Bob Solow on rents and decoupling of productivity and wages

Atypical or difficult to explain movements in capital/labor ratio, productivity per worker and real wages have stimulated recent attempts to square the facts with neoclassical economics, make some adjustments in the neoclassical paradigm, or scrap it altogether.  I have already written here about Stiglitz’s recent focus on the difference between K (productive capital) and W (monetary wealth) as one way whereby increasing wealth/output ratios, emphasized by Piketty, can be made compatible with stagnant wages.

Bob Solow explored a couple of days ago another possibility. Going back to his own seminal work on the theory of growth, some 60 years ago, Solow asked the following question: why did we assume that there is perfect competition and that factors are paid their perfect competition marginal products? We knew, continued Solow, that there were monopolies; moreover, the theory of imperfect competition (Edward Chamberlin and Joan Robinson) existed since the 1930s. Solow said: “I could not find a good reason, but since theory and facts were broadly in accord, nobody bothered much with the assumptions”. That is, until recently. How can we explain, continued Solow, a sustained and significant divergence between non-farm sector productivity and real wage? Despite some quibbles about the measurement of the two, there is no doubt that  they have diverged. But that goes against everything we thought we knew! (I am paraphrasing Solow here.)

However, if you assume a model of imperfect competition, where in addition to labor and capital, there is also a rent (due to the fact that price is greater than the marginal revenue product), the issue becomes: how is that rent going to be distributed between labor and capital? And until the early 1980, due to trade union power (“The treaty of Detroit”), relative shortage of labor, trilateral (government-capital-labor) negotiations etc., the rent was divided in a way that favored labor. But with the decline of the unions, ideological assault on labor (the Reagan revolution) and a huge expansion of available wage-labor worldwide (as China and Eastern Europe rejoined the world economy),  the bargaining power of labor waned and that of capital increased. Consequently, the share of capital in national income increased, and productivity growth got decoupled from real wage growth.

This is my interpretation of Solow’s talk. There is  no paper yet, and, just to emphasize, I might have gotten something wrong. Or Solow might introduce some changes in his model. 

 What I find interesting here is a “marriage” between a standard neoclassical view of how income shares of capital and labor are determined (because even if they are determined in a kind of a monopolistic competition, this is still handled by the neoclassical production function), and the distribution of the rent that responds only in part to economic, and mostly to political factors. Readers will remember that the latter was an old idea, going back to neo-Ricardians who simply argued that the distribution between w and r can take place at any point along the w-r frontier: it is entirely politically determined. In Solow’s view, the determination of what share of the rent goes to labor and what to capital is not solely political. It depends also on their relative scarcities (or put it the other way, on "the reserve army of the unemployed"). But political factors do play a role too: power of trade unions, ideology, who controls the government, probably fear or not of a social revolution etc. So, as these  political factors have moved in a direction adverse for labor, the division of the pie has become more favorable to capital.

It is a nice story, and I like that it seems realistic in its combination of purely economic analysis with real-world politics. It needs to be obviously, fleshed out. Solow was surprised by lack of empirical knowledge among economists of the price mark-ups in different industries (mark-ups are an indication of the existence of rents). Apparently, it is not much studied empirically.  If, as Solow said, we come up with an estimate that (say) 20-30% of national income is rent, then surely political factors can explain why capital's share is up. If our estimate of rent is 2-3% of national income, then this is not a very promising story. So, it is back to the empirics!—a nice theory to test where many a young economist can hope to make a difference and become famous. Perhaps, who knows, as much as Solow has!