THE DISCONNECT SYNDROME    

Don Byrne & Ed Derbin

An Economics Newsletter for the New Millennium http://byrned.faculty.udmercy.edu/

 

 

I Want it All – NOW! (we’ll worry about paying for it later) 

 

In both the private sector and the government sector, the household has developed behavior patterns that reflect a disconnected view of economic reality.  In the government sector, the household, as voter, elects candidates that want to spend more and grow the government sector.  As this pattern continues, governments run into fiscal crises, as in California and other states.  The households, if given the opportunity through referenda, will then veto the pattern they have supported for several elections.  Michigan has its Headlee Amendment http://www.michiganinbrief.org/edition06/text/issues/issue-31.htm, California its Proposition 13 http://www.leginfo.ca.gov/.const/.article_13A , and Minnesota its Unallotment Provision (http://www.house.leg.state.mn.us/sessionweekly/art.asp?ls_year=85&issueid_=19&storyid=543&year_=2008)  . 

 

Voters do not apparently see that eventually, increased government spending, especially at the state and local level, must be funded by taxes.  Deficits and a rising debt are more ‘dangerous per dollar’ for state and local governments than for the central or federal government because of the limited taxing jurisdiction of state and local governments.  The benefits of state and local government spending are more likely to ‘leak out’ as well.  That is why fiscal policies to stabilize the macro economy are left for the central or federal government.  This is also the reason why state and local governments usually have a balanced budget provision in their charters and constitutions.

 

An even greater disconnect has occurred in federally mandated programs that are left to state governments to administer and gradually to fund partially or wholly after a few ears.  Medicaid is such a federally mandated program and some proposed versions of the so-called healthcare reform have the funding eventually shifted to the state governments. 

 

…it’s not just in government

 

There is an analogous disconnect syndrome in the private sector.  The public is very sensitive to their income, the rewards they receive in supplying productive resources such as labor to firms in the transformation process called production.  High compensation rates of auto workers employed in the former “Big Three” are often not seen as the major cause of these firms’ inability to sell cars at a sustainable price without losing market share to the transplants.  However, the markets for goods and services such as automotive vehicles are inextricably intertwined with the markets for the productive resources such as labor and management (blue and white collar, so to speak).  Labor legislation at both the federal level and in some states gives labor a substantial power through collective bargaining.  In states like Michigan, business shies away from entering because of high labor costs to which its (June 2009) 15.2 percent unemployment rate gives testimony. 

 

It has been very clear for many years that the “Big Three” of the American auto industry were headed for a financial disaster.  Excessive labor compensation and productivity destroying work rules and contract hurdles were matched by a bloated and increasingly excessive compensated management.  The stockholders were a necessary evil and could be ignored.  Unit labor costs and unit management costs soared relative to the transplant firms in the U. S. auto industry.  The market share of the Big Three fell from around 90% in 1950 to around 30% as the current on ongoing collapse started a year or so ago.  The public smiled at the lucrative labor contracts for the workers but then would not pay the high prices for automotive vehicles that were caused by the high compensation to labor and management.  You do not have one without the other, as the words to Frank Sinatra’s “Love and Marriage” song remind us.

 

 

THE THEORY: CIRCULAR FLOW OF ECONOMIC ACTIVITY

 

Economics is a social science that studies the interactions of people – real people, as they cope with the problem of scarcity.  Scarcity means that all of us cannot have all we want of everything we want.  Resources to produce the goods and services desired are simply insufficient.  The technology at our disposal, while awe inspiring, is nonetheless a finite technology.

 

 

 

The Big Picture:

The Circular Flow of Real Economic Activity 

 

 

 

 

 

 

 

 

Production (transformation of productive resources into goods and services occurring at the firm) 

 

Society’s real income is the goods the economic system produces.     Production is the process that transforms productive resources such as capital and labor into useful goods and services.  It is these goods and services that constitute society’s real income.  The more resources and the more productive are those resources, the more goods and services that are produced.

 

Income (flows from Firms to Households in payment for productive resources)

Income is the reward the productive resources receive for participating in this production process.  Income and production are similar to two sides of the same coin.  Income is the reward for to the resources or inputs and production is the measure of the output resulting from the combination and transformation of those inputs or resources.  Some households have this income reduced by paying taxes.  Others experience transfer payments such as family income allowances and have a disposable income that is higher than what they have earned as productive resources.

 

The Firm (answers the question where — as in where production occurs)

 

The firm is a place where production occurs.  It can be a private sector firm such as Wal-Mart or a government owned firm such as port authority.  Absent productive resources, nothing happens at the firm such as when a strike or lockout occurs.  The owners are not the firm.  In the private sector, the owners are the equity capitalists who are productive resources just as is labor.  Profits are the reward to the equity capitalists and in economic analysis, are a cost to the firm.  Private sector firms can be organized as a corporation in which the equity capitalists are the owners as well as a productive resource or in a non-corporate form such as a partnership or proprietorship.  In this latter case, the proprietors and partners are the equity capitalists but also productive resources employed by the firm they own.  The entrepreneurs are the productive resource that make the decisions for the firm.  Entrepreneurs may or may not also be equity capitalists or labor supplying more than one type of productive resource to the firm in the transformation process called production.

