Labour shortages, productivity and incomes

Tony Venables is The Productivity Institute’s Research Director and Professor of Economics at Alliance Manchester Business School, The University of Manchester. He’s also the academic lead for our Geography & place research theme.

The UK is experiencing labour shortages in many areas. The adult population is around 1/2 percent smaller than expected due to lower net migration and Covid-related excess deaths. And the activity rate (the proportion of the working age population in or seeking work) is at its lowest level for more than a decade. These changes are against a backdrop of an increasing dependency ratio as the population ages.

How will the economy react to these shocks? We won’t know the answer for several years, but economic reasoning gives some pointers to what we might expect, and offers a critical evaluation of some possible outcomes.

Wage increases are already being seen, some of which are a temporary spike, some of which will be sustained. Outcomes will be determined by the flexibility of supply and demand responses to these wage and price changes, this flexibility dependent on three key factors. One is the ease with which firms can pass on wage and cost increases to consumers. The second is the extent to which firms take measures to increase the productivity of workers. And the third is the extent to which shortages can be filled by attracting workers from jobs elsewhere in the economy.

Passing on wage increases to consumer prices is hard in sectors that are open to international competition, and relatively easier in non-tradable sectors, those less open to trade. In non-tradable sectors each firm’s competitors are likely to face the same wage pressures and seek to make similar price increases, so face little risk of loss of market share. Wage and consequent price increases in these sectors is redistributive, from consumers to workers. To the extent that labour shortages are concentrated in relatively low-skill sectors this is likely to cause an improvement in income distribution, although it is zero-sum for aggregate income.

The pass-through of wages to prices is mitigated if firms make productivity improvements. Such improvements can come about in various ways. One is that the least productive firms in affected sectors are culled and supply shifts to more productive firms. Another is automation or better equipment and training for staff, i.e. increasing physical and human capital. This is the outcome we would like to see, but it is far from automatic and not necessarily cheap. In some sectors there will be little incentive to make these improvements; as we have seen, if there is little international competition then wage increases can simply be passed through into prices. In other sectors making productivity improvements will be expensive, perhaps prohibitively so.

The fact that these improvements have not previously been achieved is a clear indication that they are costly. And in some cases we may see changes in business practice that cut costs and that show up in the data as productivity increases, but are in fact a reduction in quality of service. Examples are fewer care-workers or hospitality staff serving the same number of clients with the same equipment.

The third factor is the extent to which sectors that face labour shortages are able to attract workers from elsewhere in the economy. This labour supply response dampens wage and price increases, and will be a large part of the adjustment that occurs. If the move is in response to a wage differential over and above alternative employment, then this may be measured as an increase in overall GDP and productivity. However, evaluation of this requires thinking about what workers would have been doing had they not been drawn into their new jobs. For example, the wage increment might simply be sufficient to compensate the worker for taking on a job he/she dislikes. While the data records this as an increase in income there is no net gain to well-being if the wage increment is just enough to compensate for high psychic or physical costs of performing the job.

Outcomes will vary across sectors and skills depending on these factors, but in all cases it is important to ask, what output is lost because of the shortage of workers? In sectors that are open to international competition and substitutes for lost workers cannot be found, output will fall and market share will be lost to imports. Other sectors will attract workers to fill gaps, but this too has an opportunity cost as output suffers in sectors releasing these workers.

As employment in various sectors changes in response to labour shortages, what is the overall change in the structure of UK employment that follows? To the extent that the initial shock was the loss of relatively low-skill workers, the response is a shift of the UK labour force into these low-skill jobs. These jobs may now pay higher wages than previously, but they remain relatively low-skilled. Such movements are not part of a move towards a ‘high-skill, high-wage’ economy. We can make the most of the UK’s comparative advantage in relatively high-skill activities if relatively low-skill goods and services can be imported – either as imports or as workers. Moving parts of the domestic labour force into lower-skilled jobs is not the way to do this.