Full text of Economic Quarterly (Federal Reserve Bank of Richmond) : August 1971

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FEDERAL RESERVE BANK OF RICHM OND

MONTHLY
REVIEW




Cyclical Indicators of Economic Activity: Part I
INTRODUCTION
Techniques developed for the purpose of pre­
dicting changes in economic activity date back as
far as 1862 when Clement Juglar, a French statis­
tician, observed that time series data on “ prices and
finance” appeared to suggest cyclical movements in
business conditions. Since that time, significant pro­
gress has been made in business forecasting and
prediction. Today, the important types of forecast­
ing techniques include (1 ) comprehensive economic
models, of varying degrees of formality, that postu­
late certain relationships between key variables;
(2 ) extrapolative methods that depend upon past
and current values of particular variables in de­
termining future values; and (3 ) analysis of selected
business cycle indicators chosen for their consistency
in signaling turning points in aggregate economic
activity.
This article is the first in a two-part series de­
signed to familiarize the reader with the major uses
and limitations of business cycle indicators, a group
of statistical series that have proved useful to analysts
o f cyclical or cycle-like swings in business.
Analysts generally group these indicators into three
classes: (1 ) the so-called leading indicators, which
move in advance of changes in the direction of gen­
eral business activity; (2 ) the coincident indicators,
which move coincidentally with general business;
and (3 ) the lagging indicators, which usually change
direction after general business has turned around.
The first article concentrates on the leading indi­
cators. A subsequent article will discuss coincident
and lagging indicators, along with the so-called dif­
fusion indexes that are useful in confirming cyclical
turns in economic conditions.
The first group of widely-known economic indi­
cators was published in 1919 by the Harvard U ni­
versity Committee on Economic Research under the
direction of Warren M. Persons.

The Harvard In­

dex Chart consisted of three basic categories of ac­
tivity: ( A ) speculation (stock p rices); (B ) busi­
ness

the development of techniques used in the selection
of modern business indicators.
The identification of particular statistical series
that are especially useful in studying business fluctua­
tions has been largely the work of the National
Bureau of Economic Research (N B E R ). Selection
is based on economic significance, statistical ade­
quacy, historical conformity to general business
fluctuations, smoothness, currency of publication, and
cyclical timing. Some of the indicators are classified
according to timing. Generally speaking, these are
of greatest immediate interest to business analysts,
although all the selected series can be useful in ex­
plaining business fluctuations. Other indicators that
play an important role in the explanation of cyclical
movements are also selected, but these are not gen­
erally as reliable as those classified by timing.
The business cycle indicators used by today’s
analysts are an outgrowth of the work of the N B E R .
Since its inception in 1920, this organization has
made extensive studies of massive amounts of sta­
tistical data bearing on business activity. Over 500
series were investigated before its first list of indi­
cators was published in 1938. The initial list con­
sisted of twenty-one indicators of cyclical recovery.
M ajor reviews and updates of the series were con­
ducted in 1950, 1960, and 1966.
A t the present time, the N B E R classifies and re­
ports seventy-three individual economic series by
timing and economic process. These series are re­
ported monthly in Business Conditions Digest
(B C D ) — formerly called Business Cycle D evelop­
ments— a publication of the U. S. Department of
Commerce. Selection of the cyclical indicators re­
ported in BCD is the responsibility of the N B E R ,
although the Department of Commerce includes
several additional measures of economic activity.
O f the seventy-three indicators currently reported
by B C D , thirty-seven are leaders, twenty-five are
coinciders, and eleven are laggers. They are cross­
classified into six economic processes as shown in
Table I.

(wholesale prices, later bank debits) ; and

(C ) money market (short-term interest rates). The
A -B -C sequence, as it was commonly called, has
been developed because of its outstanding conformity
to business conditions prior to W orld W ar I.

A l­

though the index performed well in the 1920’s, its
failure to anticipate the Great Depression led to its
demise in the thirties.

2



Its major contribution was

LEADING

IN DICATO RS

Leading indicators are those indicators that, in the
past, have generally led changes in aggregate busi­
ness conditions. They are used mainly to decrease
the recognition lag of cyclical turning points. Be­
cause the leads vary considerably in length and
changes in individual series are often erratic, their

use in the determination of significant turning points
in the general economy usually requires the ex­
ercise of considerable caution. Successive increases
or declines in leading indicators have occasionally
occurred in the past without subsequent turning
points in aggregate business conditions.
Generally speaking, leading indicators include
“ flow ” series as opposed to “ stock” series since
flows change direction before their corresponding
stocks. For example, investment in plant and equip­
ment at a rate greater than capital depreciation adds
to the stock of capital. Hence, the stock of capital
can continue to grow even though the current flow
of investment expenditure may be declining. Other
typical examples of leading indicators include build­
ing permits or contracts that precede actual con­
struction, and job vacancies that precede changes in
employment.
In addition to their value in anticipating future
turning points, study of the leading indicators has
helped to develop and explain links between different
types of economic activity.
Reasonably consistent
patterns have developed between many of the leaders
and the coincident and lagging indicators that follow.
Although the selection is based primarily on his­
torical timing, economic logic also plays a significant
role in the selection process.

N B E R Short L ist and C om posite Index T he
N B E R specifies a short list of twelve indicators from
its complete list of leading indicators. They purport
to provide a current view of substantially undupli­
cated economic processes that have been reasonably
consistent in leading previous cyclical turning points.
Eleven of the series are reported monthly by the
source agency; the twelfth— corporate profits after
taxes— is reported quarterly.
A convenient summary measure of the twelve
leaders is computed monthly and reported as a com ­
posite index.
In computing the composite index,
each series is standardized so that all have an equal
opportunity to influence the total index. Then, each
of the twelve indicators is weighted according to its
score (past performance) as an economic indicator.1
The composite index of twelve leading indicators
has been criticized by forecasters on several grounds.
One of the major weaknesses lies in the extreme
variability of its leads for business peaks and its
extremely short leads at business troughs.
Lead
times of the composite index were 6, 22, 13, and 7
months at the 1953, 1957, 1960, and 1969 peaks.
1 For a more detailed description o f the construction o f composite
indexes, see Business Conditions D igest (Septem ber 1969 ), p. 104.
For discussion o f the scoring system, see Geoffrey H . M oore and
Julius Shiskin, Indicators o f Business E xpan sions and Contractions
(N ew Y o r k : N B E R , 1 9 6 7 ).

Table I

CROSS-CLASSIFICATION OF CYCLICAL INDICATORS BY ECONOMIC PROCESS AND CYCLICAL TIMING

N.

