determined how the mass of the population live their lives – how well they eat, the standard of housing they are able to afford, how much leisure they can afford, their ability to travel and so forth.

I made as similar point about the relative importance of real wages levels and income distribution last year in my review of Thomas Piketty’s book, Capital in the Twenty-First Century. I asked:

“What happens if technological progress makes capital a close substitute for labour? If a substantial component of the capital of the future can be thought of as a work-force of robots, the economic consequences might be a little bit like introducing slave labour to compete with the existing workforce. Real wages might fall under such a scenario, even though national income could be expected to continue to rise.”

I then went on to refer to an article on this blog a few years ago in which I asked: Will history judge Marx to have been right about the effects of technological progress on income distribution? Looking back now, I think the answer I gave was not too bad - but it was not particularly enlightening.

In trying to consider how to give a better answer I have been trying to come to terms with some maths in economic models relating to bias in technological change (including in a master’s thesis on technological change and capital labour substitution in Australian agriculture that I wrote over 40 years ago) and some relevant empirical research. I think some of this stuff is helping me to understand what might be going on, but in trying to explain it (even to myself) it is more useful to refer to some very simple economic models that can be described verbally.

The place I start is to consider what would happen if technological change consisted entirely of the introduction of robots that are very close substitutes for humans with respect to all attributes relevant to production processes. I then consider some implications of the deficiencies of that model.

As I wrote earlier, the consequences might be like introducing slave labour to compete with the existing workforce. Real wages might fall under such a scenario, but we should not be too hasty in reaching that conclusion.

It appears obvious that an increase in the supply of labour will cause the price to fall. People with rudimentary economics training might think of it in terms of the law of diminishing returns. As you add more labour, keeping other factors of production unchanged, the marginal productivity of labour tends to fall and this is accompanied by a fall in real wages. Of course, it is not even necessary to have a rudimentary knowledge of economics to grasp the idea that an influx of migrants which resulted in a substantial increase in supply of labour could reduce wage rates of workers.

The problem with that analysis is that it is unreasonable to expect other factors of production to remain unchanged in the face of an expansion in labour supply. An increase in quantity of labour will tend to raise the rate of return on capital (by raising the marginal productivity of capital) and thus provide an incentive for further investment. If the supply of capital is sufficiently elastic, real wages need not fall as a consequence of the increase in labour supply.

The potential for an expansion in labour supply to be consistent with higher living standards comes as no surprise to anyone familiar with empirical modelling of the economic effects of migration. For example, a recent study undertaken for Australia suggests that immigration has a strongly positive impact on labour participation, employment and wage levels.

So, in economic terms it seems that we would not have too much to worry about from an influx of robots who were just like humans.

However, the model of technological change I have presented above is deficient in several respects. One major deficiency is that technological progress consists of much more than introduction of machines that perform similar functions to humans. It also involves technical innovations that enable humans to do their jobs better and the introduction of superior consumer goods. If we take a broader view of technological change there is less room to fear that it might result in lower real wages.

Another major deficiency of the model is that it fails to recognize that the replacement of human labour by non-human labour is an ongoing process rather than a new phenomenon. Nick Rowe explained it this way a few years ago:

“Horses were once like robots. Horses could do a lot of the same work that humans could do. Humans and horses can pull things, if you feed them. But then mechanical horses, called tractors, were invented, that could pull heavier things with cheaper food. Tractors pushed horses' wages below subsistence, so the horse population declined.

The robot horse displaced horses, just as horses displaced humans from all the jobs where humans pulled things. But humans, unlike horses, can do lots of other jobs beside pulling things. Humans are very versatile. Horses can't really do anything except pull things. So humans switched to doing other jobs, while horses couldn't. And the marginal product of labour, and hence wages in those other jobs, increased. Horses and tractors were complementary factors to human labour in those other jobs.

But that won't happen if robots are invented that really are just like humans, and can do all the jobs that humans can do. Robots that are just like humans would be just like slaves, rather than like tractors and horses.”

What we are seeing now is robots that are displacing humans from a range of activities and freeing them to do things that robots can’t do - just as horses did. There are adjustment problems for people in the affected industries, but the impact on average real wages is likely to be positive. Over time, superior robots are likely to be invented that will replace the initial series of robots, just as tractors displaced horses. If robots can eventually reproduce like crazy, their capacity to live off “the smell of an oily rag” might mean that wages in many industries in which humans are currently employed will be driven below human subsistence levels.

 

However, it seems unlikely that robots will ever be viewed by humans as close substitutes for human labour with respect to all attributes relevant to all economic activities. My guess is that many humans will show a strong preference for some goods with a high human labour input e.g. home produced food, restaurant meals and beverages that are served by humans, live music by local musicians, handicrafts and works of art produced by humans, and some manufactured goods that individual humans have designed specifically for themselves or friends and relatives.

