Chart of the WeekWhen it Comes to Services vs. Manufacturing, Words Matter

By Reda Cherif and Fuad Hasanov Efforts to revive national manufacturing sectors get a lot of airtime. After all, the sector propelled many East and South East Asian economies—the so-called “East Asia Miracle”—and was a gateway to the middle class for millions of workers. However, for all the obsession with manufacturing, economists for their part […]

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The Economic Way of Travel

Thinking like an economist about travel.

Here’s what happened yesterday. A good friend called me and asked me for advice. I often hesitate to give advice but I don’t hesitate to ask lots of questions. At the end, usually the person can figure it out for himself or come close with a little intellectual nudging.

He’s a fellow academic and I don’t want to reveal his identity so I’ll call him Fred. Fred took Amtrak last week from California to his boyhood home in the East for Christmas. He found that he got a lot of work done on a paper he’s working on: at least 3 hours a day of intense uninterrupted work over a 2.5 day trip.

He’s trying to decide whether to come back to California by train or fly. We talked through COVID-19 risks first and he’s convinced that they’re comparable. (When he took the train, it was 40% full and he had his own compartment. That tilts in favor of the train, but the train takes about 9 times as long as the airplane, which tilts in favor of the airplane.) I had no expertise on those risks and so I didn’t offer any. The point is that he was convinced that the risks are roughly equal and I had no basis for contradicting that.

The next question I asked Fred is whether if he got back to California early (by taking the plane) he could work at least 3 hours a day at home. He said he probably couldn’t work nearly as effectively because the absence of distractions on the train was something he couldn’t easily replicate where he lives.

In short, he would be more productive if he took the train.

I then asked whether getting the work done on the train on the way back to California creates some momentum in his work that helps him when he gets home. He said it does.

There was one main issue left: relative fares. The one way airfare is about $500 and the Amtrak fare is a whopping $1,300.

“$1,300 is a lot of money,” he said.

I replied that the relevant number was not $1,300 but $800 because that’s the increment in outlay from taking the train. He got the point immediately and then said, “See? That’s why I like talking to you. You give me clarity.”

“Moreover,” I said, “maybe you could deduct the train fare. Are you visiting fellow academics back there? If not, make sure you do. Take one or a few for coffee to talk about your work, and socially distance. If you can justify deducting the fare, the real difference in monetary cost to you is (1- t)* $800, where t is your marginal tax rate. I happen to know that your marginal tax rate on your Schedule C income is about 40%. So the real difference in cost is $480. I know your net worth quite well and you can easily afford this. But even if you can’t deduct, $800 is not a large number for you relative to your net worth. Is your added productivity worth at least $800?”

He decided to take the train.

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More Capital Per Worker Makes Workers More Productive

 

In a recent blog post, I wrote:

Aside for non-economists: Why would reductions in income tax rates on corporations and on high-income individuals even be expected, at a theoretical level, to increase real wages? By increasing the incentive to invest in capital. The greater the capital to labor ratio, the higher are real wages.

Commenter Robert asked:

Could someone expand on this a bit for me? Does investing in capital, mean investing in capital goods (i.e., land, machinery, tools, etc)? I don’t understand why that would necessarily lead to higher real wages.

Commenter Laron gave a nice succinct answer:

The capital goods like machinery increase labor’s productivity, which increases wages. Others can chime in with more detail or to correct me tho.

Here’s what the article on “Capital Gains Taxes” in The Concise Encyclopedia of Economics says about the issue:

Between 1900 and 2000, real wages in the United States quintupled from around fifteen cents an hour (worth three dollars in 2000 dollars) to more than fifteen dollars an hour. In other words, a worker in 2000 earned as much, adjusted for inflation, in twelve minutes as a worker in 1900 earned in an hour. That surge in the living standard of the American worker is explained, in part, by the increase in capital over that period. The main reason U.S. farmers and manufacturing workers are more productive, and their real wages higher, than those of most other industrial nations is that America has one of the highest ratios of capital to worker in the world. Even Americans working in the service sector are highly paid relative to workers in other nations as a result of the capital they work with. In their textbook, Nobel laureate Paul Samuelson and William D. Nordhaus noted: “Because each worker has more capital to work with, his or her marginal product rises. Therefore, the competitive real wage rises as workers become worth more to capitalists and meet with spirited bidding up of their market wage rates.” The capital-to-labor ratio explains roughly 95 percent of the fluctuation in wages over the past forty years. When the ratio rises, wages rise; when the ratio stays constant, wages stagnate.

The quintupling in the above is certainly an underestimate because the Consumer Price Index, used to adjust for inflation, overstates inflation.

A way to think about it is with a person on a desert island catching fish. If he does it with his bare hands, he can catch, say 2 fish a day, enough to keep from starving. But if he fashions a stick that can spear the fish, he can catch, say 4 fish a day. So that one piece of capital, the spear, has doubled his productivity. His real wage has doubled.

Then Robert followed up:

Thanks Laron. That was kind of what I was assuming was meant in the quote. I don’t know if I fully trust a business to return higher productivity back to workers in the form of higher salaries, but I can see how and why that could happen.

Here’s why it would happen. A worker becomes more productive, not just with his current employer but also with other potential employers. So if an employer does not pay the employee an increased wage for increased productivity, another employer will offer more than the current employer. That will happen until the marginal revenue product (the marginal revenue produced by the employee’s marginal product) equals the wage.

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