Cyclical
Timing

Economic
Process

1. E M P L O Y M E N T
AND
U N EM P L O Y M E N T
(15 series)

II. PRODUCTION,
INCOM E,
C O N SU M P T IO N ,
AND TRADE
(8 series)

III. F IX E D CAPITAL
IN V E ST M E N T
(14 series)

IV. IN V E N T O R IE S
AND
IN VEN TO R Y
IN V E ST M E N T
(9 series)

V. PRICES, COSTS,
A N D PR O FIT S
(10 series)

VI. M O N EY
A N D C R E D IT
(17 series)

Formation of business
enterprises
(2 series)
New investment
com mitments
(8 series)

Inventory investment
and purchasing
(7 series)

Sensitive commodity
prices
(1 series)
Stock prices
(1 series)
Profits and profit
margins
(4 series)

Flows of money
and credit
(6 series)
Credit difficulties
(2 series)

Comprehensive
wholesale
prices
(2 series)

Bank reserves
(1 series)
Money market interest
rates
(4 series)

Unit labor costs
(2 series)

Outstanding debt
(2 series)
Interest rates on
business loans
and mortgages
(2 series)

N.

Marginal employment
adjustments
(6 series)
L EA DIN G IN D IC A T O R S
(3 7 series)

RO U G H LY C O IN C ID EN T
IN D IC A TO R S
(25 series)

Job vacancies
(2 series)
Comprehensive
employment
(3 series)
Comprehensive
unemployment
(3 series)

Long-duration
unemployment
(1 series)

Backlog of investment
Comprehensive
production
com mitments
(3 series)
(2 series)
Comprehensive income
(2 series)
Comprehensive
consumption
and trade (3 series)

Investment
expenditures
(2 series)

LAGGING IN D IC A TO R S
(11 series)

Source:

U. S. Departm ent of Commerce, Business Conditions Digest, June 1971.




Inventories
(2 series)

Lead times were 5, 0, 2, and 0 months respectively
for the 1954, 1958, 1961, and 1970 cyclical troughs.
Although the leads are highly variable, generally
speaking they have been too long in expansionary
periods to be helpful in signaling a need for policy
change to prevent an oncoming recession. Further­
more, contractions have frequently come to an end
and recovery has begun before a change in direction
of the leading indicators is confirmed.
Adjustments in the Composite Because m ost o f
the components in the composite index are flows or
changes in stock components that exhibit no secular
trend, the composite index itself exhibits no secular
upward trend. On the other hand, the components
of the composite coincident index are primarily pro­
duction and employment series that follow a secular
trend similar to that of aggregate economic output.
T o facilitate comparison of the leading composite
with the coincident and lagging composites, the lead­
ing index has been adjusted. The adjustment tech­
nique was developed under the direction of Julius
Shiskin, Chief Economic Statistician at the Bureau
of the Census. In brief, the technique involves re­
moving whatever trend exists in the leading com ­
posite and adding the trend exhibited by the coinci­
dent composite to the leading index. The statistical
method is called “ reverse trend adjustment” since a
trend is added to the series rather than removed from
the series in the usual statistical sense.2
Reverse trend adjustment of the composite index
has also reduced the lead variability at cyclical peaks
and troughs and has diminished the likelihood of
false signals of recessions. Trend adjustment de­
creases lead times in expansions and increases lead
times around troughs. It also moderates false signals
of recessions that occur in periods of sustained ex­
pansion. In summarizing the advantages and limita­
tions of reverse-trend adjustment, Shiskin states:
“ Reverse-trend adjustment promises to be another
advance in the developm ent of . . . techniques
[that make statistical data serve practical ends]. No
one should expect it to make the leading indicators
error-proof forecasting tools, nor to eliminate the
difficulties of interpreting current changes.” 3
Preliminary and Revised Composite Index A
prelim inary m onthly report of the com posite
leading indicators is issued b y the Com m erce D e­
partment. A t the time of release, only eight of
the tw elve individual series are usually available.
Three of the four m issing com ponents are re­
2 Julius Shiskin, “ Reverse Trend Adjustm ent of Leading Indicators,”
The R eview o f Econom ics and Statistics, 49, N o. 1 (February 1 9 6 7 ),
45-49.
3 Ibid., p. 49.

4



ported on a m onthly basis at a later date. A s
these figures becom e available, the com posite in­
dex is revised to show the influence of these
factors. Th e fourth com ponent, corporate p ro ­
fits after taxes, is available on a quarterly basis
only. This figure is linearly interpolated into a
m onthly series when it is reported by the source
agency, and the com posite index is again revised.
A dditional revisions are som etim es made as a re­
sult of changes in seasonal adjustm ent factors or
when other more com plete inform ation is fur­
nished by the source agency of the com ponent
series.
Initial reports for the composite index are issued
with approximately a one month lag. The largest
revisions for a given monthly index usually occur
in the next one to two months. A s a result, lead
times should be at least two months, preferably
longer, to be useful in anticipating turning points.
Performance Record P erform ance of the leading
indicators has been measured by several different
tests. The most common criteria include determina­
tion of average lead times and variability of lead
times. Other common criteria a re : the percentage of
times an indicator or group of indicators within the
composite group actually led the cycle, the percentage
of times a series or group turned at a business cycle
turning point, and the percentage of times a series
or group turned without a turn in general business
conditions.
Individual leading indicators, as a rule, are not
as reliable for purposes of prediction as the com ­
posite group of indicators. Single components often
have lead times that vary considerably from one
cycle, or a phase of a cycle, to another. The index
for the group as a whole is generally much smoother
since erratic swings in individual components often
offset one another.
A s a result, the primary usefulness in analyzing
individual components is to determine sectors of the
economy that are likely to weaken in the near future.
For example, a decline in contracts and orders for
plant and equipment for several months will lead a
decline in business expenditures for plant and equip­
ment. Careful study of the components may also be
helpful in determining other less obvious links be­
tween different types of economic activity, as sug­
gested earlier in this article.
The performance of thirty leading indicators has
been studied by Michael K. Evans over the post­
w a r period through 1965.4 His requirements were
4 Michael K. Evans, Macroeconom ic A c tiv ity : Theory, Forecasting,
and Control (N ew Y o rk : H arper & Row , Publishers, Inc., 1 9 6 9 ),
pp. 455-60.

rather restrictive in that he considered all series with
mean leads of less than four months of little value
in anticipating turning points. This procedure elimi­
nated six series at the peaks and twenty-four series
at the troughs. He also eliminated series with highly
variable lead times by deleting those series with high
variability compared to the average (mean) lead
over the previous peaks and troughs. For example,
a series that led one downturn by twenty months and
another downturn by two months would have been
eliminated by Evans since the variation in lead times
from cycle to cycle was so large compared with the
average lead for that series. High variance in lead
times eliminated nineteen of the remaining twentyfour series at peaks and three of the six series re­
maining at troughs. O f those passing both tests,
only two were efficient in predicting both peaks and
troughs.
Evans’ procedure illustrates one of the major rea­
sons why the forecaster should be wary of using in­

dividual series in predicting future economic con­
ditions. Many analysts have cautioned against the
use of individual time series for the purpose of an­
ticipating turning points. A s mentioned earlier, the
primary research value in studying separate com ­
ponents is to discover and analyze links between dif­
ferent types of economic processes.
Evans continued his study of the thirty leading
indicators with an investigation of false signals.

and 1962), he found that only four of the thirty lead­
ing indicators in his sample gave no false signals;
three others had relatively small declines compared
to their average declines in actual recessions.

teen of the indicators signaled one or less false
Adding the 1967 false downturn to Evans’ results
changes them very little.

