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Economics/Productivity effect on prices for less productive sectors

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Question
Hello once more Eklimur Raza,

I have a new question for which I´d appreciate some insights.

I understand that, for a particular country, as economy grows and people enjoy greater productivity, salaries tend to increase, hence labor costs tend to increase also. Some sectors of the economy, particularly non tradable (like some services) don´t usually follow these productivity increases. However, the HBS effect should ensure that prices for those services increase, in order to pay for these increased costs of labor. Please correct me if I'm wrong until now.

I believe that some sectors of economy, while tradable, particularly technological intense products/services, tend to enjoy greater productivity improvements and human innovation here has no limits. However, what should happen to some sectors that may not follow such overall productivity improvements. For instance (and I don´t know if it is or not the case), agricultural, farming and food producing sectors, at least not very industrialized ones: as labor costs increase due to increased overall productivity for a country, should the price of food tend to increase, has it happens to some non tradable sectors, in accordance to the HBS theory?

Hope I have been clear enough in order for you to understand my question and I thank you in advance for reading.

Best Regards,
Luís

Answer
Hi Luis,

Thank you for posing a very interesting question. First, I beg my apology for being a trifle late in responding to your question as I was quite busy. Second, before I would make an attempt at answering your question, I would rather be very sure that I understand your question full well. As such, I would like to paraphrase your question under the first heading in the following lines of logical reasoning before I get down to answering your question. Third, as far as I understand your reasoning in questioning proceeds quite logically but only needed to be slightly differently worded for placement into the appropriate grove for proper answering, I put forward my answer in the hope that your query would be dealt with in right earnest. Fourth, should you still require further clarification, we may take that up subsequently. So my answer to your question is placed under the following head.  

A: YOUR QUESTION HAS FOUR PARTS

1.   As an economy grows, productivity grows. [Geometrically, this may be viewed as an upward shift of the production-possibility curve.] The growth in productivity causes prices for the services involved in production to increase. This increase in “factor rewards,” also includes “rewards of the factor labor,” which may be termed “wages/salaries.” Thus wages increase. The increase in wages, which means increase in cost of [one or the other or of all] of the factors of production, leads to a rise in labor costs.  

2.   Productivity grows, sometimes even exponentially, through human innovation in the high-tech tradable-goods sector. As a result, wages together with other factor costs increase simultaneously and rapidly in the tradable-goods sector.

3.   Productivity may not grow as rapidly in some low-tech sectors –such as agriculture and farming sectors –compared to that in the high-tech sector. As productivity grows rather sluggishly in such low-tech sector, rewards to factors of production in such sector also grow rather slowly. This means wages/salaries in the low-tech sector are likely to grow only slowly.

4.   Should the price of the products of those low-tech sectors go up, as it does in the high-tech tradable sectors, in accordance with the HBS theory?

B: DOES THE ARGUMENT ENUMERATED IN (4) UNDER HEADING (A) ABOVE HOLD WATER?

Let us get at the answer systematically on the basis of the above strands of reasoning.
First, the reasoning (1) doesn’t necessarily mean costs of production of all the output will go up owing to rise in productivity. Take the case of computer. There was a time computer, in the wake of its introduction to the world through Charles Babbage and Harvard University, made its debut with gigantic machines and elementary programming methods. Over time this made tremendous strides in the information technology. Together with productivity being on the upgrade, cost of production went sliding down, even though labour cost was going up, which was a blessing to mankind from technology. As early as a couple of decades back, a computer would cost roughly $5,000, and the programming, as well as usage, was extremely difficult for the ordinary people. As bulbs gave way to circuits, as silicon dioxide became an abundantly available raw material, cost went further tumbling down. Now it is within reach of almost everybody, at a fraction of a price, but with more sophistication, better resolution, divergent features, etc. The automobile industry, right from Henry Ford’s mass production, has also registered similar, though not that spectacular, fall in cost of production.

Examples may be multiplied. Look at textile. What happened in Lancashire in Britain, or Calcutta in India, textile production was very costly and very few poor people could afford good clothes because of high prices relative to their earnings resulting from high cost of production under outmoded technology. Just enjoy the beautiful French movie of Hugo’s “Les Miserables” or almost equally beautiful English movie of Charles Dickens’s “Great Expectations.” What you see in those countries which are today the economic giants? Most people had tattered, torn, dirty clothes, which is unimaginable in those societies, unless people choose to do so by boozing along. Why do we see clothes are no problem at all in Canadian and American societies? Again, this is because these are too affordable? Why affordable? For production costs, owing to improvement in productivity, have plummeted. Yet, thanks to spurts in living standards, wages have increased. Hence labour cost has gone up. What does that mean? Labour cost is only a part of the total cost, both variable and fixed costs.

This tells us that, as economy grows through higher productivity made available by technological improvements, wages go up but average cost of production goes down. You may visualize it as a U-shapes AC curve in an oligopolistic or imperfectly competitive market such as in the U.S. or in Canada. In fact, for large industries such as in the automobile or computer industries, AC curve is almost J-shaped, with tail slightly slanting downward. That signifies the blessings of technology.

Now the corollary kicks in. What happens to price? Yes, price indeed goes up. Yet, not all prices go up at equal pace, some prices soaring very high, some rising sluggishly, and some may even going down (especially in the most high-tech sectors). That is another reason economists don’t say inflation means prices of everything going up, rather inflation means there is a consistent upward “trend” in general price level. When general price level goes up, wages in almost all sectors naturally go up, especially in the advanced countries to make peoples’ living standards indexed to costs of living.

Second, as for our reasoning (2), it is true that productivity grows exponentially through human innovation in the high-tech tradable-goods sector. The primary reason is the outcome of diversification, division of labour, gains from trade to both the exporters and the importers. Yet countries with advantage in finished products gain more, and retailers even more. Hence poor Egyptian cotton farmers or poor Pakistani cotton farmers don’t gain as much as garments manufactures in India or in China, but the maximum gains come to Wall-mart, Macy, Woolworth, etc. What we find is that there is rise in wages in the tradable-goods sector. Yet you may observe that wages lag far behind prices. Wages are not going that much high up. A guy in Starbucks or a teller behind Bank of America desk is not earning as much as there have been rises in prices of Cappuccinos or in costs of mortgages or credits. So wages are a factor but not the main factor in the cause for rise in prices.

Third, we now bring our attention to the crux of the problem. As stated in (3) under (A) above, productivity may not grow as rapidly in some low-tech sectors –such as agriculture and farming sectors –compared to that in the high-tech sector. You may get a very good handle of the raison d’être of rather sluggishly productivity growth in low-tech sectors if you quickly glance through the different industry structures in any microeconomic textbook. You know that a firm under perfect competition cannot make economic profit (but makes only normal profit) under perfect competition, and a firm under oligopoly or a monopoly firm does make supernormal profit. As you also know, low-tech sectors such as agriculture and farming are more in the scale towards perfect competition (large number of producers and consumers with perfect knowledge and no influence on prices) than in the scale towards oligopoly or monopoly (few or one producer with buyers having imperfect knowledge). Naturally, wages in such low-tech sectors (with large number of semi- or unskilled workers) are likely to be low relative to that in high-tech sectors (with few experienced and technical hands). And so, rewards to factors of production in such sector also grow rather slowly as such sectors don’t grow as rapidly as the high-tech sectors. This means wages/salaries in the low-tech sector are likely to grow only slowly.

Finally, we now zero in on your main question: Should, in accordance with the HBS theory, the price in the low-tech agricultural or farming sectors go up in tandem with the price of the products of those high-tech tradable-goods sectors. The answer is yes, and no. Yes, to a certain extent. No, mainly. Why?

