No Such Thing as a Free Lunch: Principles of Economics (Part 158)

A study of economics usually reveals that the best time to buy anything is last year.

Marty Allen

Household and Firm Behavior in the Macroeconomy: A Further Look

(Part H)

by

Charles Lamson 

Productivity and the Business Cycle

We can now use what we have learned (in the last few posts) about firm behavior to analyze movements in productivity. Productivity, sometimes called labor productivity, is defined as output per worker hour. If output is Y and the number of hours worked in the economy is H, then productivity is Y/H. Simply stated, productivity measures how much output an average worker produces in one hour.

Productivity fluctuates over the business cycle, tending to rise during expansions and fall during contractions. The fact that firms at times hold excess labor explains why productivity fluctuates in the same direction as output.

Figure 8 shows the pattern of employment and output for a hypothetical economy over time. Employment does not fluctuate as much as output over the business cycle. It is precisely this pattern that leads to higher productivity during periods of high output and lower productivity during periods of low output. During expansions in the economy, output rises by a larger percentage than employment, and the ratio of output to workers rises. During down swings, output falls faster than employment and the ratio of output to workers falls. 

The existence of excess labor when the economy is in a slump means productivity as measured by the ratio Y/H tends to fall at such times. Does this mean labor is in some sense "less productive" during recessions than before? Not really: It means only that firms choose to employ more labor than they need. For this reason, some workers are in effect idle some of the time, even though they are considered employed. They are not less productive in the sense of having less potential to produce output; they are merely not working part of the time that they are counted as working. 

Productivity in the Long Run Theories of long-run economic behavior, which attempt to explain how and why economies grow over time, focus on productivity, usually measured in this case as output per worker, or its closely related measure, GDP per capita. Productivity defined this way is a key index of an economy's performance over the long run. As we shall see in a future post, the growth of output per worker depends on technological progress and on the growth of the capital stock.

Productivity figures can be misleading when used to diagnose the health of the economy over the short run, because business cycles can distort the meaning of productivity measurements. Output per worker falls in recessions because firms hold excess labor during slumps. Output per worker rises in expansions because firms put the excess labor back to work. Neither of these conditions has anything to do with the economy's long-run potential to produce output. 

*CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 624-625*

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