The UK productivity puzzle: is the answer in consumers’ hands?

Inflation in the UK has climbed again, reaching 11.1% in October 2022, when measured by the Consumer Prices Index (CPI). This has led many workers to demand pay increases to compensate for the increased cost of living. Employers have often seen such demands as an opportunity to see through productivity improvements, to partially offset wage increases.

Over the long term, productivity growth and average real wage increases have moved closely together. According to Office for National Statistics (ONS) data, wage increases and productivity, starting from a base measure of 100 in 2000, tracked each other quite closely until 2021 when the index of both had reached 120.

So, there is a lot of truth in the statement that real terms wage increases (wages adjusted for inflation) must be earned by productivity improvements. But despite this simple claim, we need to look beneath the surface to understand more about how wages, inflation and consumers’ purchasing behaviour are linked. In particular, do changes in consumer behaviour have an effect on productivity?

The drop in productivity

In principle, measuring labour productivity is easy - it is the ratio of units of outputs divided by the labour hours required to produce that output. For the manufactured goods sectors, this can be quite easy to track. For example the number of labour hours required to make a car has consistently reduced as a result of automation. The economic, political and social context of a country determines what proportion of these labour productivity gains are passed on to employees through higher wages or to consumers through lower prices.

Probe a little deeper, and markers of productivity can be blurred by issues of measurement, often translated into Gross Value Added. For example, there are international differences in whether staff breaks are included in workers inputs. But notwithstanding difficulties in measurement, ONS statistics show that output per hour grew between 2009 to 2019 at less than half the average rate for the previous decade, and is currently at 20 per cent below its pre-2008 trend rate. This drop in productivity has been described as the “productivity puzzle”, with many possible explanations proposed.

Making customers the workers?

The problem of measuring productivity becomes conceptually and technically even more difficult for services like healthcare or finance. This is important, because in most developed economies, services account for about three-quarters of Gross Domestic Product (GDP). Services normally involve some degree of “co-production” by customers, who effectively become joint producers. So, in the case of supermarket self-scanning checkouts, should the consumer go in the top or bottom of the input-output ratio calculation? As a customer, they are consuming. But they are also doing work traditionally undertaken by supermarket employees.

Some sectors such as financial services have shown strong productivity growth, which may be attributable to consumers’ co-production. ONS statistics report that activities “auxiliary to financial services and insurance” showed a productivity growth of about 20% between 2009 and 2019. This was hugely helped by automation and customers now performing many tasks previously undertaken by banks’ employees. Just think about how much more we can do now with banking apps, that before would have been done in-house. In the retail sector, the productivity improvement of about 15 per cent over this period may be more nuanced. In-store automation such as self-checkouts have been improving productivity, while more home delivery has reduced it, when measured by sales per employee.

Small businesses are (usually) less productive

Another curiosity in trying to understand the “productivity puzzle” is consumers’ trend - orchestrated by politicians - to “buy local” and “support small businesses”. Customers and politicians may be ideologically attracted to small local businesses and the distinctive and personal service they often provide. They have been shown in many studies to be a great source of innovation. However, there is also much evidence that they are less productive than their larger competitors, when comparing similar units of output. There is a lot of nuance in the detail, but small businesses generally lack the economies of scale which contribute to productivity improvements. Small businesses are less likely to have efficient distribution channels than their larger rivals.

Poorest hit harder by inflation

Inflation is received quite differently by different groups in society. For example, a comfortable retiree with a good pension and no outstanding mortgage will have quite a different rate of inflation compared to a single parent living in rented accommodation. ONS recognises that there is not one single rate of inflation applicable to all and now produces segment specific measures. An analysis of this data by the Resolution Foundation found that the 10 per cent of UK households in the lowest household income category - who commit a bigger share of their budgets to energy and food - have a current effective inflation rate of 12.5 per cent , compared to 9.6 per cent for the richest ten per cent.

A further intriguing issue arises about the productivity puzzle. The poorer groups who are worse affected by inflation are probably more likely to resort to self-service methods - preparing meals from basic ingredients rather than buying semi-prepared food; collecting goods from a store rather than having them delivered. In principle this will reduce the time available for poorer groups to undertake productive activities which are captured in measures of GDP.

By contrast, better off groups have a greater cushion against the effects of inflation and may be able to afford added value services which are beyond the budgets of poorer groups. They’ll more likely continue having products delivered rather than collecting themselves, and enjoy a coffee made in a coffee shop rather than made by themselves at home.

A further paradox – and a new twist to the “productivity puzzle” – is that the inflationary effects on both groups may indirectly further undermine national productivity indicators. Richer groups may find themselves buying more of the labour intensive, low value-added services which may have restrained productivity growth, while the poorer groups divert their labour market productive time away from buying mass produced goods and services to producing goods and services in what might be a less productive home environment.

GDP or happiness?

Greater self-production by households raises a further interesting post-pandemic question. The pandemic led to many people doing things themselves in their homes, discovering how to make food and clothes, among other things. Consumers shifted from engaging in work in high productivity units to self-production in a low productivity home context. Growing your own food is quite likely to be less efficient than using modern agricultural methods, measured using conventional definitions. This may have a further depressing effect on productivity within the economy, but it also raises the broader question of whether we should concentrate our measures of economic performance on GDP or resurrecting the idea elevated during the Cameron government of measuring national happiness.

That is a bigger debate and puts another angle on the productivity puzzle which might bring consumers into the discussion, not just as passive consumers, but also as active producers.