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The Economy and The Worker Value-added Fallacy

Economics / Corporate Earnings Oct 29, 2007 - 02:49 PM GMT

By: Gerard_Jackson

Economics Now that the Labor Party has the sniff of victory in its lungs, some of its most ‘brilliant economic thinkers' are already dreaming up schemes that will impose heavy costs on the Australian economy. One of these dirigiste schemes is based on the value-added fallacy. There are two assumptions behind their thinking: One is the belief that the state (politicians and union hacks) can impose high-value-added structures on the economy that will provide a buffer against commodity-driven booms. This policy will lead — so they think — to more value-added export-orientated production. The second assumption is the unfounded belief that value added always equals high-tech.

The problem here should be self-evident to anyone with a sound grasp of basic economics: it is the old one of confusing value added with profitability and hi-tech investment. This approach raises an important point: if value-added is a genuine measure of profitability then firms would move capital and labour into those lines of production and compete away the profits. Of course, this question is never asked.

Regardless of what leftwing fanatics assert, the economic way of thinking is vital to our understanding of these matters. By this means we know that as a rule the greater the ratio of capital to labour in any line of production the greater will be the value-added. This is because as firms become more capital intensive labour costs as proportion of total costs fall. But this does not mean that these industries should be fed subsidies and all manner of tax breaks offered up to them: to do so might very well have the perverse effect of lowering per capita income.

The reason is that the market allocates factors to their most valued uses. If politicians interfere with this process they will be responsible for the formation of less efficient factor combinations. Unfortunately our would-be planners simply do not understand the nature of scarcity, particularly when it comes to capital. In any case, high value-added does not always mean high-tech. When Paul Krugman was still comparatively sane he pointed out that in 1988 value added per worker in thousands of dollars was:

Cigarettes  488.3
Oil refineries  283.4
Cars    98.5
Iron and steel    96.7
Aircraft    97.8
Electronics    63.9
All manufacturing    65.9
Paul Krugman, Peddling Prosperity , W. W. Norton & Company, 1994, pp. 261-62

(One should note very carefully that these figures are value added per worker . This does not mean that the value added is a profit. It is simply the quotient from dividing sales revenue by the number of workers. Hence a firm employing 500 people with $100,000,000 in annual sales revenue would have $200,000 valued added per worker. Now, if the costs of bought-in raw materials, services and components amount to $95,000,000 then value added — not valued added per worker — would be $5,000,000: the price of the firm's inputs deducted from its sales revenue)*.

Being hopelessly out of their depth, these would-be central planners might decide, for example, that the way to make the Australian textile industry competitive would be to raise the value of its output by subsidising investment. Note that such a policy assumes that that the necessary technology exists. This begs the question of why the industry did not adopt it. Nevertheless, let ua assume that the technology does exist and that the government policy of using subsidies to encourage the industry to ‘invest' in it has been successful. The result of this misdirected investment would be a considerable shedding of labour unless the increased productivity sufficiently lowered prices as to increase demand to the degree that the same amount of labour would still be required. A highly unlikely event.

To deduce from the above that technology causes unemployment would be to fall into the trap of the fallacy of composition. The overall effect of technology is to increase the aggregate real demand for labour, even if the demand for labour might fall in certain industries. (George Terborgh The Automation Hysteria , W. W. Norton & Company Inc. 1966).

But the value-added argument is based on the desirability of maintaining employment in the chosen industries. It never occurs to these people that firms exist to meet the demand for goods and services, not to create jobs. Moreover, capital is always scarce, regardless of what monetary cranks claim. Therefore, if a Labor government were to direct resources into the textile industry it has to deny those resources to other industries where they are more highly valued.

The likes of Kim Carr assume that if labour intensive industries develop a high value-added structure they must automatically become more profitable. There are absolutely no grounds whatsoever to support this assumption. Unfortunately, when it comes to this kind of argument the Liberal government is as clueless as the Labor Party.

*The value added concept can mislead people into thinking that it is costs that determine value while in fact it is utility that is the ultimate source of value. It is utility — in the form of a scale of consumer preferences — that determines the value of factors and their allocation.


By Gerard Jackson

Gerard Jackson is Brookes' economics editor.

Gerard Jackson Archive

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