Thursday, 26 September 2013

Dynamic efficiency of pre-distribution

Andrea Vance reckons that David Cunliffe's team will be working up some pre-distribution policies, an idea that has reached these shores from Yale via the Policy Network and the UK labour party.

The main objective of pre-distribution is to increase disposable income for the least well-off, leaving less "work" for the welfare system to do. Unless you can find price cuts for essential stuff, that basically means higher wages.

I agree with Neil O'Brien that pre-distribution is an interesting idea but will be hard to do in practice. Certainly its very easy to scoff at proposals to put a floor under wages, even if they are now supported by a former employers' advocate. We all know the drill: higher wages result in lower levels of employment, which is bad for those that lose work but good for those who get higher wages. For workers in aggregate, that could be a good or bad thing, depending on the shape of labour demand curves. More on this below.

Meantime, what about the firms? The interesting firms are those that shed labour in response to higher wages. Put yourself in the position of a savvy business owner who is laying off staff in response to the wage increase. That is not the end of the story. You also need to adjust to doing business with less labour, which gives you two basic options: invest or shrink.

If business is good, you would presumably want to maintain output with less labour. That requires investment in new capacity to replace the sacked workers, such as automation or streamlined processes. That investment raises the productivity of the remaining workforce, helping justify higher wages and making them more affordable.

Alternatively, if business is bad you might reduce output. Get started on that first long, looping circle around the drain.  

Net result: good firms get better and bad ones head for the exits. It sounds like the kind of thing that might finally kill off some hopeless firms, or shock them into improvement. Either way, it qualitatively improves the stock of firms in the economy. That looks like a dynamic efficiency benefit to me. Higher costs do impose a productive efficiency loss, but there is at least an open question as to whether they might be outweighed by the dynamic efficiency gains.

That doesn't mean wage hikes are a free hit. Even if you agree with my analysis of the effect on firms (and I'm keen to hear other views), its obvious that you could take wage increases too far, driving lots of perfectly sound firms out of business.

Where is the sweet spot? Not sure, but here are a couple of ideas. One option is to use the impact on aggregate wages as the guide: increase wages provided that those remaining in work get enough extra wages to fully compensate for the wages of the newly unemployed. Another is to do the same thing from the perspective of the government's tax & welfare accounts.

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