On August 18, 2019, Blair Fix writes on Economics:
Did you hear the joke about the economists who tested their theory by defining it to be true? Oh, I forgot. It’s not a joke. It’s standard practice among mainstream economists. They propose that productivity explains income. And then they ‘test’ this idea by defining productivity in terms of income.
In this post, I’m going to show you this circular logic. Then I’ll show you what productivity differences look like when productivity is measure objectively. They’re far too small to explain income differences.
Marginal productivity theory
The marginal productivity theory of income distribution was born a little over a century ago. Its principle creator, John Bates Clark, was explicit that his theory was about ideology and not science. Clark wanted show that in capitalist societies, everyone got what they produced, and hence all was fair:
It is the purpose of this work to show that the distribution of the income of society is controlled by a natural law, and that this law, if it worked without friction, would give to every agent of production the amount of wealth which that agent creates. (John Bates Clark in The Distribution of Wealth)
Clark was also explicit about why his theory was needed. The stability of the capitalist order was at stake! Here’s Clark again:
The welfare of the laboring classes depends on whether they get much or little; but their attitude toward other classes—and, therefore, the stability of the social state—depends chiefly on the question, whether the amount that they get, be it large or small, is what they produce. If they create a small amount of wealth and get the whole of it, they may not seek to revolutionize society; but if it were to appear that they produce an ample amount and get only a part of it, many of them would become revolutionists, and all would have the right to do so. (John Bates Clark in The Distribution of Wealth)
So the neoclassical theory of income distribution was born as an ideological response to Marxism. According to Marx, capitalists extract a surplus from workers, and so workers get less than what they deserve. Clark’s marginal productivity theory aimed to show that this was not true. Both capitalists and workers, Clark claimed, got what they deserved.
The message of Clark’s theory is simple: workers need to stay in their place. They already earn what they produce, so they have no right to demand more.
The human capital extension
Clark created marginal productivity theory to explain class-based income — the income split between laborers and capitalists. But his theory was soon used to explain income differences between workers.
In the mid 20th century, neoclassical economists invented a new form of capital. Workers, the economists claimed, owned ‘human capital’ — a stock of skills and knowledge. This human capital made skilled workers more productive, and hence, made them earn more money. So not only did productivity explain class-based income, it now explained personal income.
With the birth of human capital theory in the 1960s, the marginal revolution was complete. All income differences, economists claimed, could be tied to productivity differences. And from then onward, there was an endless stream of empirical work that ‘confirmed’ that productivity explained income.
A sticky problem: how do we compare different outputs?
Before we look at how economists ‘confirm’ marginal productivity theory, we have to backtrack a bit. We have to understand a basic problem with the concept of productivity.
Imagine we want to compare the productivity of a corn farmer to the productivity of a composer. The corn farmer produces corn. The composer produces music. How do we compare these two outputs?
I think it’s obvious that we cannot do so objectively. Any comparison will require a subjective decision about how to convert corn and music into the same dimension. The lesson is simple. We cannot objectively compare the productivity of two workers unless they produce the same thing.
Think about how severely this problem undermines marginal productivity theory. The theory claims that productivity differences universally explain income differences. But we can never actually test the theory, because productivity differences cannot be universally measured.
Even worse, it’s possible to earn income without producing anything. Think about the practice of patent trolling. Patent trolls are people who buy the patent for a product that they neither invented nor produce. These individuals don’t ‘produce’ anything. But they still make money. How? Because they get the government to enforce their property rights. Patent trolls sue (or just threaten to sue) anyone who infringes on their patent. Viola, they earn income without producing anything.
My point here is to show that marginal productivity theory is plagued by a simple problem. We can’t compare the productivity of people who produce different things. And some people don’t ‘produce’ anything at all. This problem seems to severely limit any test of marginal productivity theory.
Economists’ sleight of hand: defining productivity using income
Given the problems with comparing the productivity of workers with different outputs, you’d think that marginal productivity theory would have died long ago. After all, a theory that can’t be tested is scientifically useless.
Fortunately (for themselves), neoclassical economists don’t play by the normal rules of science. If you browse the economics literature, you’ll find an endless stream of studies claiming that wages are proportional to productivity. Under the hood of these studies is a trick that allows productivity to be universally compared. And even better, it guarantees that income will be proportional to productivity.
To understand the trick, we have to look at some basic accounting definitions. Figure 1 shows how a firm’s income stream gets split. The firm earns income in the form of sales (right). Part of this income is paid to the firm’s owners as ‘profits’, and part of it is paid to workers as ‘wages’. The rest goes to other firms as ‘non-labor costs’.