Three showed no ap­

preciable turn, and eight other indicators declined

C h art

In d e x :

1950

Sou rce:

1952

1954

(July) (A p r.)
P
T

1956

1958

P

1

1967=100

( M a y ) (Feb.)
T

1960

(N o v .) (N o v .)
P
T

1962

U. S. D e p a r tm e n t o f C o m m e rce , B u sin e ss C o n d it io n s D ig e st, Ju n e 1971.




F if­

turns.

COMPOSITE INDEX OF TWELVE LEADING IN DICATO RS
(July) (A u g . )
P
T

In

his sample of four false downturns (1952, 1956, 1959,

1964

19 66

1968

1970

The 1952 and 1967 downturns in business activity
were the weakest non-recessionary periods in the
post-W ar era. Indeed, declines in real G N P were re­
corded in two quarters in the 1951-1952 slowdown
and in one quarter in 1967. O f the non-recessionary
slowdowns since the W ar, only the 1962 period
failed to experience at least one quarterly decline in
real GN P. Real growth did, however, fall to an an­
nual rate of 2.2 percent by the end of 1962. Hence,
it is clear that the false signals given by the leading
indicators in the non-recessionary post-W ar periods
did in fact signal slowdowns in economic activity,
even though these slowdowns were not severe
enough to be classified as recessions.

less than their average decline in actual recessions.
(T w o are no longer reported in B C D .)
Since components of the N B E R short list of twelve
leading indicators were selected because of their better-than-average performance record and economic
significance in previous cyclical periods, the short
list has been more reliable than Evans’ list of thirty
indicators. The performance record of the twelve
leading indicators is summarized in Table II.
Average lead times at peaks varied between sixteen
months for new housing permits to six months for
both plant and equipment contracts and orders and
change in value of inventory for manufacturing and
trade establishments. Average lead times at troughs
were considerably shorter. Again, new housing per­
mits exhibited the longest lead time with an average
of seven months. The ratio of price to unit labor
cost in manufacturing was the only leading indicator
in the group that failed to show a positive mean lead
time over the five post-W ar recessions.
False signals were registered by eight of the twelve
indicators in non-recessionary downturns. One in­
dicator exhibited four false signals, and two others
exhibited three false signals.
The only indicator that failed to signal a recession
was contracts and orders for plant and equipment.
The indicator fluctuated around a flat trend line prior
to the 1960-1961 recession but failed to show any
appreciable decline prior to the turning point.
The composite index of twelve leading indicators

Sum m ary T he m ajor contribution of the leading
indicators is to help forecasters and policymakers
to recognize turning points in general economic con­
ditions before they actually occur. Their record of
performance suggests that they have been reasonably
reliable in anticipating downturns. One of the ob­
vious weaknesses of the indicators, however, has
been their inability to determine the magnitude of
expected slowdowns. The percentage decline in the
leading indicators is not highly correlated with the
severity of subsequent declines in economic activity.
Inconsistent lead times also pose a problem to
users of leading indicators. Lead times at peaks are
usually longer than lead times at troughs, and spe­
cific indicators are not consistent from peak to peak
and trough to trough. There is little doubt, how ­
ever, that the leading indicators are useful— where
model builders have had little success— in determin­
ing the timing of prospective changes in economic
activity.
Clyde H . Farnszvorth, Jr.

had a mean lead time of five months around peaks
and a mean lead time of four months around troughs.
It did not fail to signal any of the post-W ar reces­
sions, but it did falsely signal a recession in 1952
and 1967.

T a b le

II

PERFORMANCE RECORD OF TWELVE LEADING INDICATORS, 1945-1971
M e a n Lead
T im e,*
Se rie s

P e a k s (m os.)

Nam e

A v e r a g e w o r k w e e k , p ro d u c tio n w o rk e rs, m a n u f a c tu r in g
A v e r a g e w e e k ly in itia l c la im s, S t a t e u n e m p lo y m e n t in su ra n c e
N e w b u ild in g p erm its, p r iv a te h o u s in g units
N e t b u sin e s s fo r m a t io n
N e w o rd e rs, d u r a b le g o o d s in d u strie s
C o n t ra c t s a n d o rd e rs, p la n t a n d e q u ip m e n t
C h a n g e in b o o k v a lu e , m a n u f a c t u r in g a n d t r a d e in v e n to rie s

*T h e

1948-49, 1953-54,

19 57 -5 8, 1960-61,

6
6

12

In d u s tr ia l m a t e ria ls prices
S to ck prices, 5 0 0 co m m o n stocks
C o r p o r a t e p ro fits a fte r t a x e s
R a tio, price to un it la b o r cost, m a n u f a c tu r in g
C h a n g e in c o n su m e r in sta llm e n t d e b t
C o m p o s ite in d e x , reverse tren d a d ju ste d

* * B a s e d on a r a n g e o f 0 to 1 0 0 % .
Y o rk : N B E R , 1967).

11
15
16
1 5 ***
7

9
9
14
13
5

19 6 9 -7 0 re c e ssio n s w e r e

M e a n Lead
T im e,*
T r o u g h s (m os.)

False
S ig n a ls
(N o .)

2

3

1

2

7
3
2

2
2
2
2

1

4

4
5

2

2

2

2
2

0

1

3
4

3

2

Source:

0
0
0
0
0
1
0
0
0
0
0
0
0

A v e r a g e -* *
Sc o re
(percen t)

66
73
67

68
78
64
65
67
81
63
69
63

u se d to d e te rm in e le a d tim es.

Se e G e o f f r e y H. M o o r e a n d J u liu s S h isk in , In d ic a t o r s o f B u sin e ss E x p a n s io n s a n d C o n t r a c t io n s (N e w

* * * l n d e x o f net b u sin e s s fo r m a t io n s w a s n ot a v a i la b le in d e t e r m in in g le a d tim e p rio r to the 1948 p e a k .
U. S. D e p a rtm e n t o f C o m m e rce , B u s in e ss C o n d it io n s D ig e st, Ju n e 1971.




F a ilu re to
S i g n a l (N o .)

