Macroeconomics

F I G U R E

3 - 5

1.0

0.8

0.6

0.4

0.2

0

Labor’s share

of total income

1960 1965

Year

1970 1975 1980 1985 1990

1995

2000

2005

2010

Labor Productivity as the Key Determinant 

of Real Wages

The neoclassical theory of distribution tells us that the real wage W/P equals the

marginal product of labor. The Cobb–Douglas production function tells us that

the marginal product of labor is proportional to average labor productivity Y/L.

If this theory is right, then workers should enjoy rapidly rising living standards

when labor productivity is growing robustly. Is this true?

Table 3-1 presents some data on growth in productivity and real wages for the

U.S. economy. From 1959 to 2007, productivity as measured by output per hour

CASE STUDY

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60

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P A R T   I I

Classical Theory: The Economy in the Long Run

of work grew about 2.1 percent per year. Real wages grew at 2.0 percent—almost

exactly the same rate. With a growth rate of 2 percent per year, productivity and

real wages double about every 35 years.

Productivity growth varies over time. The table shows the data for three short-

er periods that economists have identified as having different productivity expe-

riences. (A case study in Chapter 8 examines the reasons for these changes in

productivity growth.) Around 1973, the U.S. economy experienced a significant

slowdown in productivity growth that lasted until 1995. The cause of the pro-

ductivity slowdown is not well understood, but the link between productivity

and real wages was exactly as standard theory predicts. The slowdown in pro-

ductivity growth from 2.8 to 1.4 percent per year coincided with a slowdown in

real wage growth from 2.8 to 1.2 percent per year.

Productivity growth picked up again around 1995, and many observers hailed

the arrival of the “new economy.” This productivity acceleration is often attrib-

uted to the spread of computers and information technology. As theory predicts,

growth in real wages picked up as well. From 1995 to 2007, productivity grew

by 2.5 percent per year and real wages by 2.4 percent per year.

Theory and history both confirm the close link between labor productivity

and real wages. This lesson is the key to understanding why workers today are

better off than workers in previous generations. 

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