The point here is that the income on the right (sales) is the source of the income on the left (profits and wages). So a larger income on the right translates into larger incomes on the left. Thus sales per worker will obviously correlate with wages. Given our accounting definition, it has too.
With our accounting definition in hand, we’re ready for the trick used by neoclassical economists. To test their theory, they define ‘productivity’ in terms of income! They assume that a firm’s sales indicate its ‘output’.
Figure 2 shows this slight of hand. Neoclassical economists take the firm’s income stream and reverse it’s direction. Presto! Sales now indicate output! [1]
With this slight of hand, we can endlessly confirm that productivity ‘explains’ income. We find that productivity — as measured by sales per worker — is highly correlated with wages!
The key here is to forget that we are dealing with an accounting truism. Sales are no longer ‘income’. Sales are now ‘output’. And this output miraculously ‘explains’ wages!
I wish I could tell you that this is a joke, since it doesn’t pass the laugh test. But it’s not. Measuring ‘productivity’ using sales (or value added) is standard practice in mainstream economics.
And so economists test their theory of income distribution by assuming it is true. They measure productivity in terms of income. Then they find (unsurprisingly) that productivity ‘explains’ income.
How to show that productivity ‘explains’ income:
I’ve taken the liberty of creating a step by step guide for how to test marginal productivity theory and guarantee that the theory succeeds:
- Find an income-accounting equation that is true by definition.
- Forget that you are dealing with an accounting equation.
- Pick a form of income (in your equation) that you want to explain.
- Given your choice, look at the opposite side of your accounting equation.
- Convince yourself that this opposite side no longer measures income. It now measure output.
- Regress the two sides of your accounting equation.
- Celebrate when you find a strong correlation.
- Claim you that have found evidence that productivity explains income.
- Never tell anyone that your results were guaranteed because they followed from an income-accounting equation. (This step is unnecessary if Step 2 is successful).
Productivity differences cannot explain income inequality
Neoclassical economists resort to slight of hand to measure productivity differences, and so endlessly confirm their theory. But what happens if we try to measure productivity differences objectively?
We find that productivity differences cannot possibly explain income inequality.
To measure productivity objectively, we can only compare workers doing the same task. For instance, we can compare the productivity of two workers who make rivets. Or two workers who both deliver mail. Since the workers have an output with the same dimension, we can objectively compare their productivity.
Here’s an interesting question: how much does productivity vary among workers doing the same task? The psychologist John E. Hunter spent much of his career answering this question. According to his results, the answer is ‘not very much’.
Figure 3 takes Hunter’s data and compares it to data on income inequality within countries. Let’s break down the results. First, I measure inequality using the Gini index, which varies from 0 (no inequality) to 1 (maximum inequality). In Figure 3, the x-axis shows the Gini index. The y-axis shows the ‘density’, or relative frequency, of the particular Gini value.
The red curve in Figure 3 shows the Gini index for workers’ productivity. For each task reported by Hunter, I’ve converted the workers’ productivity differences into a Gini index. The red curve shows the distribution of Gini indexes for all of the reported tasks. According to Hunter’s data, differences in workers’ productivity clump tightly around a Gini index of 0.1.
Next to this productivity data, I’ve plotted the distribution of inequality within all the countries of the world (the blue curve). The average Gini index within these countries is about 0.4.
The lesson here is that differences in workers’ productivity are tiny compared to differences in income. So it’s inconceivable that productivity differences (as measured here) can explain income inequality.
Let’s kill the productivity-income thought virus
The idea that income is caused by productivity is a dead end. Marginal productivity theory only survives because economists never test it objectively. Instead, they resort to slight of hand. They measure productivity using income, and claim that this ‘confirms’ their theory.
Let’s not mince words. Marginal productivity is a thought virus that is sabotaging the scientific study of income. It needs to die.
Notes
[1] Economists will often subtract non-labor costs from sales to calculate ‘value-added’. They’ll then claim that value-added measures firm output. It’s the same slight of hand, since they’re still converting an income stream into an ‘output’.
Gary Reber Comments:
This article would be clearer if it were not based on one-factor “labor” thinking, as with Marxism in which all production is the result of worker (labor) input. The term “capitalists” should instead be “capital owners” –– meaning owners of the non-human capital asset input in production. This would help to understand the income split between laborers and capital owners.
