George L. Perry

English

Research Papers in Economics

GEORGE  L.  PERRY 
Brookings Institution 
Controls  and 
Income  Shares 
I AGREE WITH  SO MUCH of what Gardner  Ackley has written  about the 
Phase  II program  that  I hesitate  to take  issue  with  his paper  at all. Since  the 
end of the freeze,  prices  have risen  too rapidly,  and the goal of bringing 
the inflation  rate below 3 percent  will not be reached  unless  the Phase II 
authorities  get tougher.  Some of the operating  procedures  of the Price 
Commission  should be revised  to accomplish  this improvement;  and I 
agree, in particular,  that the commission  should not rely on term-limit 
pricing  arrangements  and on cost estimates  supplied  by firms  themselves. 
But I do disagree  with Ackley's  treatment  of cost absorption.  And that 
point is so central  to the issue of income  shares  under  Phase  II-an  issue 
that,  in turn,  is so emotionally  charged  that  it threatens  to disrupt  support 
for the overall  program-that a comment  is in order. 
Ackley  defines  concepts  of "cost  absorption"  for  both  labor  and  business 
and uses them to show that unless  there  is cost absorption  by one or the 
other,  inflation  will  not slow down.  He then  argues  that  present  procedures 
require  no cost absorption  by business,  while  they  do require  it from  labor. 
He concludes  that  the program  should  be restructured  to require  some  cost 
absorption  by business,  and suggests  that a vigorous  enforcement  of the 
overriding  profit  margin  regulation  be used  to accomplish  this. 
This analysis  implies  that  the present  program  is unfair  to labor  in prin- 
ciple.  However,  this  conclusion  follows  from  a definition  of cost absorption 
by labor that I find inappropriate.  A "fair,"  or neutral,  program  can be 
reasonably  defined  as one that does not change  the relative  shares  of in- 
191 192  Brookings  Papers  on Economic  Activity,  1:1972 
come going  to profits  and wages  from  what  they would  have  been  without 
the program.  But  it can  be shown  that  requiring  cost absorption  by business 
would  lead  to a reallocation  of income  shares  from  profits  to wages,  while 
without  cost absorption  by business,  shares  would be unaffected  by the 
program.  Yet inflation  would still slow down if the rate of wage increase 
slowed. 
Let me use Ackley's  model,  and  his notation,  and  generalize  it slightly  to 
allow  for any degree  of cost absorption  by business  or labor  on his defini- 
tions. For wages, 
(3*)=  W-t-  (1  +P)[1  +  q  -  )1 
where  q is the "pass-through"  ratio  (equal  to 1 minus  the absorption  ratio). 
When q =  1, prices are fully passed through into wages and we have 
Ackley's  equation  (3). For prices, 
(5*)  Pt=  Pt-,  [I  +  r  -t 
[  Wt_  (1  +p  )] 
where  r is the pass-through  ratio  of costs  into prices.  When  r =  1, we have 
the pricing  relation  implied  by Ackley's  equations  (5) and  (2). 
Substituting  (3*) into (5*) and simplifying  yields 
(6*)  P  rq  -  1,  +  1. 
If there  is no absorption  by business  or  labor,  so that  r =  q-1,  inflation 
will not slow down,  which  is Ackley's  result.  But now the twin labels  "ab- 
sorption"  are  misleading.  For it makes  quite  a difference  whether  inflation 
slows by bringing  r or q below 1. Neutrality  does not imply  that  r and  q be 
made  smaller  together. 
Labor's  share,  L,, is given  by 
(4*}  L  NtWt 
and  with  Ackley's  equation  (2) specifying  the productivity  trend, 
(7*)  Lt  _  Wtl(l  +  p)Wt-, 
Lt-,  Pt/Pt_l George  L. Perry  193 
is the ratio of labor's  share  from one period  to the next. With equations 
(3*) and  (6*) above  substituted  for wage  and  price  changes, 
(8*)  Lt  =  (r  i,i) 
1+  r 
- 
Thus,  if there  is no business  cost absorption  (r =  1), these shares  are un- 
changed  (Lt = Li-1) regardless  of the value  of q, while  if business  absorbs 
some costs (O  < r <  1), labor's  share  grows as a result of the program 
(Lt > Lt-1)  regardless  of the value  of q. 
Thus,  cost absorption  by business  and labor,  as they have been defined 
here,  are  quite  different  things.  Bringing  either  q or r below 1 slows  the in- 