 

 

The Household (dual role of supplying productive resources and demanding goods and services —consumer)

 

In free market capitalism, all resources are owned by the households and supplied to the firm in the transformation process called production.  Conventionally, they are divided into four categories, labor, debt and equity capital, entrepreneurship, and land.  As an economy develops, labor is increasingly embodied human capital, resulting from education, training and experience.  Capital can be provided by creditors in which case it is debt capital or by the owners in which case it is equity capital.  Entrepreneurship is the decision making resource that determines what is produced by the firm and the way in which it will be produced.  They also determine the prices to be charged buyers and the prices to be paid for resources.  Land includes all natural resources and location or space.  The rewards from each of the resources are compensation to employees for labor, profits for equity capitalists, interest for debt capitalists, etc.

 

 

 

THE THEORY: UNIT LABOR COSTS  

 

As of June 2009, according to the U.S. Department of Labor, the average worker in the United States receives total compensation per hour of $29.39.  It is divided into wages of approximately $20.49 per hour and nonwage compensation such as company paid health care and pensions of $8.90 per hour. 

 

http://www.bls.gov/news.release/ecec.nr0.htm

 

Further, assume an average physical productivity of the workforce is 15 units per hour.  By dividing the compensation per hour by the worker’s physical productivity per hour, the unit labor costs for this style of production is determined. In this case, we divide $30 by 15 units and arrive at $2.00 per unit as the unit labor cost.  

 

Unit labor costs rise when labor compensation increases at a rate greater than the rate of increase in labor Productivity and fall when compensation increases at a rate less than the increase in the labor productivity rate of increase.  

 

 

Example: Cost/Productivity/Price to Consumer

 

 

 

 

 

 

 

 

Note from our example that if compensation rates rise, unit labor costs increase.  As physical productivity rises, unit labor costs fall.  If the compensation rate rises at a faster rate than the increase in the physical productivity rate per worker, unit labor costs rise and the firm will see  profits fall or will attempt to pass the higher costs on by raising the price of the product that labor helps produce.  If the costs cannot be fully passed on in the form of a higher price and especially if profits fall below a reasonable level, the so called required rate of return on investment, the firm will try to change the method of production by shifting from a more labor intensive technology to another technology that uses capital more intensively and labor less intensively.  This is called automation.  The firm can also switch from making the product to buying it.  This is the meaning of the term outsourcing.   Using contract labor rather than permanent employees is also another possibility. 

 

Bloated and excessively compensated management results in the same cost problems that lead to higher product prices and STICKER SHOCK.   High compensation rates for labor and management lead to high prices for the products people buy.  This holistic view is the antidote to the disconnect syndrome.

 

 

Next: A WARNING TO THE EDUCATION INDUSTRY IN THE U.S.

 

Disconnect between the cost and value..?

 

The education industry can be similarly analyzed.  The teacher/worker, especially in the public sector, is compensated at levels, when adjusted for nine months or so of actual teaching, approaching the UAW worker standard at the “Big Three” auto firms.  Teaching loads and class size are severely restricted by union contracts or the fear that the faculty will vote a union in as collective bargaining agent.  Of course such constraints reduce the productivity of the teacher/worker and raise significantly the unit labor-teacher costs.  Bloated administrations, including the large cadre of curricula advisors, rivaled the bloat of the Big Three auto firms, especially in the tax funded or tuition subsidized public sector. 

 

With tuition rising even at public-owned colleges and universities, the same public that voiced no opposition to the unionization of teachers, is now shrieking that their kids cannot go to college without incurring enormous debt by graduation.  We are seeing the early signs in education brought the current state of the Big Three portion of the U.S. auto industry.  What will the outcome look like in the education industry?  As in recent years in the auto industry, huge discounts in tuition by various guises are occurring in higher education.  Price discrimination has become rampant as the price of education becomes increasingly unaffordable to even the financially well off.  Below the college level, taxes to support public education are headed for near-confiscatory levels and other revenues sources are being added such as gambling and sales taxes.  Will the rising costs of so-called health care reform be the straw that breaks the camels back?

 

What is needed to eliminate this disconnect syndrome so widely infecting the voters, is a simple understanding that the markets for goods and services are directly related to the market for productive resources such as management and labor.  The reverse is also true.  The markets for productive resources are directly related to the prices in the markets for firm’s goods and services.  This is true in the public sector as well as the private sector.  If voters understand the circular flow of economic activity, then these two way causal linkages become apparent. 

 

 

Yes, it’s really as simple as this…

 

The law of demand is as close to a universal as exists.  The higher the price, the less quantity is demanded.  This is true for the demand for automobiles and education.  It is also true for the demand for labor and management.

 

Everybody wants ‘it’ all and everybody wants ‘it’ for zero dollars…

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