In simple terms, binary economic thinking recognizes that there are two independent factors of production: humans (labor workers who contribute manual, intellectual, creative and entrepreneurial work) and non-human physical capital (productive land; structures; infrastructure; tools; machines; robotics; computer processing and apps; artificial intelligence, certain intangibles that have the characteristics of property, such as patents and trade or firm names the like which are owned by people individually or in association with others). Fundamentally, economic value is created through human and non-human contributions. NOTE, real physical productive capital isn’t money; it is measured in money (financial capital), but it is really producing power and earning power through ownership of the non-human factor of production organized through businesses, owned by individuals or assemblages of people. Financial capital, such as stocks and bonds, is just an ownership claim on the productive power of real capital. In the law, property is the bundle of rights that determines one’s relationship to things.
Over the past century there has been an ever-accelerating shift to productive capital — which reflects tectonic shifts in the technologies of production. The mixture of labor “worker” input and physical capital “worker” input has been rapidly changing at an exponential rate of increase for over 240 years in step with the Industrial Revolution (starting in 1776) and had even been changing long before that with man’s discovery of the first tools, but at a much slower rate. Up until the close of the nineteenth century, the United States remained a working democracy, with the production of products and services dependent on labor worker input. When the American Industrial Revolution began and subsequent technological advances amplified the productive power of non-human capital, as it has to this day, plutocratic finance channeled its ownership into fewer and fewer hands, as we continue to witness today with government by the wealthy evidenced at all levels. While historically, the expansion of productive technology had created jobs, today the trend is that the new jobs being created are increasingly being filled by a “machine” at inception, while the jobs remaining still rest in the crosshairs of technological development and application.
People invented “tools” to reduce toil, enable otherwise impossible production, create new highly automated industries, and significantly change the way in which products and services are produced from labor intensive to capital intensive — the core function of technological invention and innovation. Binary economist and author Louis O. Kelso attributed most changes in the productive capacity of the world since the beginning of the Industrial Revolution to technological improvements in our capital assets, and a relatively diminishing proportion to human labor. Capital, in Kelso’s terms, does not “enhance” labor productivity (labor’s ability to produce economic goods). In fact, the opposite is true. It makes many forms of labor unnecessary.
In the article, the authors asks us to “Imagine we want to compare the productivity of a corn farmer to the productivity of a composer. The corn farmer produces corn. The composer produces music.” Once upon a time, the corn farmer actually labored in his fields (capital asset) without very much “machinery.” Likewise the composer wrote music by hand with pen and ink on paper. Today, the corn farmer owns sophisticated machinery which is employed to plant seed and harvest the corn produced on his land. The output is now capital intensive as opposed to labor intensive. The musician today uses a computer and composing programming to compose. Again, a shift to capital intensive rather than labor intensive. In reality, both the corn farmer and the musician today are largely dependent on the non-human “tools” they own and use to produce their respective products (outputs).
The author is correct saying that it is really not possible for one to compare these two outputs objectively. That is the role of the “free market.” We as a collection of people form a “marketplace” with varied needs, wants and tastes deciding the value of what is produced (outputed). As well, the distribution of the earnings of both capital and labor should be decided by the free market.
However, as pertaining to labor, free-market forces no longer establish the “value” of labor. Instead, the price of labor is artificially elevated by government through minimum wage legislation, overtime laws, and collective bargaining legislation or by government employment and government subsidization of private employment solely to increase consumer income.
The author goes on to say that “productivity difference cannot by universally measured.” And says that it is possible to earn income without producing anything, referring to buying a patent for a product. Awe, but the patent, itself, which has the characteristics of physical property, is a capital asset that is owned, and the owner of the patent is protected by the rights, under our constitution. to own property, as with any other form of “property,” whether used to produce or for personal consumption.
The author gets confused in not understanding that sales are the basis of income, and sales are tied to output, referencing various goods, products and services produced by the inputs of labor (human) and capital (non-human).
Sales are measured in money. As Kelso and co-author Patricia Hetter put it, “Money is not a part of the visible sector of the economy; people do not consume money. Money is not a physical factor of production, but rather a yardstick for measuring economic input, economic outtake and the relative values of the real goods and services of the economic world. Money provides a method of measuring obligations, rights, powers and privileges. It provides a means whereby certain individuals can accumulate claims against others, or against the economy as a whole, or against many economies. It is a system of symbols that many economists substitute for the visible sector and its productive enterprises, goods, products and services, thereby losing sight of the fact that a monetary system is a part only of the invisible sector of the economy, and that its adequacy can only be measured by its effect upon the visible sector.”