Income Distribution and Its Measurement
PART I= DISTRIBUTION AMONG THE FACTORS OF PRODUCTION

Economic analysis in recent years has focused in­
creasingly on the question of income distribution.
There are a number of reasons for this resurgence
of interest in a subject which occupied much of the
attention of nineteenth century economists. In the
first place, public concern over the problem of poverty
has stimulated efforts to determine whether the gap
between the poorest stratum and the rest of an in­
creasingly affluent society is narrowing or widening.
Second, recent experience with inflation and unem­
ployment has generated a suspicion in some quarters
that these two economic evils may have resulted in
a significant redistribution of purchasing power
among socioeconomic groupings.
Then, too, the
steadily increasing emphasis on human capital in eco­
nomic analysis has pointed up the connection between
education and productivity on the one hand and in­
come on the other, suggesting that wide disparities
in income levels might indicate large long term losses
of output for society. Finally, the increasing quantity
and quality of national income data has enabled re­
searchers to undertake empirical evaluation of long
accepted but largely untested theoretical models of
distributive shares.
Analysts tackling the subject generally distinguish
between size distribution and functional distribution
of income. Size distribution refers to the division of
income among families and individuals classified by
income brackets. Functional distribution denotes the
division of the national income among the factors of
production— land, labor, capital, and enterpreneurship— that combine to produce it.
The paragraphs that follow outline the evolution
of distributive share analysis in economic thought,
discuss the behavior of the functional distribution of
income in the United States, and describe some of
the methods and measures employed by researchers
who study it. A second article, to appear in a future
issue of the Monthly Review, will discuss the size
distribution of income.
EARLY DISTRIBUTIVE SHARE A N A LYSIS
Traditionally, economists have devoted more at­
tention to the functional than to the size distribution
of income.
Early nineteenth century economic
analysis was dominated by the view, associated
largely with David Ricardo, that the study of dis­
tributive shares held the key to the understanding




of the entire economic mechanism, including the
forces determining the rate and character of eco­
nomic growth. T o the Classical Economists of
nineteenth century England, who took their cue
largely from Ricardo, the distribution of income
served three purposes. It divided the recipients into
mutually exclusive economic groups, identified by
their function in the production process; it served
as an indicator of the relative welfare of the re­
spective grou ps; and it defined the social classes that
would play key roles in the economic evolution of
the nation. Economic development was looked upon
as a drama in which the actors were grouped by
economic function, serving specified socioeconomic
roles. For example, the working class not only sup­
plied labor but, through procreation, insured the
existence of labor supplies in perpeturity. The in­
dustrial class was associated with accumulation and
the capital-supplying function, while the landed
aristocracy exercised stewardship over land, a scarce
and increasingly remunerative resource.
On the
basis of this model, British economists predicted
that excessive procreation by the laboring class would
combine with diminishing returns in land cultivation
to bring bare minimum subsistence wages to labor,
zero profits to capitalists, riches to landowners, and
eventually cessation of growth for the economy as
a whole.
Karl Marx, writing later in the century, also
identified each factor of production with a distinct
social class.
Following the classical tradition, his
analysis assumed that no income recipient could be­
long to more than one economic group, supply more
than one type of productive resource, nor receive
more than one type of factor income. A laborer
could not simultaneously be a capitalist, nor a capital­
ist a laborer.
In M arx’s scenario, accelerating
antagonism between an ever growing laboring class
doomed to subsistence wages and an increasingly
exclusive and wealthy capitalist class meant the
eventual end of traditional capitalist socioeconomic
organization, along with its political superstructure.
By the time M arx systematized his model of class
conflict, however, a new breed of classicists were
weaving an intricate analysis demonstrating that the
free market would achieve distributive justice and
(Continued on page 10)

7

C H A R T S 1 A N D 2 Consum er credit, w hich fi­
nances nearly 20% of the value of all consumer
purchases, is comprised of short- or intermediateterm loans for automobiles, household appliances,
and other personal debts. Although consumer spend­
ing is determined primarily by current and expected
levels of income, changes in the volume of consumer
credit, along with changes in saving, have often
contributed to some short-run movements in con­
sumption. Normally, as income rises, so does spend­
ing, saving, and the accumulation of debt. Sudden
changes in income, however, often result in adjust­
ments in saving and debt accumulation in order to
maintain spending.
On the other hand, during
periods of uncertain economic conditions, consumers
may postpone current spending and increase saving
while curtailing debt accumulation. All these phe­
nomena have occurred in recent years.
From 1965 through the first half of 1968, rapid
economic expansion was accompanied by similar in­
creases in consumer spending, saving, and credit.
Following the surtax of July 1968, the expected
slowdown in consumer spending did not materialize.
Instead, consumers relied more heavily on consumer

CONSUMER CREDIT TRENDS
credit and decreased their rate of saving in order to
maintain spending levels.
This pattern continued
into the tight money period of 1969. The saving
rate increased sharply in the third quarter of 1969
and continued to rise in 1970. Faced with un­
certainty over inflation, unemployment, and political
problems, consumers reduced their borrowing in re­
lation to disposable income. During the first quarter
of 1971, however, consumer spending regained some
of its lost strength, despite a drop in consumer credit
outstanding. Again consumers appeared to rely on
a reduced saving rate to finance current spending.

C H A R T 5 Installm ent credit extended reached
a peak of 16.8% of disposable income in the second
quarter of 1969 and then decreased slowly until the
first quarter of 1970. The decline in this percentage
was caused primarily by the decrease in automobile
sales and the consumer’s desire for cheaper, smaller
cars.

C H A R T 3 Consum er credit is com posed o f in­
stallment and noninstallment credit. Noninstallment
credit, the smaller of the two components, consists

C H A R T 4 M ore than 80% of all consum er
credit outstanding is extended on an installment
basis, with repayment scheduled in more or less equal
monthly installments running over a specified period.
Automobile paper, other consumer goods paper, re­
pair and modernization loans, and personal loans
are the major components of installment credit.
Automobile loans, the largest and most volatile com ­
ponent, make up approximately 38% of all install­
ment credit. Automobile credit expanded rapidly
throughout 1968, tapered off in 1969 and 1970, then

of single-payment loans, charge accounts, and serv­

declined during the General Motors strike in the

fourth quarter of 1970, primarily because of the wrork

ice credit. Single-payment loans and charge accounts,

fourth quarter of 1970.

stoppage in the industry in that quarter.

although decreasing slightly during the economic

stallment credit continued to expand throughout this

Ch art 1

C h art

C O M P O N E N T S OF CO NSUM ER CREDIT
O U TSTAN D IN G

slowdown of 1969-70, have shown substantial net in­
creases over the past three years. Service credit
was singularly unaffected by the slowdown and has
continued to increase steadily since 1968.

period; however, their small increase was not suf­
ficient to offset the drop in automobile paper in the
fourth quarter of 1970. In the first quarter of 1971
the surge in automobile sales following the strike
was not accompanied by an increase in automobile
paper outstanding, suggesting that many new car
sales were financed from past savings rather than
credit.

la r t

2

PERSONAL S A V IN G A S A PERCENTAGE
OF DISPOSABLE PERSONAL IN CO M E

Other components of in­

income in the second quarter of 1970, repayments
of installment debt rose steadily through the first
quarter of this year and exceeded extensions in the

Jane N. Haws

C h art 4

C h art 5

C O M P O N EN T S OF INSTALLMENT LOANS
O U TSTAN DIN G

INSTALLMENT CREDIT A S A PERCENTAGE
OF DISPOSABLE IN C O M E

3

C O M P O N E N T S *'fN O N IN S T A L L M E N T
LOAN S
ST A N D IN G

After hitting a low point of 14.6% of disposable

( S e a s o n a lly A d ju s t e d A n n u a l
Per C e n t

$ B illio n s

$ B illio n s

$ B illio n s
301----------

Rate)

Per C e n t

120

TOTAL IN S TA L LM E N T L O A N S

TOTAL N O N I jTALLMENT L O A N S

■ .yment

A u to m o b ile

Loans

Paper

s

R e p a id
O th er C o n su m e r G o o d s P aper
A c c o u n ts

14
R e p a ir &
M o d e r n iz a tio n
Loans
Serie C re d it

P e rso n a l

Loans

- i ______I_____ i______i_____ i
1968
Sou rce:

1969
F e d e ra l R e se rv e Bu lle tin .




1970

1968
S o u rc e :

1969

19 70

S u r v e y o f C u rre n t B u sin e ss.

