Monday, November 25, 2013

The Reality of the ‘Real Wage’

Calculating trends in the real wage is much harder than we realize, because every household has different tastes. Such an exercise is misleading at best and meaningless at worst.

Economists often debate the implications of trends in the “median real wage.” There is no such thing. We have statistics on the hourly wages of workers, and we can compare the median in 1970 to the median in 2012. However, that only gives us the median nominal wage, not adjusted for inflation. To convert a nominal wage to a real wage, we need to apply a cost-of-living adjustment. A cost-of-living adjustment in turn is based on computing quality adjustments and price changes for a given market basket of goods and services. The problem is that every household has different tastes, and this means that there is no such thing as the cost of living.

In recent decades, the relative prices of goods and services have diverged sharply. In the United States, the share of disposable income that we spend on food and manufactured goods has gone down, while the share that we devote to education and health care has gone up. The share of income spent on another service, housing, depends a great deal on where one chooses to live.

The hours of work at the median wage required to purchase basic household appliances had declined by over 80 percent between 1958 and 2012.

The divergence between the costs of different consumption items was illustrated in an article by Chris Conover last December. Conover cited figures compiled by American Enterprise Institute scholar Mark Perry showing that the hours of work at the median wage required to purchase basic household appliances had declined by over 80 percent between 1958 and 2012. In contrast, average health care spending per capita relative to the median wage had more than quadrupled over that same period.

However, this comparison does not mean that the cost of health care has quadrupled since 1958. My guess is that if you could find a health insurance policy today that only covered diagnostic procedures and treatments that were available in 1958, the cost of that policy would not be much higher than it was then. Much of the additional spending goes for MRIs and other advanced medical equipment, as well as for health care professionals with more extensive specialization and training than what was available 50 years ago.

It is debatable whether the value of health care, in terms of medical outcomes, has gone up sufficiently to justify the sharp rise in expense, or whether instead we undertake many medical procedures that are not cost-effective, particularly in the last year of life. It is also debatable whether our “taste” for using health care services would be as strong if we were paying more out of pocket, rather than having 90 percent of our medical spending covered by either government or private health insurance. In any case, if health care spending is up because we have acquired a “taste” for advanced medical equipment, new medicines, and new medical specialties, then we have to be careful about making statements about how the cost of living has changed over the last half century.

Another major expenditure component in which costs have risen sharply with even less apparent improvement in outcomes is schooling. From preschool through college, parents and taxpayers have suffered sticker shock over the past 50 years. However, studies often show that, holding constant the caliber of the entering students, schools make very little difference in terms of outcomes. For example, economists Stacy Dale and Alan B. Krueger found that although students who attend highly selective colleges earn a substantial wage premium compared to students who attend lesser colleges, this premium disappears once one controls for the ability of the students when they applied to college.

What this suggests is that for middle- and upper-income parents, it is a matter of taste if one chooses to spend a substantial sum to send a child to an elite preschool, or to live in a neighborhood with an elite public school, or to send a child to an elite college. Given the child's ability, such schooling decisions make relatively little difference at the margin.

These issues also affect international comparisons. For example, development economist Dani Rodrik recently pointed out that the share of manufacturing employment in China, Brazil, and India appears to have peaked. He notes that this peak has occurred before average wages in those countries reached the levels that were achieved in more advanced countries when the early industrializers reached their peak share of manufacturing employment. Rodrik wrote:

When the US, Britain, Germany, and Sweden began to deindustrialize, their per capita incomes had reached $9,000-11,000 (at 1990 prices). In developing countries, by contrast, manufacturing has begun to shrink while per capita incomes have been a fraction of that level: Brazil’s deindustrialization began at $5,000, China’s at $3,000, and India’s at $2,000.

Rodrik considers this to be an alarming sign that China, Brazil, and India are going to fall short of the growth needed to achieve affluence. However, if we expect people in other countries to follow our exact path of industrialization, then we should hold our breath waiting for their consumers to load up on analog televisions, record players, amplifiers, speakers, typewriters, and Ford Pintos.

The fact is that since the United States and Western Europe industrialized, productivity has increased and quality has improved in manufacturing. It is possible that China, Brazil, and India can achieve affluence without ever devoting as much of their labor force to manufacturing as we once did. Instead, their further development may be focused on the service sector. If so, that will be a matter of taste.

Economists and pundits are fond of making claims about trends in real wages and what they mean. However, we cannot make a statement about the purchasing power of earnings without implicitly assuming a particular pattern of household tastes. Yet tastes do not remain constant in a world of technological and cultural change.

As a result, calculating trends in the real wage is much harder than we realize. Without being explicit about it, we are lumping together in terms of “real income”: somebody who prefers living in Manhattan with someone who prefers living in the Midwest; someone for whom an Ivy League education for their children is a must with someone for whom it is not; someone who could get along with the medical state of the art in 1958 with someone who could not; or people whose countries are industrializing in a world of cell phones with people living in countries that industrialized decades earlier. Such an exercise can be misleading at best and meaningless at worst.

Source: American

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