The main reason is that the cost of production in the low-tech sector also has a “spillover” downward trend, though only to a limited extent, because of the advancement in the high-tech sectors. Isn’t it Indian or Egyptian farmers are experiencing higher productivity and lowered costs because of switching from bullock-driven mechanical ploughs to modern tractors, from reliance on vagaries of rain to controllable water flow through modern irrigation, from use of a stinted supply of cow-dung and home-grown compost to a copious supply of fertilizers? Even labour cost is also falling because of switching from using hoes, manual thrashing, etc., to modern rice mills. Same is the case, say in Alabama or in Idaho or in Florida, when modern machinery give rise to use of less time and labour. Yet the Alabama cotton farmers need subsidy from the government to compete with Egypt or Pakistan. And certainly a guy tending orange trees in Florida, working on producing cotton in Alabama or carting potatoes in Idaho doesn’t earn as much as a guy putting nuts and bolts in a Detroit factory. In general, we say, labour cost is relatively low in the low-tech industries, even though growing in fits and spurts because of derived aforesaid blessings. Referring directly to your question, prices of food therefore has a very limited range of increments.

On top of that, the low-tech sectors are quite disadvantaged for two reasons. First, as you know it is the case with perfect or near-perfect competition, a firm is saddled with the spectre of what we call “infinitely [or, at least, highly] elastic demand.” Secondly, owing to the perishable characteristics, the tradability is also very constrained. All these factors go to crimp any tendency to rise in price. So prices are not likely to rise as much as it does in the products of the high-tech sectors.

Let us not forget that rewards for services in the low-cost sector don’t undergo as rapid a rise as that in high-tech sector. Yet services in high-tech sector are today fraught with too much of uncertainties which put a damper on rise in labour cost. By the way, service sector outstrips manufacturing sector in advanced countries, but service sector has strong bearing on manufacturing sector. The HBS theory is still in the process of development in view of the changing global landscape.   

C: CONCLUSION
HBS theory goes to explain, but not exactly in detail, about these proportions. This is a vast field requiring mathematical manipulations, but not difficult mathematical concepts, and I believe you will be able to get a good grasp of it with the help of the search engine. If you have any specific question then, please don’t hesitate to write back to me. The main theme in nonmathematical and simple terms is what I have tried to make clear to you. My opinion is that, despite labour costs going up while other costs might be going down, there need not be any tendency for the prices of foodstuffs to go up at par with the prices of commodities in the non-tradable sector. Yet prices in general may go up, together with increases in labour costs (wages) triggering multiplier propagation through income effect, as productivity increases through technological improvement and globalization.
Best of luck, Luis.  

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Eklimur Raza

Expertise

It appears some students in this website are confused about elasticity of demand and the slope of the demand curve when they are trying to figure out why rectangular hyperbola comes up in case of unitary demand curve. First, they don't know that RH can be depicted in a positive quadrant of price,quantity plane. Secondly, they make the mistake that the slope of RH is constant at -1. Two points could help them: first, e=1 at each and every point of the RH, because the tangent at any point shows lower segment=upper segment (another geometric definition of e); yet slopes at different points,dQ/dP, are different; second, e is not slope but [(Slope)(P/Q)]in absolute terms. Caveat: only if we measure (log P) along the horizontal axis and (log Q) up the vertical axis, can we then say slope equals elasticity --in which case RH on P,Q plane is transformed into a straight-line demand curve [with slope= -tan 45 deg] on (log Q),(logP) plane, and e= -d(log Q)/d(log P). [By the way, logs are not used in college textbooks --although that is helpful in econometric estimation of elasticity viewed as an exponent of P, when demand equation is transformed into log-linear form.] I have not found the geometrical explanation I have given in any textbook followed in undergraduate and college classes in Canada (including the book followed in a university where I taught for a short time and in the book followed in George Brown College, Toronto, where I teach.

Experience

About 11 years' teaching economics and business studies, and also English, history and elementary French.Practical experience in a development bank, working with international donor agencies like the World Bank and the ADB. Experience in free-lance journalism, including Canada's "National Post."

Organizations
I teach micro- and macroeconomics at George Brown College (continuing education), Toronto, ON, Canada.

Publications
Many articles and editorials, on different subjects, in English newspapers. Recently an applied Major Research Paper, based on a synthesis of the Solow growth model and the Lewis two-sector model, has be accepted by Ryerson University, Toronto. Professors Thomas Barbiero and Eric Cam, Ryerson University, accepted the paper.

Education/Credentials
Master degree in Interantional Economics and Finance and diploma with honours in Business Administration from Canada.

Awards and Honors
Received First Prize in an inter-university Literary Contest.

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