1971

II
I II
1968
So u rc e :

IV

|

| I II
19<

IV

I

Fed e ra l Resve Bulle tin .

mm

II
I II
1 9 70

IV
I
1971

I

II
I II
1968

S ou rce:

IV

I

II
I II
1969

I_____ L .
IV

I

F e d e ra l R e se rve Bulle tin .

II
I II
1970

IV
I
1971

I

II
I II
1968

Source:

IV

I

II
III
1969

IV

I

F e d e ra l R e se rve Bulle tin .

II
I II
1970

IV
I
1971

Income Distribution and Its
Measurement
(Continued fi-om page 7)

harmony by providing each factor of production with
a reward just equal to its contribution to total output.
Each of these nineteenth century doctrines implied
that the lines separating the factors of production
also marked the division of social classes. Only later,
with an increasingly widespread ownership of pro­
perty and a growing degree of social mobility did
this identification of social classes and economic
function disappear from professional analysis. T o ­
day economists find it useful to retain the original
division of the factors of production, but without the
presumption of social class identification.
In recent decades the focus of distributive share
analysis has shifted away from discussions of wel­
fare. The blurring of factor ownership classes has
forced the virtual abandonment of functional dis­
tribution as a welfare indicator. The factors of pro­
duction, although analytically separate and distinct,
are now seen as overlapping at the ownership level.
Modern economists, unlike their classical predeces­
sors, recognize that individuals often own and sup­
ply several types of productive resources. For ex­
ample, it is not unusual to find the same individual
receiving wage income from his employer, rent in­
come from property leased to tenants, interest income
from bonds and savings deposits, and dividend in­
come from equity shares in the capital assets of
corporations.
Contemporary income distribution analysis focuses
on explanations of the alleged constancy of relative
shares. This focus derives largely from economists’
study of the Cobb-Douglas aggregate production
function. A production function expresses the tech­
nological relationship between output and the as­
sociated inputs used in the production process. The
Cobb-Douglas production function relates national
output to only two factors of production, labor and
capital, and implies that factor-income shares will be
constant regardless of the amounts of the two inputs
existing in the economy.
In the Cobb-Douglas
model, changes in the ratio of labor to capital re­
sulting from dissimilar growth rates of the two inputs
would have no effect on factor shares. The wide­
spread acceptance of this model among economists
has helped to foster the presumption of constant
factor shares.
DISTRIBUTIVE SHARES IN 1970
The statistical series which most closely corres­
ponds to the economist’s concept of factor shares is

10




published by the Department of Commerce in the
Survey of Current Business. This series shows the
distribution of the national income (prior to govern­
ment taxes and transfers) by type of payment. The
percentage breakdown for 1970 is as follow s:
Employee Compensation
Proprietors’ Income
Corporate Profit
Interest
Rental Income of Persons
Total

75.0%
8.4%
9.6%
4.2%
2.8%
100.0%

The lion’s share of national income goes to em­
ployees, with corporate profits and proprietors’ in­
come running a distant second and third, respectively,
and interest accounting for most of the remainder.
The relative size of the slice of the national income
pie claimed by labor resources is especially note­
worthy in view of the vital and conspicuous role
played by capital resources in the production pro­
cess. One might expect capital resources to claim
a large part of the income generated by the world’s
most “ capitalistic” economy.
Flowever, a quick
calculation from the above figures indicates that ap­
proximately 82% of the national income pie was dis­
tributed to labor resources, leaving only 18% to be
claimed by capital resources. This estimate was made
by counting employee compensation as labor-resource income and all profits, interest, and rent as
capital-resource income, and by dividing proprietors’
income into labor and capital income in the propor­
tion which the share of employee compensation bears
to the combined shares of profits, interest, and rent
(75.0 to 16.6). T oo much faith should not be placed
on the accuracy of these figures. For example,
probably 3 or 4 percentage points of the 75 per­
centage point employee compensation share consists
of salaries of corporation executives, not usually
considered as labor income in the ordinary sense.
Furthermore, the allocation of proprietors’ income is
arbitrary. Nevertheless, the order of magnitude of
the estimates is correct and it may safely be said
that, in 1970, between three-fourths and four-fifths
of the national income pie went to sellers of labor
services.
M EASUREMENT A N D INTERPRETATION
Although the Department of Commerce’s classifica­
tion of distributive shares is the best the economist
has to work with, it is imperfectly suited to his needs.
For example, two of the income claims, proprietors’
income and corporate profits, are classified by type
of business institution rather than b y type of
economic resource to which payment is made. This

and other discrepancies between theoretical concepts
and empirical measures create a host of problems for
the researcher in his analysis of the behavior of rela­
tive shares. Some of the major problems are dis­
cussed below.
Im pure In com e Categories The Com m erce D e­
partment’s measures of employee compensation, pro­
prietors’ income and property income (corporate pro­
fits, interest, and rent) are comprised of heterogenous
income elements whereas the wage, rent, interest,
and profit components of economic theory are
conceptually homogeneous and distinct. Economic
theory defines wages as the payment for human ef­
fort exerted in the production process; rent as the
return to non-reproducible resources supplied in
fixed amounts by nature; interest as the return to
non-human, reproducible means of production; and
profits as the residual reward to entrepreneurship
for risk-bearing, coordinating, and innovating ac­
tivity. In the national income accounts, however,
the employee compensation category includes in­
determinable amounts of “ interest” yield on invest­
ment in education and training plus rent on unique
ability, in addition to pure wage income. The em­
ployee compensation category may also include some
entrepreneurial type income because the salaries of
top corporation executives are included.
The other national income categories are also a
mixture of income elements and thus do not cor­
respond precisely to their theoretical counterparts.
The rent share recorded in the national income ac­
counts is comprised mainly of rental income on
housing and other leased structures. Very little of
it represents the return to scarce natural resources,
the theoretical concept of rent.
Moreover, only
rental income going to persons is recorded. Rental
income received by corporations is excluded.
Some of the measured interest income consists of
interest on consumer debt as well as the yield on
tangible capital equipment— the interest concept of
economic theory.
Finally, neither the corporate
profits nor proprietors’ income categories consist
solely of pure economic profit. The former includes
some rent and interest income received by corpora­
tions, and the latter includes the implicit wage, rent,
and interest income on the labor, land, and capital
owned by proprietors and employed in their own
enterprises.
A pportion ing P roprietors’ Incom e
System atic
study of functional shares also encounters a difficulty
in splitting proprietors’ income into its labor and
capital income components.