My bottom line is that over the next few decades the impact of robots in replacing human labour is likely to be a relatively small part of the total impact of technological change on the quality of life. Rather than worrying about robots replacing human labour perhaps we should be more concerned that the rate of technological progress may be slowing down. I will turn to that question in my next post.

Postscript:

I would like to draw attention to comments by Jim Belshaw (see below). Since the discussion may be of wider interest I will reproduce the main points here:

Jim:  Doesn't the evidence suggest that we have a higher proportion of the population employed in lower wage jobs and a higher proportion joining the ranks of the longer term unemployed? I accept that part of the impact is distributional and timing.

Winton: The evidence you refer to is one of the reasons I have been thinking about technological change and productivity growth. Some of the move to lower paid jobs and less job security could be associated with adjustment to technological change i.e. the timing problem you refer to. Some could also be associated with lower productivity growth and insufficient investment.
If tech change is a big factor I would expect it to be affecting older people, with young people finding it easy to pick up jobs created by new technologies. We do see older workers losing jobs, but we also see young people finding it more difficult to find employment.

Jim: We have seen lots of cases of older people losing jobs and dropping out of the work force. That was a particular feature of the early nineties adjustment. However, older workers are also more likely to be in "secure" jobs and to have been there for a time. There is a higher separation cost for the firm. This was a feature of Germany ten years back.
It is actually not clear to me how many jobs have been created by new technology compared to jobs lost. I am no Ned Ludd. I am well aware of previous cases (the industrial revolution is a huge example) where the application of new technology has produced long term gains. I would also agree and have been worried by what I perceive to be the slow-down in technological advance.
But we seem to be in a situation now where technological improvement is dominated by refinement, process improvement and cost reduction. I used to argue that we didn't need to worry about that because Government and community services broadly defined would redistribute benefits. Then and now there were just so many things that could be done to improve the quality of life.
I accept that was a naive view, partly because of globalisation, partly because of a cut-back in what Government might do. Realistically, the wealthier countries have to accept that they have reached a wealth peak, that competition will limit their gains while redistributing wealth to others.

Winton: I would have expected the cost reduction to have resulted in profitable investment opportunities and an accompanying expansion of employment opportunities. It doesn't seem to have happened and I don't really know why at this stage. I find it hard to perceive of cost reductions that do not increase profitability of investment. Perhaps we have reached the satiation point that Keynes wrote about, but I doubt it. 

Jim:  On Keynes, I doubt it too. I think one key issue with cost reductions lies in sustainability. There has been a problem with cost reductions designed to maximise immediate impact that have actually reduced value over the longer term.
There is also an issue that cost reductions increase the yield on what we do now but do not affect the yield on future investments. Increased profitability may increase the capacity to invest, but there is no necessary reason why additional investment should follow.
A recent RBA paper (referred to in a post on Jim’s blog) outlined the way in which investment decision processes (hurdle rates, pay back periods) might impede investment now. However, there is a timing issue here. If you accept that firm decision making processes have a degree of rationality, once firms are convinced that low inflation and lower interest rates will last for the immediate future, then the hurdle rate will come down.
The industrial revolution was based on the creation of mass markets. One of the difficulties in the thinning out of the middle class in many Western countries lies in the reduction of those markets. However, the mass market is growing elsewhere with economic development and globalisation. Investment rates in those countries are higher.

Winton: There are some interesting ideas there that are particularly relevant to Australia.
Another thought that has occurred to me is that a fair amount of the cost reduction is occurring in industries that are attempting to survive against competition from the free content available on the Internet. Think of the news media as an example. The internet is a major innovation providing substantial benefits, but causing a great disruption to the capitalist system as we once knew it. This is also part of the story about the apparent decline in the rate of productivity growth in the wealthy countries - the output of the Internet is not measured very well.

There has been a fair amount written around this topic but I have not yet come across anything that puts the pieces of the puzzle together in a coherent way.

Does nature show us the way to flourish?

There are good reasons to look to nature for an understanding of what it means for a human to flourish. By looking at nature we know that in many respects humans are similar to other animals. We consider some aspects of human flourishing in same way as we might consider whether animals in a zoo have adequate opportunities to flourish. For example, we consider whether humans have the food, shelter, companionship, and environmental interactions that are necessary for their physical and mental health.

However, when we look at human nature we also see potentialities that differ from those of other animals. We see greater cognitive capabilities, and greater potential for choice and self-direction. That suggests that human flourishing must involve development and exercise of cognitive abilities and skills in self-direction. When humans are flourishing they make fewer bad choices and are better at learning from their mistakes than when they are languishing.

