The Benefits of High Wages

One of my special interests is the way that commonly accepted economic theories have radical implications. For example, the idea that competition causes prices to fall towards marginal cost makes markets unworkable when marginal costs are very low compared to high fixed costs. In my book, Railroading Economics, as I showed how competitive forces were causing repetitive bankruptcies in the railroading industry in the 19th-century, so much so that the major economists in the US came to favor trusts, cartels, and monopolies. When Joseph Schumpeter revived this idea, without the slightest acknowledgment to any predecessors, he was seen as a brilliant economist. Unfortunately, none of his admirers seem to understand the radical implications of that idea.

Another radical idea from conventional economics is that high wages promote rapid technological change. Most modern economists would accept that business attempts to economize on expensive factors, but rarely take the next step that high wages can promote rapid economic change. As I discussed in railroading economics, this idea was popular between the late 19th century and the 1920s. Unfortunately, today the idea is that high wages represent an impediment to competitiveness.

Admittedly, the upsurge in globalization complicates the argument, but economies have the choice between competing by cutting wages — what I call the Haitian Road to Development — or making labor more expensive to encourage business to develop either high technology production techniques or better products to gain a competitive edge.

Rarely do I see economists displaying some understanding of this phenomenon below are my notes from one article that does so:

Alesina, Alberto and Joseph Zeira. 2006. “Technology and Labor Regulations.”

Abstract: “Many low skilled jobs have been substituted away for machines in Europe, or eliminated, much more so than in the US, while technological progress at the “top”, i.e. at the hightech sector, is faster in the US than in Europe. This paper suggests that the main difference between Europe and the US in this respect is their different labor market policies. European countries reduce wage flexibility and inequality through a host of labor market regulations, like binding minimum wage laws, permanent unemployment subsidies, firing costs, etc. Such policies create incentives to develop and adopt labor saving capital intensive technologies at the low end of the skill distribution. At the same time technical progress in the US is more skill biased than in Europe, since American skilled wages are higher.”

Here are my notes from the article:

“It is close to impossible to find a parking attendant in Paris, Frankfurt or Milan, while in New York City they are common. When you arrive even in an average Hotel in an American city you are received by a platoon of bag carriers, door openers etc. In a similar hotel in Europe you often have to carry your bag on your own.” see Zeira, J. (1998), “Workers, Machines and Economic Growth,” Quarterly Journal of Economics, 113, 1091-1113.

In other words, low wages for unskilled workers tend to make business use large amounts of low-wage labor.

Blanchard, O. J. (1997), “The Medium Run,” Brookings Papers on Economic Activity 2: 89-141 mentions substitution of labor by capital as one of the explanations for high unemployment in Europe.

“… after the shocks of the seventies European firms shifted to labor saving technologies which led to an increase in the capital labor ratio and after a period of adjustment, to higher profits. He shows that from 1980 to the late nineties the capital labor ratios are steadily and sharply increasing in Continental economies, while they have been quite stable in the Anglo-Saxon economies.”

“One could safely argue that computers substitute for relatively high skill labor while robots substitute for low skill labor. The figures show that there are significantly more PCs per capita in the US than in the other three European countries [France, Italy and Germany] while there are significantly more robots per capita the three European countries than in the US.”

[What Blanchard misses is that an intelligent application of labor-displacing technology can create extra demand elsewhere, increasing employment, as Ricardo showed nearly 19th-century.]

“Another technology that presents a sharp difference in adoption between Europe and the US is railway electrification. Clearly, there are many factors that affect the decision to electrify railways, like density of transportation, but one is also wages, since electrified railways are capital intensive, while diesel locomotives require more labor, and mainly more unskilled labor. Interestingly, the US had more electrified rails in the past, 3,000 thousand route miles in the 1930s, while now it went down to less than 1,000 route miles. Less than a percent of US railways are electrified, and only 47 locomotives out of more than 20 thousand are electric. In France, Italy and Germany on the contrary 45% of the locomotives are electric, and the percentage of electrified rail is even higher.”

“,,, in 1980 the US had a relatively higher skilled capital labor ratio than Europe. Over the next 20 years the ratio between the two capital labor ratios was quite stable for the US, while it decreased significantly for Europe.”

“Using plant level data, Lewis shows that the degree of adoption of automation technologies (thus of capital intensity) is higher in US cities that have received less immigration of low skill workers. This suggests that availability and relative costs of low skill workers affect firms’ technological choices. The same author even finds evidence of de-adoption of automation technologies in cities that receive an especially large influx of immigrants.” [Lewis, E. 2005. “Immigration, Skill Mix, and the Choice of Technique,” Federal Reserve Bank of Philadelphia Working Paper.]

“One implication of our argument is that the ratio of high skilled jobs created in Europe should be higher than in the US. This is precisely the implication of the analysis of job creation in Europe by Pissarides (2006). He argues that the Lisbon target for job creation in Europe will not be achieved because of sluggish creation of jobs in Europe in the labor intensive low skilled service sectors, which is where most job creation has occurred in the US and UK. Pissarides (2006) concludes that European countries have been successful at creating jobs in the “knowledge sectors” …. but have been unsuccessful at creating them in labor intensiv-sectors” which is exactly one of the implication of our model. This author also show a strong negative correlation between the level of labor market.” Pissarides C. 2006. “Lisbon Five Years Later.” Keynote Address at the Austrian Government Conference on Innovations in Labor Market Polcies, February.

“Job creation in Europe would have been even lower and unemployment higher without the use of public employment to alleviate unemployment at relatively low skilled level. Often public job programs for “community service jobs” (as above) such as cleaning parks and roads assistance to elderly living at home alone etc are staffed by hiring individuals that would not be absorbed by the private sector. Evidence on this point is provided by Edin and Topel (1997), Bjorklund and Freeman (1997) and Kahn (1998a) for Norway and Sweden (see however Kahn (2000b) for some discussion of robustness); by Blau and Kahn (2000b) for Germany and by Alesina, Danninger and Rostagno (2001) for Southern Italy.

[Here, the problem is one of imbalances. The answer is creating a more egalitarian society in which larger numbers of people can participate in the more high-tech activities. Their prosperity will create more demand for the others.]

Our model can easily account for this by redefining the unemployment subsidy as the wage of a public job. Then a worker would accept a job in the private sector only at a wage higher than the public sector job. The “unemployed” in our model would then be redefined as public employees. Another relevant factor is that when low skilled jobs are scarce, the opportunity costs of staying in school declines and young people stay in school longer. In Italy the average age of college graduation is 27.8.”

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