Wage Elasticity and the Short-Run Productivity Puzzle

Perfect competition implies stage two production for labor, where increased employment lowers productivity and decreased employment increases productivity. In contrast, empirical studies of individual firms and macroeconomic studies of the business cycle have document pro-cyclical productivity. This paper explains this productivity puzzle. Specifically, it is shown that recent estimates of the wage elasticity of labor supply to a firm (Manning, 2003, Booth and Katic, 2010, Depew and Sorensen, 2013, and others) are consistent with stage one production for labor with pro-cyclical productivity. It is also shown that in a two resource economy, pro-cyclical productivity implies stage three production for capital and a negative marginal product of capital. It is argued that both stage one production for labor and stage three production for capital have important policy implications.