Unit Labor Costs

One of the creepy things about learning economics is all the technical jargon. Diminishing marginal utility, gross private domestic investment, and the production possibilities frontier are good examples. What the hell are these things? That can be the subject of another post because today I want to focus on another term economists throw around like salmon at the Seattle Fish Market.

Today I want to discuss unit labor costs. Say that 30 times and I promise you and all those within 50 feet of you the best sleep you have had in months. It's better than a My Pillow. To make sure I don’t lose you, let’s rename it ULC. ULC rhymes with sulk but that has no consequence here. 

ULC could be the most important macroeconomic variable in town this year. So you should know her. If you saw ULC sitting alone at the end of a bar, you would ordinarily tip toe quietly in the other direction. But this year, ULC is the Queen of the Ball.

That’s quite a claim. Yet I don’t hear anyone talking about her. Before I am done with you today, I want to convince you that ULC is at the heart of many issues we discuss today – rising wages, rising prices, the next recession, and of course, the size of our new tariffs on Armagnac.

Imagine any product – let’s think about a bottle of JD. Most of the cost of producing one more bottle of JD is what you pay the employees to produce it. This includes their wages and any other earnings they might receive in the way of benefits. Logic suggests that, if everything else is the same, a rise in labor costs means the company will have to charge more for a bottle of JD. If it used to cost $10 to produce another bottle of JD and now it costs $12, then one would expect the price to reflect that cost increase. 

The labor representative will interrupt us now and point to the fact that the extra wage won't lead to a price increase because the JD workers were more productive this year. The price of a bottle of JD depends on the labor cost and the labor productivity.

For example, suppose wages go up 5% this year. Don’t we have to charge more for a bottle of Jack? Nope – it depends on how productive labor was. Suppose workers got really jacked up this year and produced 10% more bottles of Jack. That is, you got 10% more Jack for 5% more money. In that example the cost of labor in each bottle of Jack was lower! Thus they can sell the Jack at a lower price.

ULC is, therefore, a delicious macro concept that summarizes the key factors impacting the cost of goods and service:

• ULC went up – cost per unit is higher and therefore we ought to raise price (or take lower profits)  
• ULC went down – cost per unit is lower and therefore we can lower price and be more competitive (or keep prices the same and take higher profits)
• ULC did not change – cost per unit is the same. Go fishing.

So you can see that ULC is a vital part of the economy and yet most of you thought it meant Underware Latex Creep.  

Here is the most fun part. The graph at the bottom of this life-saving exercise shows you the history of changes in ULC since before Joe Biden was born. I won’t bore you millennials with all that history stuff but you can see that before 1980, ULC was quite the party animal. It was all over the place – rising by almost 13% in 1974 not long after a mere blip of 1% a few years before. Imagine if you were selling Kool-Aid in the front yard and the cost of getting your mom to make the Kool-Aid for you rose by 13% one year. If you passed that cost increase on to your customers, they might decide to go down the road to Peter's house.

Notice that since 1980, ULC became more well-behaved. It has its cycles but they are much less pronounced. The mean change of costs per unit is about 2.5%. Notice also that just about every recession —the grey bars – was preceded by a rising trend in ULC. Clearly, when costs per unit are on the rise the resulting higher prices of goods and services seems juicy – but if this keeps up the economy can no longer handle it.

This brings us to the present. The average change in ULC is remarkably less than 2.5%, and there is no discernible upward trend. After it dropped into negative territory recently, it jumped back to positive territory but there is no clear upward trend. In fact, if you look at behavior since around 2011, you might see a downward trend.

If it ordinarily takes a few years of rising ULC to cause a recession, there is little in this graph to suggest an imminent recession or slowdown in the economy. But aren’t wages beginning to rise faster? Won’t that make ULC jump and signal bad times ahead? Yes, wages might rise but remember ULC is impacted by productivity changes as well. If productivity changes as much or more than ULC – then ULC won’t change at all.

So fasten your seatbelts, kids. This is a race between wage growth and productivity. Which one are you betting on for the next few years?

Is Inflation like Cooking with Gas?

Cartoon by Jim Gibson

If you ever want to be really popular at a cocktail party or a high school swim meet, just drop the term “unit labor costs”. I jest but now I have your undivided attention at least until you get a text from your local pizza delivery service.

I would not say that unit labor costs (ULC) are the key to world peace or eternal personal salvation but I would claim that ULC is the least known and most helpful economic indicator for understanding the economy and especially what will come in the way of future inflation. Most of us are riveted now to stories about the Fed and I will not discount the fact that Fed policy is critically important to future economic growth and inflation. But let’s face facts, even if her majesty Hillary Clinton were to become the next Fed chair, we would still be stuck with ULC and she would have very little to do with that. What I show below is that sub-par inflation today is the result of two labor market factors – the rate of labor usage and wage increases. If these are temporary aberrations that disappear as we exit a very slow growth period, then we should be worried about inflation. But if longer term forces are at work in the US labor markets, then inflation could remain tame for some time despite massive monetary overhang.  

