Wednesday, August 16, 2006

Commandeering 'the profit margin puzzle'

Amendment: I've made a couple changes to this piece to correct bad terminology.

I'm stumped. Knzn points to an odd pattern occurring in the U.S.:

Labor costs have risen at an average rate of 1.5% over the past 15 years, but prices have risen at an average rate of more than 2%. That means labor is really cheap today compared to what it was 15 years ago. Why isn’t somebody hiring that cheap labor and undercutting competitors by charging lower prices (bringing down the rate of price growth, or bringing up the rate of labor cost growth by bidding more for labor)? I consider several explanations, but none seems quite satisfactory.

I came up with two explanations of my own. I don't think either of these (if they stand up) could account for huge discrepancies between the growth of labour costs and the growth of prices, but surely it's more likely that behind every .1%, a myriad of factors are working in favour of high prices over costs of input.
1. Rival acquisition and vertical integration. Consider if a firm buys out its competition and then proceeds to control everything it needs: it cultivates raw material, it handles factory production, and it finalizes its own product. Labour and capital costs could be kept down, but prices could be kept artificially high. Further, with an artificially high price of the final product, they could subsidize their own labour costs. As long as the company is self-contained through vertical integration, an increase in the price of raw materials wouldn't mean that profits are escaping to other industries. An example of this is a tire maker that cultivates rubber trees, as explained in an article from the Aug 14 WSJ (h/t Barry Ritholtz):

Shortages and high prices for raw materials are fueling a new and unusual wave of acquisitions and deals. Steelmakers are buying iron-ore mines, airplane manufacturers are striking long-term deals for titanium, and the world's second-largest tire maker is cultivating rubber trees.
This return to a type of vertical integration that has been out of favor for decadessignals a new phase of industry consolidation. Having bulked up by acquiring rivals, manufacturers are turning their deal-making prowess to raw materials providersin hopes of ensuring adequate supplies and controlling costs."

2. Marginal revenue product of labour could be increasing above wages.
Perhaps an increased number of firms are operating where marginal revenue product of labour equals marginal expense, while wages are offered below both. Firms would be able to subsidize the costs of their own factors of production. The growth of labour costs would therefore rise at a lesser rate than the growth of prices.
For example, this situation could occur as the amount of firm-specific training increases. If a firm invests in the specialized training of employees, it can pay lower wages because the employees can't (or won't, perhaps due to mobility costs) use their firm-specific skills elsewhere (if the firm were a monopoly, we could replace “firm-specific” with “industry-specific”). Employees usually only pay the burden of training when the training is generalized (the employer wouldn't want to pay if the employee can use his/her general skills elsewhere).
Over a period of time we could expect the number of firm-specific workers to multiply: when
the economy is going through a slump, workers with general training (or no training at all) will be the ones laid off (Ehrenberg, 2004). Skilled, firm-specific workers will be retained. And remember, the workers with firm-specific training are the ones getting paid less than the marginal revenue product of labour.
Unfortunately, I can't think of any good examples of this, so maybe my case is weak.
Also, I think Knzn brings up a good point: “Some of what is counted as profits may actually be rents, and those rents may be rising.”

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