The Productivity-Welfare Linkage: A Decomposition

According to Paul Krugman (1994, chapter 1), "Productivity isn’t everything, but in the long run it is almost everything. A country’s ability to improve its standard of living over time depends almost entirely on its ability to raise its output per worker." But productivity and the standard of living are different concepts and are measured in different ways, so the question is, what is the linkage between them? Productivity is typically measured by GDP per hour. The standard of living has potentially many aspects such as health, longevity, personal security, and relationships. But here I take a narrower view and stick to the national accounts. So the standard of living is measured by the household disposable income of the median individual. I use the median rather than the mean so that inequality is taken into account. I develop a decomposition of the growth of median household income which relates it to the growth of productivity via eight additional factors, one of which is inequality; four other factors are measures of labour market performance. I apply this decomposition to the UK over the period 1977 to 2019. I find that productivity growth was far and away the most important factor in accounting for the growth of living standards which was substantial up to 2007; rising inequality prior to 2007 retarded the growth of living standards but not by much. Since 2007 productivity growth has collapsed as has also the growth of living standards. The fall in the latter has been mitigated a bit by a fall in inequality.