Productivity is a measure of economic efficiency that shows how effectively economic inputs are converted into output. Productivity is measured by comparing the amount of goods and services produced with the inputs which were used in production. Labor productivity is the ratio of output of goods and services to the labor hours devoted to the production of that output. In other words, productivity measures the output per man hour, or the output generated by one hour of labor. This is labor productivity. Output per hour of all persons is the most commonly used productivity measure. Labor is an easily identified input to virtually every production process.

In terms of costs, it represents about two-thirds of the value produced. Business sector output is based on GDP, but also includes a subset of the goods and services included in GDP. The business sector comprises about 80% of the GDP, since it must exclude those portions of the economy for which productivity measures cannot be constructed. General government, the output of employees of non-profit institutions, private households, and the rental value of owner-occupied real estate are excluded. The primary source of hours and employment data comes from the Bureau of Labor Statistics which provides data on total employment and average weekly hours of production and non-supervisory workers in non-agricultural establishments.

Unit labor costs are calculated by dividing total labor compensation by real output, or equivalently, by dividing hourly compensation by productivity. That is, unit labor cost is equal to total labor compensation divided by output. Compensation is a measure of the cost to the employer of securing the services of labor. It includes wages and salaries and such things as bonus and incentive payments and employer contributions to employer benefit plans.

Real output is the total output of the economy after inflation, as mentioned above. Productivity growth, which is a main determinant of economic growth, depends on the economic times. For instance, in the 1970s when inflation was rising from 2-3% to 15%, productivity growth was very low (between 0-1%). However, in the 1980s after inflation started to decline from 15% to close to 2-3%, productivity growth steadily rose. In the manufacturing sector in the 1990s, it was not unusual to find productivity growth around 5-6%. Such strong productivity growth was the main reason why in the 1980s and 1990s the U.S. achieved such high levels of wealth and prosperity.

Growth in productivity is one of the most important indicators providing information on the health of the economy. Let's see why this indicator is important. Let's say you are the only producer of a widget in a country that does not have competitors for your product. It takes an entire day to produce one widget and you sell it for $50 at the end of the day. Your income is therefore $50 per day. Then, because of some technology that you have learned to apply to the process of building widgets, you improve the output per day from one widget to two widgets. Since you are the only producer, your income has increased to $100 per day. In other words, as you doubled your productivity, your income has also increased by the same amount.

Growth in productivity is closely related to growth in income. A country cannot hope to grow faster, or a person cannot become wealthier, if productivity does not increase accordingly.

Productivity also has an important impact on profitability. In order to increase profitability, corporations have to absorb increases in wages in raw material costs and other costs. Let's say that productivity increases by 4% and all these other costs also increase by 4%. The impact on profits after productivity is taken into account is zero. In other words, costs have not increased because the improvement in productivity has absorbed their impact. Productivity is a major determinant to economic growth. As productivity slows down, the economy will eventually slow down because income, which depends on productivity, slows down. As income slows downs, sales slow down and the whole economy suffers.

The first sign that the economy is improving is when productivity increases. The increase in productivity suggests income and profitability are also going to increase. As a result, the whole economy will benefit. Data on productivity are released by the Bureau of Labor Statistics.

Trends in corporate profits are also an indicator of economic health and future economic activity. The reason is that as corporations’ profits increase, business is likely to increase investments to expand capacity, buy new machinery, and hire more employees. Another important indicator of corporate profits is earnings per share of the S&P 500 corporations. Earning per share information is available weekly in Barron's.

Periods of low inflation have usually been associated with strong productivity growth. Periods of rising inflation have been associated with periods of slower productivity growth. The importance of strong and rising productivity growth is in the fact that business is capable of absorbing higher wages without impacting profitability. The problem with lower productivity growth is that business will not be able to absorb increased costs, and therefore, will experience downward pressure and profitability. The only line of action is to cut employment, cut costs, and cause a slowdown in the economy. For this reason, maintaining strong productivity growth is one of the paramount objectives of policy makers.

(From Chapter 2 of my book Profiting in Bull or Bear Markets. Published also in Mandarin and on sale in China).

George Dagnino, PhD Editor,
The Peter Dag Portfolio.
Since 1977
2009 Market Timer of the Year by Timer Digest
Portfolio manager

Disclaimer.The content on this site is provided as general information only and should not be taken as investment advice nor is it a recommendation to buy or sell any financial instrument. Actions you undertake as a consequence of any analysis, opinion or advertisement on this site are your sole responsibility.

Shouldn't you too subscribe to The Peter Dag Portfolio?

No comments: