Questions Series - Why productivity improvements aren't deflationary

Starting today I'm going to be using my Sunday articles to respond to comments from readers. I am always interested in the thoughts and questions of others, and will try my best to help generate a greater understanding of what is happening.

Today, I'm writing a more extensive response to a question e-mailed from Marty Carbone. He and I have had a few good discussions about various economic situations and last week he asked the question:

If national productivity increases, that will theoretically produce deflation in direct proportion to the increase in productivity (all other things being equal). That would theoretically increase our standard of living proportionally. It seems obvious that has not happened since 1900 -- why?

The question is not one an ardent capitalist would envision because of how they view the interrelation between labor and management, but it is understandable at some levels. And in theory the question is correct. Productivity increases do reduce the cost of production for goods, so if companies were willing to allow their profit amounts to remain static, over time prices would drop along with the reduction in costs.

That at least is a theory, but reality tends to work differently.

The best way to describe how it works is to note that most economists see wages and prices as "downward sticky". Its not all that difficult to raise prices or wages if there is pressure to do so, but reducting either occurs only under some duress. Prices usually only drop if there is competitive pressures or a recession, so while the increased productivity reduces the cost of producing the products, it does not generate a reduction in prices. Instead companies turn the increased profits into new advances and hire additional workers. This adds spending power into the economy (as the new workers are paid by the companies), and over time actually produces an inflationary effect as more money is available to be spent on goods.

In fact, Warner Brothers produced a cartoon that explains the way most businesses used to view productivity increases. The cartoon is "Yankee Dood It" and at 5:00 in an elf that looks much like Elmer Fudd takes about 90 seconds to explain to an old shoemaker how and why he needs to upgrade equipment and move his production forward. Sadly, some of this short lecture is no longer true due to government interference in markets as the payment of dividends to investors is no longer common. Instead companies work to increase their market valuation and stock holders look to see their portfolio values increase, rather than holding stocks for the dividend payments. However, that argument belongs in an article all its own.

The better way to look at the deflationary expectations arising from improving productivity is actually to see it as an anti-inflationary effect. The automobile market is a great example because its one area where the effect has been noticeable. Cars today are still expensive, but if you compare a 1980 car price to today, the increases have not matched inflation. Also, a car of today has more features, better safety, and much more advanced technology than one from even 10 years ago. All of this is a product of the productivity increases being flowed back into the production cycle and into the automobiles themselves. The companies don't reduce the price on a product, but instead look for ways to advance into new markets thanks to the increased productivity.

This strikes out at Marty's response to my explanation. He noted that

I can see your point -- the productivity increase turns up as profits and the owners do what owners do -- they keep the profits.

One could say this is directly in line with Henry George who argued effectively that all profits wind up going to the landowner as opposed to the worker -- simply because the landowner can always increase rents to absorb any increase in productivity by the tenant farmer.

I think the cartoon shows that at least in the past, most business/economic scholars did not agree with Henry George's argument. Yes, the landowner does see increased profits as workers improve productivity, but there are also massive pressures on the owners to justly compensate workers for their efforts in today's markets. We no longer live in the age of tenant farmers, where the ability of workers to move in search of new and better jobs was greatly limited by technology and politics. Today a worker who feels that the local job market is not willing to pay him fairly for his efforts is not prevented from moving long distances in search of better paying employers. This forces companies to pay closer attention to how well they pay workers. If they fail to recognize the most productive of their workers, they could lose them to other companies. No company wants to see its profits walk away, so a truly productive worker usually finds that their wages increase when they prove their worth to the company.

I would never say that the majority of CEOs are the best of people, nor that companies do not seek every possible penny of profit they can squeeze out of markets and workers, sometimes causing long-term pain in the search of a short-term gain. They do even when it's clear they should not be conducting themselves in such a manner. However, in the productivity arena, companies do work within market constraints that limit their ability to push prices freely without open collusion or manipulation.