Academic journal article Economic Inquiry

Relating Labor Productivity to Wages in Service Sectors: A Long-Run Approach

Academic journal article Economic Inquiry

Relating Labor Productivity to Wages in Service Sectors: A Long-Run Approach

Article excerpt


This article introduces a systematic approach to the study of unbalanced productivity growth that can be readily applied across any sectors with unbalanced productivity growth. This approach is based on a cointegrating relationship between sectoral productivity and real sectoral compensation. Strong support for this relationship is found in U.S. service sectors from 1947 to 1993. The results show that Baumol's theory of "cost disease" due to unbalanced productivity growth has been a widespread phenomenon and that the relationship, between labor productivity and real compensation is well represented with general forms of the production function. (JEL 047)


Baumol's model of "cost disease" has received considerable attention since it was introduced in 1967. Using a simple model of production, Baumol showed that differing rates of industrial or sectoral productivity growth could explain shifting patterns of employment, declining aggregate productivity, and rising costs in low-productivity growth industries or sectors. Unbalanced productivity growth has been found in empirical studies of the performing arts (Baumol and Bowen 1966; Felton 1994), television broadcasting (Baumol, Batey Blackman, and Wolff 1985), and health and education (Baumol 1993). In these studies, labor productivity in services is shown to be increasing more slowly than for the economy as a whole and the price of these services is shown to be rising faster than aggregate price indices. The underlying assumption is that nominal wages equalize across sectors so that lower productivity growth shows up as relatively faster growth of prices hence, cost disease--the increasing cost of outputs from lo w-productivity sectors.

Within a single industry, competition in labor and product markets is frequently assumed to lead to uniform wages and prices. If labor is mobile across firms, then productivity gains at one firm will lead to lower prices as that firm captures a larger share of the market and employs a larger fraction of the workforce. Productivity gains in one industry (say, the production of skateboards), however, do not lead to lower prices across other industries (say, the production of educated children). Lower prices in high-productivity growth industries will make the output of those industries relatively mote attractive to consumers. Consumers, however, may be unwilling to substitute the output of high-productivity growth industries for the output of low-productivity growth industries.

Empirical studies of cost disease have been limited to the few high-profile service sectors mentioned above and economy-wide studies (notably Fuchs [1968] and Kendrick [1985]) that have shown that productivity growth in aggregate services has lagged behind that of manufacturing. The lack of empirical work has been due, presumably, to difficulties in relating productivity growth to price and wage growth either across sectors or over time. The implications of unbalanced productivity growth are long-run implications that are unlikely to do well in explanations of short-run behavior of prices and wages. In addition, productivity, in terms of marginal products of labor, is difficult to measure.

To my knowledge, there have been no formal time-series tests on the relationship between differing rates of sectoral productivity growth and differing growth rates of prices or labor costs. The analysis in this article applies cointegration techniques to the relationship between sectoral productivity and labor costs. I interpret the theory of unbalanced growth as a statement about trends in relative productivity and relative labor costs--relative productivity and relative labor costs should share a stochastic trend. The result of this analysis is surprisingly strong for most service sectors examined: relative productivity has been cointegrated with relative labor costs, and the cointegrating vector suggests that sectoral level data are well represented by a general form of the production function. …

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