Unit Labour Cost

I have become interested in Unit Labour Cost through reading some of the twaddle which is coming out of the ECB. Unit Labour Cost (ULC) is a major justification for the austerity agenda, because it is held that it is a reasonable measure of "competitiveness", not just at the level of particular firms competing in the same industry; but at the level of countries. The idea is that labour costs per unit of output are a factor in the price of goods; the price of goods is the measure of competitiveness; competitive goods sell better than uncompetitive ones; and therefore lowering the ULC will result in higher exports for any given country and therefore will lead to better economic growth.

This is akin to the fallacy of composition which is also seen in equating the behaviour of economies with the behaviour of households. I do not think it holds any better, and so far as I have read there is very little empirical evidence to support that view: but that never bothers the ECB (or its associated institutions, like the IMF). They just "know".

Even if we accept that this is a reasonable thing to do (which I don't) it is quite important to look at how the measure is calculated, to see if it does what it says on the tin. So I was quite interested to see this:

www.oecd.org/std/productivity-stats/37664867.pdf

What this explains is why the OECD, in calculating ULC, chooses to leave out 5-10% of the economy when calculating the figure. Well, I say "explains", but it does nothing of the sort, as it happens. It just looks like fiddling, to me.

When they calculate the ULC, they are calculating the share of the national economy which goes to labour. To quote the definition from the OECD website


If you are a firm making pencils that is something you would want to know and it is perfectly possible to find it out: it is not even difficult. As we saw in another thread, you relate the wage bill to the number of pencils produced and that tells you how much it costs in pay to produce a pencil. So if firm A has one worker and he produces 100 pencils in an hour for a wage of £5 an hour the ULC of that firm's pencils is 5p an hour. In firm B that same worker produces 50 pencils in an hour for a wage of £5 an hour so the ULC here is 10p per pencil. And so firm B is in trouble, according to this measure and needs to do something about it.

What it does about it is not a simple question, however. It depends on what makes the difference. If Firm A invested in a better pencil making machine the answer does not lie in cutting wages, clearly(well, I say "clearly" but it is not apparently clear to everyone); if Firm B makes significantly better pencils and they sell to a premium market which is stable or growing then Firm B is not in trouble at all, clearly (again, I say "clearly" but that is not clear to everyone either, though it seems they have recently stumbled upon this and are quite excited about it).

In short you can use this as a measure of competitiveness only for two firms making exactly the same product; and even then you cannot ignore investment decisions as a reduction in short term profit to buy a better machine might well be the answer. That is useful at the level of two firms in direct competition to sell the same goods: but it has little to do with what happens at what they are pleased to call the "sector" level (for not all pencils are the same) and it is nothing at all to do with what happens at the level of countries, where such comparisons are quite literally foolish.

http://unstats.un.org/unsd/nationalaccount/docs/1993sna.pdf

It has taken me some time and some reading to get to grips with the concept of ULC as it applies to countries. It is becoming a familiar experience to start reading about some of this stuff and to have the thought: it can't be a stupid as that. And maybe it isn't. If it isn't then perhaps someone can show me where I have gone wrong.

As noted above the ULC of a firm which produces medium sized dry goods is a fairly simple calculation and it does have some obvious use. It is not a measure of competitiveness even there, but it does have a nodding acquaintance with it. Economists seem to think that is enough and they blithely say certeris paribus and move swiftly on as if that made sense. Business men do not say that: if they make and sell better pencils at a higher price and at higher cost they know that not all else is equal and they are not so foolish as to pretend that it is.

At the level of business, if two firms are producing the same thing on the same machine with the same costs of transportation and energy etc then the ULC might indeed reflect something we might call competitiveness. Assuming, always, that the profit is fixed.

That is seldom discussed, but it is important: because the ULC will be higher if wages are higher for the same output and the price remains the same. Which obviously means that the profit will be lower; but the "competitiveness" will be unaffected. I do not see why that is considered a bad thing, personally: because it is just the same as lowering wages, and that is considered to be good. You need some fancy footwork to make a case for this different attitude, thought it can be done, sort of. Since it is pretty much unconvincing it is normally not addressed. Fact remains that you have to assume the same profit before you can relate UCL to competivenss: and that is a political as well as a practical decision. It also depends on how price is determined. That is a curious field which is beyond the scope of this post but I will just note that the outcome is very different depending on which part of the forest you happen to be in. If you think that price is determined by a fixed mark up on cost then higher wages will indeed push it up, by definition. If, on the other hand, you think that price is determined by a desire to put goods on the market at the lowest possible price commensurate with a thriving business ( ie, in response to the much vaunted benefit of keen competition), that does not follow. It depends on how much profit you think is necessary to that end. And of course that decision is not made by the employees. It is made by the person who gets the profit.

That problem is writ large when you come to look at the country level. For this simple reason, already touched on. There are no pencils.

In face of that fact the country UCL is derived from a sum which is like this:

Total Labour Costs/ GDP


You see the immediate problem when you remember that GDP is measured in one of two ways: it is the monetary value of all spending or the monetary value of all consumption in a country. So it includes the wages which are the numerator

Simply put it is of the form

P/ P+Y


That is not a measure of competitiveness in any sense at all. It is a measure of the share of national wealth which labour gets. And that is all it is.

Edited by FionaK - 28/7/2013, 11:47