One of the key ob­

jectives of empirical research on income distribution




is to test the frequently stated hypothesis of the “ re­
markable constancy of relative factor shares.” As
previously mentioned, the hypothesis of constant
relative shares is based upon certain theoretical eco­
nomic models embracing only two factors of produc­
tion labor and capital. In order to test the hypothesis
of factor-share constancy, researchers must consoli­
date the national income categories into the two
groups recognized by the theory. Little difficulty is
experienced in consolidating rent, interest, and cor­
porate profits into a capital income component, and
assigning employee compensation to the labor income
component. But the allocation of proprietors’ in­
come, which is an amalgam of labor and capital (in ­
cluding profits) returns, is a different matter.
The question of how the proprietors’ share should
be divided is one of the most vexing and controversial
in the study of income distribution. Three positions
have been taken regarding the disposition of pro­
prietors’ income. According to one view, it is vir­
tually impossible to identify the labor and capital
components and therefore, any separation must be
completely arbitrary. Advocates of this view hold
that the analysis of relative shares should be limited
to those sectors of the economy not dominated by
unincorporated forms of business enterprise.
A second view argues that proprietors’ income is
too important to ignore and that it should all be as­
signed to the labor share category. Proponents of
this view rationalize that a large part of proprietors’
income goes to self-employed professionals (doctors,
accountants, architects, lawyers) and to proprietors
of retail trade establishments, all engaged in pre­
dominantly labor type activities.
A third view, adopted by the majority of re­
searchers in the field of income distribution, is op­
posed to the complete allocation of proprietors’ in­
come to labor because such a procedure implies that
the property used by the self-employed in their work
has a zero yield. Advocates of this position hold that
alternative procedures can be used to obtain a rea­
sonably accurate disentanglement of the constituent
parts of proprietor income. Suggested techniques in­
clude (1 ) dividing the shares in the same ratio as
they are divided in the corporate sector, and (2 )
imputing to each self-employed person a labor in­
come equal to the annual wages of a worker and a
capital income equivalent to the market yield on
assets similar to those owned by the self-employed.
Im putation of G overnm ent-Sector Incom e

An­

other problem arises from the way in which product
and income originating in the government sector is
measured.

Government output cannot be valued at
11

market price because, unlike private output, it is not
sold on the market. Instead, it is valued at labor
cost of production. That is, in the official statistics,
the value of output and income produced in the public
sector consists solely of the public payroll. The out­
put contributions of government-owned land and
capital are not measured. In short, government
product, as officially measured, is 100% labor-in­
tensive. The overstatement of employee contribution
to public output may exert an upward bias in labor’s
share as the relative importance of the government
sector in the total economy increases.
The conceptual problems discussed in this section
make the task of interpreting movements in income
shares treacherous. Observed changes in the shares
may be the result of measurement bias rather than
of real forces. These hazards weaken the reliability
of empirical investigation. It may be hard to de­
termine from the discrepancies between measured
and predicted movements of factor shares whether it
is the theory or the measurement that is in error.

T a b le I

DISTRIBUTIVE SHARES (PER CENT) OF TOTAL IN
U. S. N A T IO N A L INCOM E, 1900-1970
(Decade Averages of Shares for Individual Years)

Decade

Em ­
p lo y e e
Com ­
p en sa­
tion

P ro ­
p rie to rs'
In co m e

C o r­
p o r a te
P ro fits

In tere st

Rent

19 00 -1 90 9
1 9 1 0 -1 9 1 9
1 9 2 0 -1 9 2 9
19 30 -1 93 9

55.0
53.6
60.0
67.5

23.7
23.8
17.5
14.8

6.8
9.1
7.8
4.0

5.5
5.4
6.2
8.7

9.0
8.1
7.7
5.0

100
100
100
100

19 39 -1 94 8
19 49 -1 95 8
19 54 -1 96 3
1 9 6 3 -1 9 7 0

64.6
67.3
69.9
71.7

17.2
13.9
11.9
9.6

11.9
12.5
11.2
12.1

3.1
2.9
4.0
3.5

3.3
3.4
3.0
3.2

100
100
100
100

So u rc e :

To tal

Ir v in g K r a v is , " In c o m e D istrib u tio n : F u n ctio n a l S h a r e , "
In te r n a t io n a l E n c y c lo p e d ia of S o c ia l Scie nces, V o lu m e 7
( N e w Y o rk : M a c M i ll a n a n d Free Press, 1968), p. 134.
R e p rin te d w ith p e r m issio n o f the P u b lish e r fr o m TH E
IN T E R N A T I O N A L
E N C Y C L O P E D IA
OF
THE
S O C IA L
S C IE N C E S , D a v id L. S ills, E ditor. C o p y r ig h t 1968 b y C r o ­
w e ll C o llie r a n d M a c M i ll a n , Inc.; B u s in e ss C o n d it io n s
D ige st.

LONG-TERM TRENDS
Formidable measurement problems notwithstand­
ing, the bulk of the research on functional income
distribution has been devoted to explaining the
secular behavior of relative factor shares. Table I
shows estimates of the percentage distribution of na­
tional income since 1900. The data for the period
since 1929 were developed by economists in the De­
partment of Commerce. Data for earlier years are
the estimates of several scholars, including Simon
Kuznets of Harvard, D. Gale Johnson of the U ni­
versity of Chicago, and Irving Kravis of the U ni­
versity of Pennsylvania.
The table indicates that over the century the
measured wage share has risen substantially, largely
at the expense of the proprietor share and only
slightly at the expense of the combined shares of in­
terest, rent, and corporate profits. Although the
relative shares, as measured, display a moderate de­
gree of stability over the 25-year post-W orld W ar II
period, the figures in Table I do not reveal the “ re­
markable constancy” which economists often pro­
claim as the most conspicuous characteristic of dis­

have tended to consolidate all non-labor shares into
a “ property income” category whose overall stability
conceals the divergent behavior of its constituent
parts.
Explanations of the Trend of Labor’s Share H ow
do the experts account for the secular rise in labor’s
relative share as measured in the national income
accounts? Tw o alternative explanations have been
offered. The first emphasizes structural alterations
in the product-mix and industry-mix of the economy.
This explanation, which appears in the work of E. F.
Denison of the Brookings Institution and D. Gale
Johnson, implies that the data can be reconciled with
the theory of constant shares by showing that income
distribution would remain unchanged in the absence
of shifts in the composition of output.

The second

explanation, advanced by Irving Kravis, stresses the
differing supply and demand conditions in the mark­
ets for labor and capital. Each of these explanations
is discussed in greater detail below.
Structural Changes

The major structural shifts

tributive shares.
Most of the research effort has been devoted to

affecting labor’s share include (1 ) the rise in the

investigation of the trend in labor income.

The dis­

corporate form of enterprise increasingly supplanted

parate trends of corporate profits (up from 7 % to

the individual proprietorship, (2 ) the growth in the

1 2 % ), interest (dow n from 5.5% to 3 .5 % ), and

importance of the government sector, and (3 ) the

proportion of wage earners to proprietors as the

rent (down from 9 % to 3 % ) have received rela­

shift from land-intensive agriculture production to

tively little study.