The view just expressed is, of course, a Western libertarian view that owes much to Aristotle’s naturalistic perceptions of human flourishing. Contrary views are often heard, some of which also claim links to Aristotle. It is often argued that even adult humans are so prone to making bad choices – despite the help of family, friends and professional advisors - that they are unlikely to have happy lives unless they are subjected to a lot of paternalistic intervention by governments. Those who hold that view seem to think that governments are capable of designing and implementing regulatory systems that will enable people to have happier lives than under a spontaneous order relying on individual autonomy and mutually beneficial interactions with others. Such paternalists encourage people to become dependent on government like animals in a zoo become dependent on their keepers. 

 

The seemingly endless dispute over the relative merits of spontaneous orders and paternalistic governance has parallels in the disputes between Daoism and Confucianism in ancient China. That became evident to me while I was reading An Introduction to Daoist Philosophies by Steve Coutinho. The book also provides people in the West with a different way of considering what nature shows us about human flourishing.

I first encountered Daoist philosophy a few years ago when I stumbled across a quote from Laozi (also referred to as Lao-tzu or Lao-tze). I then read the Laozi (also referred to simply as the Tao Te Ching) and posted to my blog asking: Was Lao-Tzu a libertarian? When I wrote that post I had the impression Laozi was a person who lived in the 6^th century BCE, but there is actually no indisputable historical evidence of his existence. The Laozi may be a collection of the works of several authors.

In the early Daoist texts nature is perceived as the context in which humans finds their place, nurtured and sustained along with all other things. Nature is perceived as untamed, but it is not viewed through the frame of the predatory survivalism often seen in wildlife documentaries. Nor is nature viewed through the frame of Rousseau’s ideal of harmony and perfection. The Daoists saw nature as a source of inspiration about how we should live.

The Laozi does not view nature as some kind of entity which micromanages natural phenomena. It recognizes that the complex natural world could not exist if it had to be controlled or manipulated deliberately. The natural world allows living things to grow and flourish according to their natures.

The point of observing and understanding natural functioning is to provide a model of how we ourselves should behave. Steve Coutinho suggests that the inspiration that we can take from the Laozi is that we should refrain from imposing artificial structures in an attempt to control and manipulate things:

“We must first appreciate the natural tendencies of the circumstances, of our surroundings, of other people, and of ourselves. We should then explore the most efficient way of dealing with things, one that accords closely with their immediate tendencies. Rather than planning for all contingencies in advance, we should wait to observe how things develop, sense how they tend to move themselves, and then move with them, redirecting them with minimal effort”.

The somewhat anarchistic approach of Daoist philosophy stands in contrast to the Confucians, who sought to maintain social order through social hierarchies and ethical cultivation, and other branches of Chinese philosophy which advocated clear laws, regulations and standards, and emphasized language and linguistic distinctions.

Steve Coutinho’s book contains a chapter discussing the Daoist philosophy of skill, which is directly relevant to question of what nature tells us about how we can flourish. The chapter is based on the Zhuangzi and Liezi, which were written after the Laozi, but share some broad themes with it.

As Coutinho explains it, the path of cultivation of natural tendencies involves more than just going with the flow and following your desires - the interpretation of Daoist philosophy that is often implied by popularizations in the West.  Most of us no longer know instinctively how to live naturally because our thoughts and actions have become shaped by excessive artifice – unnatural complexity - which is a by-product of thousands of years of cultural development. The degree of artifice in our lives has divorced us from an intuitive understanding of the nature of things and of ourselves. The cultivation of natural tendencies and recovery of spontaneity require the undoing of some of this artifice.

What nature shows us is that natural creatures have a natural capacity to flourish without written instructions. Even when they know what they do, they do not necessarily know how or why they do what they do. It is the nature of humans to use their cognitive abilities to design and produce things and to enjoy cultural activities. What we can learn from nature is how to do these things in a simple way that is intuitive, natural, fluid and responsive to the natural tendencies of the phenomena one is engaged with.

An understanding of the Daoist message can be gained most readily by considering acquisition of physical skills. For example, in order to become skilled at archery a focus on scientific knowledge about how eyes and muscles work would be an unhelpful distraction. The skill can only be acquired through experiments in actual movement, which the teacher then attempts to correct and adjust. There are good reasons why this reminds me of the lessons I had in the Alexander Technique to help rectify stress-related back and neck problems.

The path to skill lies in nurturing the natural abilities we are born with. Many years of training are often required to develop increased sensitivity to the “innermost subtle tendencies” of the phenomena we are dealing with. Skilful performance requires awareness to be focused on the task so that potential distractions do not interfere.

The Daoist texts point toward the acquisition of the meta-level skill of being able to acquire new skills as well as the acquisition of specific skills. This “skill of skilfulness” can be applied more broadly to the art of living. As Steve Coutinho puts it:

“A flourishing life, a life lived well, for a Daoist, is one performed with consummate artistry”.

It seems to me that if more people in the West could think about that for a while it might help them to see the merits of spontaneous orders and to reject the artifices of paternalistic government.