In companies, labor, as an input, is a cost of production, as well as capital. In each case, the OWNER(S) of a company always seek to pay the least as possible to hire workers and to form capital assets. This is the market at play.
Companies strive to achieve cost efficiencies to maximize sales and profits for their owners, thus keeping labor input and other operating and production costs at a minimum. A for-profit company’s goal is pursuit of profit. Employment is one expensive byproduct of that, not the primary purpose. Companies always are implementing cost savings to stay competitive. They strive to minimize marginal costs, the cost of producing an additional unit of a good, product or service once a business has its fixed costs in place, in order to stay competitive with other companies racing to stay competitive through technological invention and innovation. Reducing marginal costs enables businesses to increase profits, offer goods, products and services at a lower price (which people as consumers seek), or both. Increasingly, new technologies are enabling companies to achieve near-zero cost growth without having to hire people. Thus, private sector job creation in numbers that match the pool of people willing and able to work is constantly being eroded by physical productive capital’s ever increasing role.
The result is that the price of products and services are extremely competitive as consumers will always seek the lowest cost/quality/performance alternative, no matter where the country of origin, and thus for-profit companies are constantly competing with each other (on a local, national and global scale) for attracting “customers with money” to purchase their goods, products or services in order to generate increased sales and profits, and thus return on investment (ROI).
Productivity should not be measured by sales per worker and be correlated with wages. Technological change makes tools, machines, structures, and processes ever more productive while leaving human productiveness largely unchanged (our human abilities are limited by physical strength and brain power — and relatively constant). Industries are always changing, evolving and innovating. The result is that primary distribution through the free-market economy, whose distributive principle is “to each according to his production,” delivers progressively more market-sourced income to capital owners and progressively less to workers who make their contribution through labor.
People invented “tools” to reduce toil, enable otherwise impossible production, create new highly automated industries, and significantly change the way in which products and services are produced from labor intensive to capital intensive — the core function of technological invention and innovation. Kelso attributed most changes in the productive capacity of the world since the beginning of the Industrial Revolution to technological improvements in our capital assets, and a relatively diminishing proportion to human labor. Capital, in Kelso’s terms, does not “enhance” labor productivity (labor’s ability to produce economic goods). In fact, the opposite is true. It makes many forms of labor unnecessary. Because of this undeniable fact, Kelso asserted that, “free-market forces no longer establish the ‘value’ of labor. Instead, the price of labor is artificially elevated by government through minimum wage legislation, overtime laws, and collective bargaining legislation or by government employment and government subsidization of private employment solely to increase consumer income.”
Furthermore, according to Kelso, productive capital is increasingly the source of the world’s economic growth and, therefore, should become the source of added property ownership incomes for all. Kelso postulated that if both labor and capital are independent factors of production, and if capital’s proportionate contributions are increasing relative to that of labor, then equality of opportunity and economic justice demands that the right to property (and access to the means of acquiring and possessing property) must in justice be extended to all. Yet, sadly, the American people and its leaders still pretend to believe that labor is becoming more productive and couch all policy directions in the name of job creation. Americans ignore the necessity to broaden personal ownership of wealth-creating, income-producing capital assets simultaneously with the growth of the economy.
Significantly though, no matter how much labor is necessary or unnecessary, it is imperative that the issue of concentrated capital ownership is addressed, and policies are enacted to simultaneously create new capital owners of the corporations growing the economy, both established and viable start-ups, as the economy grows.
The author apparently does not understand that what explains income inequality is the few owning the overwhelming productive capital asset input in an economy while the masses remain propertyless (in the productive capital sense), and dependent on a job as their ONLY means of earning an income.
I think it should be obvious that in a modern, technological era it is the ownership of productive capital wealth, not the labor of people, that is the primary creator of affluence. Hence, it is access to ownership of productive capital wealth, not to jobs, wherein the national economic policy guidelines for the 21st century ought to lie. Until we embark on the path of broadening capital ownership, we will continue to see inequality widen and deepen.
The existing taxing power of government ought to be used in a way to restructure the economy along the guidelines of universal access to ownership of productive capital wealth with a thrust toward the creation of new wealth.
The ultimate result of the use of the taxing power of government to stimulate the widespread access to ownership of productive capital wealth should be a growing independence of an economically emancipated people both from reliance upon government and from the wage slavery brought into being by monopolistic and oligarchic ownership; and the role and function in our lives both of government and of monopoly and oligarchy ownership ought to diminish.