Most of us have learnt well that inflation is all about too many dollars chasing too few goods. Many of us have tattoos that say as much. Since the Fed is in charge of how many dollars rain down on the economy we usually associate inflation with Fed policy and how that policy affects our decisions to spend and/or save. The typical story is that the Fed injects money into the system, thereby reducing market interest rates, resulting in flash mobs at your local car and real estate companies.  All that new demand for goods and services, according to this tale, stimulates Charlie Sheen and others to buy stuff and this increases output, employment and prices.   It is a demand-side story and it is told over and over and over in our universities and art galleries.

I am not writing today to deny that story though if you will look at my thousands of past posts, you will find plenty of ammo that suggests some inconsistencies in that theory. But today is instead about why that story isn’t enough. It is a nice macro/market story but it doesn’t really get into the nitty gritty of price setting. Price setting is done by firms. Companies do not change their prices randomly and in the US most firms do not get a note from the government telling them what price to charge today. Clearly the demand for a company’s goods is important to the price setting decision but much also depends on internal production issues.

Economists believe that companies either seek profits or market share when it comes to pricing. When demand increases that will get their attention. But will meeting that extra demand mean a larger profit? To know if more production will generate larger profits the firm has to answer two questions – how productive is the labor input? and how much will the extra labor cost?

Unless a company has excess labor sitting around eating handfuls of chips loaded with onion dip, a sizable permanent increase in output usually entails more workers or more worker hours. Suppose there is a demand for 100 more units of chicken noodle soup. If in one company the workers are not very productive but they are expensive, that company might not make much money by meeting the extra demand. In another company the workers are highly productive but not as expensive then that company might expect higher profits from meeting the extra demand. Depending on the productivity and labor costs either company might want to raises prices to bring in even more profits – but that might come at the expense of market share.

The point is that a demand change is not sufficient to predict changes in employment, output, or price. We also need information on what is happening to productivity and compensation costs. Which gets me to today’s topic. Despite the Fed and despite record attempts at stimulating demand in this country, we have not seen much inflation. The table below helps us see why we have seen lackluster inflation and gives us some pointers when it comes to thinking about the future and what might happen to inflation once we distance ourselves from the world recession.

I compare the last five years (2007 to 2012) of recovery from the recession (first column of the table below) to a similar period in the previous five years (2002 to 2007, last column). Using two different measures of inflation (based on the GDP price deflator and the CPI) it is clear that the last five years has shown a marked decline in inflation. Inflation has been growing at a little more than half of the previous period. We see this behavior has a lot to do with ULC. ULC measures the cost-side. It tells you how much more it COSTS to produce an additional unit of output. Firms didn’t need to raise prices much in the second period because their costs per unit of output were barely rising. Whereas ULC grew at more than 8% before 2007, they grew at just a little over 1% since 2007. That  is a remarkable change in the cost of producing an additional unit of output.

The table helps us to understand why business costs have been rising so slowly. Notice that in the last five years, labor compensation rose by 11.2%. That is half the rate of the previous five years when compensation increased by 22.2% rate. Productivity, in contrast, could not keep up the former pace of almost 13% but did manage to grow by nearly 10%. The decline in productivity growth means added costs of production but this upward impact on costs was swamped by the rapid deceleration of labor compensation.

The productivity part of the story is interesting. The decline in productivity had two major sources. First, total output of firms grew by only 3.9% in the past five years – much slower than the 18.4% in the previous five years. Equally dramatic was the reduction in labor hours – which showed a decline of 5.3% in five years. Firms were using fewer labor hours in 2012 than they did in 2007. Productivity has grown recently because firms have dramatically cut back on employment and hours worked.

We summarize all this as follows:

• Inflation is lower because costs per unit of production are growing more slowly.
• Costs per unit are growing more slowly because wage and non-wage compensation have slowed and because firms have cut back on employment.

The US economy is growing and output is rising albeit at a modest pace. The usual situation is that once the economy’s growth returns to something more normal, compensation growth will accelerate and employment will expand. This natural progression implies that productivity growth will decline, ULC changes will increase, and inflation will rise. It’s like microwave popcorn. Put the bag in the microwave, set the timer to 3 minutes, remove the bag when the popping stops, open the bag and add a little salt. Then eat. It’s like cooking with gas.

But is inflation like cooking with gas? Is it going to come back when economic growth resumes? Or will longer-term factors impede the usual employment, wage, and benefits progressions? What do you think?

                              Table: Percentage Changes

      2002-2007              2007-2012

Hours                            4.5                        -5.3

Output                         18.4                         3.9

Productivity                  12.7                         9.7

Compensation/Hour      22.2                       11.2

Unit Labor Costs            8.4                          1.4

Unit Non-Labor costs   17.3                        14.8

Inflation (GDP deflator) 11.9                          6.8

Inflation (CPI)               15.2                        10.8

Sources:  http://www.bls.gov/news.release/prod2.t06.htm

ftp://ftp.bls.gov/pub/special.requests/cpi/cpiai.txt