Researchers, in their eagerness

the production of labor-intensive services. Empirical

to test the conclusions of two-factor economic models,

techniques have been devised to measure the influence

12




of each of these factors on the growth of labor’s
share.
T o estimate the effect of the shift from proprietor­
ship to corporate form of enterprise, researchers
divide proprietors’ income into its labor and non­
labor ( “ property” ) components, using any of several
statistical procedures.
The simplest procedure is
to split proprietor income in the same ratio which
labor income bears to property income in the rest of
the economy. A more sophisticated method (a ) as­
signs a value to each proprietor’s labor equal to the
annual wages of a hired worker, (b ) estimates the
annual return on proprietors’ property from the ob­
served market yield on similar assets, and (c ) ad­
justs the total of estimated labor and property in­
come components proportionally to agree with re­
ported proprietor income. The shift out of self-em­
ployment into wage employment explains some of
the rise in labor’s share but still leaves approximately
seven to ten percentage points (depending on the
method used to split proprietors’ income) of the
rise unexplained.1
The growth of the government sector accounts for
much of the remainder. The effect of the rising
relative importance of the government on labor’s
relative share is estimated by subtracting the govern­
ment’s contribution to national income from both na­
tional income and employee compensation. Identical
amounts are excluded from both the income and the
wages categories because, as previously mentioned,
government output is valued solely at the cost of
labor input and thus the wage share in the value
of government output is 100%.
After the exclusion of the government’s contri­
bution to income and the division of proprietors’ in­
come into its labor and property components, the
relative shares of labor and capital do indeed display
a high degree of long-term stability. Kravis’ esti­
mates indicate that since 1900, labor’s adjusted share

be noted that part of the effect of the declining im­
portance of agriculture is also captured in the esti­
mate of the effect of the shift from unincorporated
to incorporated business.
In summary, significant adjustments must be made
to estimates of factor shares derived from national
income statistics before they will square with the
theorists’ oft-proclaimed “ remarkable constancy of
the relative shares,” which applies to a theoretical
construct whose share definitions find no precise
counterpart in national income statistics.

importance of agriculture in the product-mix is

Secular Changes in Input Supply and Demand An
alternative explanation of labor’s rising share goes
behind the facade of “ structural changes” to focus
on the changing conditions of demand and supply
in labor and capital markets. This explanation, as­
sociated chiefly with Irving Kravis, lumps all non­
labor income into one category (capital income) and
emphasizes total demand for labor and capital rather
than the structural changes discussed above.
In addition to explaining the rise in labor’s share,
Kravis’ demand-supply approach reconciles the fol­
lowing developments that have occurred in the
American economy since the early 1900’s: (1 ) a six­
fold rise in the capital stock, (2 ) a doubling of the
man-hour inputs, (3 ) a more than threefold rise in
the real wage rate, and (4 ) a virtually unchanged
real rate of return on capital. Kravis concludes that
these trends are due primarily to differences in the
responsiveness of the supplies of labor and capital
to increases in demand as well as to the tendency
for businessmen to substitute relatively low-price
capital for relatively high-price labor.
These conclusions are illustrated by the demand
and supply diagrams in Chart 1. The long-run sup­
ply of labor-hours (S i) is depicted as less responsive
to a rise in the price of labor-hours than is the longrun supply of capital ( S K) to a rise in its price.
Economic growth over the century has increased the
demand for labor and capital. However, because of
the differing supply conditions, the increased demand
for labor has greatly affected labor’s price, whereas
the increased demand for capital is reflected in the
rise in capital’s quantity. Because of the lack of re­

measured by comparing labor’s actual share with

sponsiveness of the supply of labor-hours to changes

what it would be if the relative importance of the

in demand, businessmen have had to quadruple the

different sectors had remained unchanged.

real wage rate to induce the additional labor into

(including proprietors’ labor income and excluding
government) has remained within the narrow range
of 69% to 76% .2
Finally, the effect on labor’s share of the declining

It should

employment. The rise in the wage rate relative to the
1 I. B. Kravis, “ Income D istribution: Functional Share,” Interna­
tional Encyclopedia o f the Social Sciences, Vol. 7 (N e w Y o rk : Mac­
Millan and Free Press, 1968) p. 134.
Note that if all o f pro­
prietors’ income share were lumped with the employee compensa­
tion share in Table I, then the resulting “ labor’s share” would in­
deed exhibit virtual long-run constancy.
A few economists, using
this procedure, argue that the statistics strongly support the theory
of constant shares.
2 1. B. Kravis, “ Relative Income Shares In Fact and Theory,”
Am erican Econom ic R eview 49 (December 1959) p. 928.




price of capital has also induced businessmen to sub­
stitute capital for labor in production and may have
stimulated the search for new, capital-using (laborsaving) technology as well. The substitution of rela­
tively cheap capital for relatively dear labor is mani­
13

fested by the sixfold rise in the amount of capital
employed versus the mere doubling of man-hours
employed. Labor income (price of x quantity of
labor) has increased more than capital’s income
(price of capital x quantity of capital) because the
rise in labor’s price relative to capital’s price has
exceeded the rise in the quantity of capital relative
to the quantity of labor.3
THE CYCLICAL BEHAVIOR OF DISTRIBUTIVE SHARES
Although relatively little research has been done
on the short-run movements of distributive shares,
many economists believe that the evidence is suf­
ficient to establish a definite cyclical pattern for the
employee compensation, fixed income (rent and in­
terest), and corporate profit shares. The wage and
fixed income shares appear to rise in periods of fall­
ing economic activity and to decline in periods of
expansion. The share of profits, on the other hand,
apparently rises in prosperity and falls in depression.
3 More precisely, labor’s income share relative to capital’s share may
be expressed as L I / K I = ( P fxQ t) / ( P^.xQ^) = ( P j/P ^ ) ( Q j/Q ^)

where

L I and K I represent the incomes o f labor and capital, Pj and P^
their respective prices, and Q( and Q . their respective quantities.
Labor’s relative share has risen because the price ratio ( P j /P

) has

These cyclical patterns were most conspicuous in the
1930’s. During the contraction of 1929-1932, the
shares of wages and interest spurted but the profits
share fell sharply. W ith the progress of recovery
after 1933, the wage and interest shares sagged and
the share of corporate profits rose.
These same cyclical patterns appear in the postW orld W ar II period, although with diminished
intensity.
Table II shows the percentage income
shares at the peak and trough dates of all post-war
cycles, as established by the National Bureau of
Economic Research. The table clearly reveals the
pro-cyclical behavior of corporate profits share and
the counter-cyclical behavior of the employee com ­
pensation, rent, and interest shares. In each cycle,
the corporate profits share was higher at the peak
than at the trough.

In all but one of the cycles the

employee compensation, interest, and rent shares
were higher at the trough than at the peak.
Overhead Costs, U nit P rofits, and D istributive
Shares

E con om ists have advanced several h y­

potheses to account for the observed cyclical be­
havior of the relative shares.

