Another interventionist fallacy: unemployment, labour costs and the value-added fallacy

Gerard Jackson
BrookesNews.Com
Monday 11 January 2010

What is it with our economics departments? Last week I received an email from a student whose leftwing lecturer had given the class an article by Peter Roberts, reporter with the Australian Financial Review, that was written about 12 years ago. According to this lecturer the students were to note that "Roberts' critique of the ruthless approach of capitalists to wages was spot on" and that he had shown how shortsighted capitalists really are. The student wanted my opinion. As a rule, lack of time forces me to turndown appeals for detailed responses. However, Roberts' thinking is so bloody awful it needs to be thoroughly refuted in the hope that the student will be able to use it against his ignoramus of a lecturer.

According to Roberts cutting labour costs might create some low-wage jobs but high wages are not a real problem for Australia, though the situation would be different if we were competing with China in the production of toys. (Bear in mind that this is 1998.) The proof of this, so he believes, is illustrated by the fact that Australia has a 20 to 30 per cent wage advantage over Europe and the US in R&D engineers and scientists. But what Roberts completely failed to see is that the real reason why Australia cannot compete with Chinese companies in the production of toys is because it is a capital and land intensive economy relative to China. As for his comment about our engineers and scientists, it says more about his grasp of economics than it does about labour costs.

Roberts asserted that advances in manufacturing mean that labour costs now have little influence on competitiveness. As an example, he told us that labour costs in the production of a digital phone are about 2 per cent and less than 5 per cent for most advanced electronic equipment. Having convinced himself that labour costs are irrelevant, he made the absurd claim that low prices for commodities remain the real "monkey" on Australia's back. Alhough that part of GDP directed towards exports has risen from 11 per cent in 1960 to 25 per cent today, export income only rose from 15 per cent to 20 per cent. From this he concluded that we have traded off 14 per cent of GDP for a mere 5 per cent rise in income.

Therefore the solution to our economic problems is not low wages but having companies "like Hewlett Packard and fewer than BHP." HP's profit growth has been 30 per cent and its revenue growth 24 per cent during the past 5 years. Where BHP has been stuck with low-value products, a 8 per cent profit growth and a revenue growth of 8 per cent.

The only thing Roberts successfully demonstrated is his total ignorance of how wage rates are determined. A nation's real wages are basically determined by the ratio of to capital to labour. As a country raises its per capita investment wages rise as labour becomes scarce relative to capital — and it is capital that raises productivity, not unions. What the likes of Roberts cannot grasp is that labour is only cheap or expensive relative to the value of its product. This is why companies in rich countries can still compete against companies in poor countries. Though a worker might earn five times more than a foreign worker, his labour is not more expensive so long as his productivity is at least five times greater. And productivity is what was missing from Roberts' article.

Now there is a tendency in every free labour market for labour to receive the full value of its marginal product. Therefore, raising labour costs above market clearing values will create unemployment. It follows that the cutting of such labour costs is not to lower cost to increase the quantity of low-wage jobs but to resurrect those jobs that the wage-fixing policies of the time destroyed. Roberts attempt to deny this economic truth by making statements about the ratio of labour costs to total costs do not hold water. Once again, it is the productivity of labour that counts and not any cost ratios or proportions. Moreover, all inputs contain labour costs. Although the purchaser does not define them as so in his own accounts, he nevertheless pays for them.

Unfortunately we must still pursue the matter further. Firms combine capital with labour in a way to minimise costs. (Even in a world where technologies requiring fixed proportions prevail, prices will still determine the combination by determining the technique to be used). If we are in a situation where labour¹ costs are a relatively small per centage of total costs, the combination will still be eventually changed to minimise the costs of production if the price of labour rises in the absence of any change in the demand for the product.

As for export earnings and GDP. So what? What matters is not whether prices per unit have fallen but the rate of return on these investments. The effect of raising productivity is to lower unit costs. That is why the prices of electronics goods have fallen consistently year after year (or is it month after month?). To state that we have traded off 14 per cent of our GDP for a 5 per cent rise in income is appalling economics. If resources have been misdirected into the primary sector, as he implies, this is not the fault of markets but government intervention. However, it would be much better if Roberts had explained himself rather than just make assertions.

Interventionists like Roberts seem to suffer from a value-added fetish. Like so many others of a similar mind he confuses value added with profitability. But this raises an important point: if value-added is a measure of profitability, why aren't these profits competed away? There really is no mystery here. Economic theory, something Roberts sneers at, suggests that the greater the ratio of capital to labour in a firm the higher value-added will be. This is because as firms become more capital intensive labour costs as proportion of total costs fall. The gross error committed by the likes of Roberts is to assume that electronics production must have high value-added per worker. There are no grounds to support this assumption, despite HP's revenue and profit figures which revealed absolutely nothing about the firm's level of value-added.

BHP's problems largely stemmed from having been an 'infant industry' that was raised in an interventionist nursery from which it never really escaped. What it needed was a good dose of free-market air, not more interventionist direction by the likes of Roberts. If Australia does not have the kind of companies that are to Roberts' taste, then this is either because economic conditions do not warrant investment in them or government meddling² has made them unprofitable. As for HP's profits, theses are the result of entrepreneurship and innovation, not value-added activities.