Productivity Growth

   The economic gains from productivity growth reach workers directly through growth in employee compensation, where compensation includes wages and the contributions that employers make for benefits such as health insurance and for government programs such as unemployment insurance and Social Security. Over long periods of time, productivity and real compensation grow at about the same rate. Real wages have grown somewhat more slowly than compensation and thus productivity over the last 20 years. The reason for this difference is that non-wage compensation, particularly employer contributions for health insurance, has accounted for an increasing share of compensation over this time period.

   Productivity growth is not a smooth process. In the recent time period, 1995 to 2005, when average productivity growth has been high, there are short periods of time where productivity growth appears to slow sharply or accelerate rapidly. Such changes in productivity growth are not uncommon. In addition, productivity sometimes grows faster than compensation, while sometimes compensation grows faster. Such short-term divergence in growth rates follows regular patterns and has been repeated many times. At times when productivity growth is particularly high, compensation growth tends to lag behind for a period of time before catching back up.

   Why does compensation tend to lag behind productivity growth? When productivity growth is high, economic growth can happen without substantial employment growth. In other words, as productivity grows, businesses are able to expand output in response to increased demand without hiring more workers; the efficiency gains imply that each individual worker produces more output in the same amount of time. As the economy continues to expand, businesses once again begin to hire new employees, and the increased demand for workers begins to push up wages and compensation. Increased demand for workers leads to a period in which compensation growth exceeds productivity growth, and the two variables then converge for a while.

   When productivity grows faster than compensation, businesses profits tend to rise because the value of the goods and services they sell rises faster than their payroll costs. As a result, profits tend to rise during periods of rapid productivity growth. As tight labor markets bid up employee compensation, the increase in labor costs cuts into profits, and profits return to normal levels. In this process, profits vary more dramatically than employee compensation, falling much more sharply during recessions and then growing much more quickly in the early parts of the recovery. Because profits represent returns to earlier investments, very high profits in some years may not represent unusually large returns on investment because they may be offset by years of losses or unusually small profits.