The most plausible

hypothesis holds that the p ro-cyclical behavior

risen by a greater percent than the percentage fall in the quantity

of profits’ share results from the relation between

<Q(/ Q K) ratio.

profits per unit of output and unit overhead costs.

Ch art 1

INPUT D E M A N D A N D SUPPLY CURVES
E co n o m ic g r o w t h sh ifts u p w a r d the d e m a n d s fo r la b o r a n d c a p ita l, in c r e a s in g the in c o m e s o f b oth .
In c o m e s in 1900 a re sh o w n a s the sm a lle r, cro ss-h a tc h e d re c ta n gle s.
In c o m e s in 1970 a s the la r g e r ,
g re e n re c ta n gle s.
L a b o r in co m e h a s in c re a se d m o re th a n c a p it a l in com e.




Table II

DISTRIBUTION OF N A TIO N A L IN C O M E SHARES (PER CENT) AT THE
CYCLICAL PEAK A N D CYCLICAL TROUGH DATES IN
FIVE POST-WAR CYCLES

Employee Compensation
Proprietors' Income
Corporate Profits
Rental Income
Net Interest
Total Shares
So u rc e :

1948
IV
P

1949
IV
T

1953
III
P

1954
II
T

1957
III
P

1958
II
T

1960
II
P

1961
1
T

1969
IV
P

1970
IV
T

63.1
17.5
15.0
3.6
0.8

65.4
16.4
13.3
4.1
0.9

68.7
13.0
13.2
4.2
0.9

68.4
13.2
12.6
4.6
1.3

69.9
12.1
12.4
4.1
1.5

70.4
12.9
10.5
4.3
1.8

70.7
11.2
12.4
3.8
1.9

71.5
11.5
10.9
3.9
2.2

74.1
8.6
10.4
2.8
4.0

75.4
8.4
9.1
2.9
4.3

100.0

100.0

100.0

100.0

100.0

100.0

100.0

100.0

100.0

100.0

B u s in e ss C o n d it io n s D ig e st.

This relation varies with changes in aggregate out­
put. During economic expansions, increased pro­
duction induced by rising aggregate demand enables
firms to spread overhead (i.e. fixed) costs— including
the wages of overhead labor as well as rent and in­
terest expenses— over a greater volume of output.
Overhead costs per unit of output fall and profit
margins rise, thereby enlarging the profits share and
diminishing the labor, interest, and rent shares in
the value of each unit of output. In recessions, out­
put falls and unit overhead costs rise, thereby
squeezing the profits share and enlarging the other
shares.
This hypothesis implies that a substantial portion
of labor income is a component of the overhead
costs of hiring firms. Many economists believe
that a sizeable part of the labor force is of the
overhead variety. Overhead labor includes su­
pervisory and adm inistrative personnel as well
as top m anagem ent officials whose salaries are
largely independent of their firms’ output volume.
Overhead labor also includes employees retained or
“ hoarded” by employers in the face of cutbacks in
output, either because they possess specialized skills
or because employers have made contractual com ­
mitments (such as a guaranteed annual wage) to
them. W orkers may also be retained because em­
ployers wish to avoid costs (e.g., severance pay) of
laying-off labor as well as the costs of rehiring and
retraining workers when business conditions improve.
More precisely, the relation between profits, price,
and costs per unit of output can be expressed a s :

charges as well as the cost of overhead labor. A s
previously mentioned, unit overhead costs fall as
output increases. The category labeled “ other unit
costs” consists largely of the costs of materials and
of unskilled and semi-skilled labor. These unit costs
are virtually constant because the firm can adjust
its material and unskilled labor inputs in roughly
the same proportion as output changes. When out­
put contracts by, say 10%, firms can lay off 10% of
their unskilled labor. Employers are less averse to
laying off unskilled and untrained workers than pro­
fessional and highly skilled workers, because the
latter are harder to find and the costs of training
their replacements would be very high.

C h art

2

UNIT COSTS, SELLING PRICE, A N D UNIT PROFITS
AT DIFFERENT OUTPUT LEVELS FOR A
HYPOTHETICAL FIRM
D o lla r s
per U nit
o f O u tp u t

selling price per unit of output equals unit overhead
costs plus other unit costs plus unit profits.

Over­

head costs consist of certain contractually fixed costs
(such as insurance, property taxes, rent, and interest
on bonded

indebtedness)




and fixed

depreciation

Level

Level

15

The remaining component of selling price is pro­
fits per unit of output. A s illustrated in Chart 2,
this unit profit component is larger at higher outputs
where the cost component of price is smaller. The
chart shows the unit cost curve of a hypothetical
firm, as well as the price at which it sells its product.
The hypothetical unit cost curve is composed of
(falling) unit overhead costs plus (constant) other
unit costs. As depicted in the chart, profits per
unit of output, i.e., the difference between price and
unit costs, are larger at the prosperity level of out­
put than at the recession output level.
Several qualifications to the preceding analysis
should be noted. T he discussion assumed that
selling price, w age rates, and produ ctivity re­
main unchanged over the cycle. In actuality,
prices, w ages, and productivity tend to expand,
albeit at different rates, during the upswing. Changes
in those variables cause the curves shown in Chart 2
to shift.

Rising prices shift the price line.

Rising

wages and productivity shift the cost curve.

Rising

wages, which tend to raise the cost curve, may be
offset by rising productivity, which tends to lower
the cost curve.

During the first half of an upswing,

productivity growth tends to more than offset wage
increases, thereby shifting the cost curve downward.
Moreover, firms enjoying some degree of monopoly
power may respond to the increase in aggregate de­
mand by raising prices as well as output.

Thus,

rising prices may combine with falling unit costs
(both a shift in the curve and a rightward move­
ment along it) in prosperity to raise unit profits
and profits’ share.

16




The favorable influence of prosperity on unit pro­
fits is likely to diminish as the expansion proceeds,
however.
During the later stages of prolonged
booms, several forces combine to raise unit costs.
As the labor market becomes tight, wage increases
accelerate, productivity growth slows, and the unit
cost curve shifts upward. Operating rates of plant
and equipment reach and then surpass their most
efficient levels. These two factors— capacity limita­
tion and wage increases in excess of productivity
growth— cause unit costs to rise faster than selling
price, thereby encroaching on unit profits. The pro­
portion of profits to the value of output declines.
The erosion of profits’ share relative to labor’s share
during the later stages of a business expansion is
well-documented. Official figures show that in all
but one of the post-W orld W ar II cycles the share
of corporate profits was lower and the share of em­
ployee’s compensation higher in the quarter of peak
economic activity than in the three quarters im­
mediately preceding the peak.
The W a g e L a g H ypoth esis A n alternative h y­
pothesis that has been advanced in explanation of the
shift in favor of profits’ share in the upswing and
in favor of labor’s share in the downswing is the
so-called wage lag hypothesis.
According to this
hypothesis, sticky money wages lag behind price in­
creases during booms and price decreases during
slumps. Twenty years ago, economists thought the
wage lag was the most important factor accounting
for the counter-cyclical behavior of labor’s share.
Recent empirical work has cast doubt on the strength
of this effect, however.
Thomas M . Humphrey