flationary  treadmill.  But  bringing  q below 1 does  not affect  relative  shares, 
while  bringing  r below 1 increases  labor's  share.  This result  should  not be 
viewed  as specific  only to the simple  model described  by Ackley and the 
equations  just presented  here.  The basic wage-price-productivity  rules of 
Phase II correspond  to equations  (3*) and (5*). Although  not stated in 
these terms, the wage rule allows increases  equal to trend productivity 
growth  plus a fraction  of past price  increases;  while  price  increases  are al- 
lowed  only to the extent  of cost increases-represented  in equation  (5*) by 
wage  changes  adjusted  for the trend  growth  in productivity. 
Nonetheless,  there  are  many  ways  in which  the real  situation  confronting 
the Phase  II administrators  can differ  from  the models  described  here.  At 
the start  of the program,  some workers  whose  wages  are changed  only at 
lengthy  intervals  had fallen  behind  the price  increases  that had occurred. 
Some  firms  whose  p"rices  had not responded  promptly  to cost changes  had 
also been left behind.  We know that the Pay Board  made allowances  for 
wage  increases  in excess  of the  normal  standard  in cases  where  wages  clearly 
had fallen  behind  price  increases  that had  been experienced  up to the start 
of the program.  While  the basic guide  for price  increases  during  Phase  II 
should  probably  be cost increases  incurred  since  the start  of the program- 
a rule  that would  conform  to equation  (5*) with  r =  1-occasional excep- 
tions  could  be made  just as they  are  on the wage  side.  It is hard  to see how a 
few "last  cows into the barn"  on either  the wage  or price  side can make  a 
great  deal of difference.  And it seems  unlikely  that a whole herd of price 
increases  would  seek  to be  justified  in this way.  Indeed,  to argue  that  many 194  Brookings Papers on Economic Activity, 1:1972 
price changes  will be justified  by cost changes  that occurred  before the 
start  of the program  is equivalent  to saying  that prices  lag wages  substan- 
tially  and  that  the wage  share  was ahead  at the start  of the program.  In this 
case, as far as shares  go, the presumption  would  be to allow  such price  in- 
creases  merely  to get back to "neutrality."  However,  I doubt  that this is a 
realistic  case  to consider.  All in all, I know  of no evidence  that  either  wages 
or prices  were  noticeably  ahead  on average  at the start  of the program. 
At another  time, some cost absorption  by business  might  have seemed 
both more necessary  and more appropriate  than it seems now. In early 
1968, I proposed  a new guidepost  formula  that called for absorption,  as 
defined  here, by both labor and business.'  At that time, wages under  the 
large  number  of long-term  wage  contracts  that were  coming  up for nego- 
tiation clearly  had fallen behind  in the inflation  that started  in 1966.  To 
ask a slowdown  from wages  in this environment  was clearly  to ask for a 
sacrifice,  and some cost absorption  by business  seemed  necessary  as the 
other  half of the bargain.  Today's  situation  is not the same. 
None of this addresses  the crucial  questions  that  Ackley  has  raised  about 
how  well  the Price  Commission  has  actually  done  its  job. His criticisms  and 
concerns  are well founded  and I share  them. But I would  prefer  that the 
commission  get tough on a correct  set of rules  rather  than adopt  new ones 
on the view  that  the existing  program  is, in principle,  unfair.  As a basic  un- 
derpinning,  this  means  price  changes,  both  up and  down,  geared  to realistic 
estimates  of productivity  trends.  I would  like to see the Price  Commission, 
in implementing  that basic rule, settle all close calls on the side of price 
stability.  But  doing  so will  still  involve  cyclical  gains  in margins,  and  a small 
cyclical  shift  in shares  toward  profits,  in a year  of rapid  expansion  such as 
1972.  Because  of the substantial  variability  in the year-to-year  productivity 
and  profit  margins  of individual  firms,  it could also mean  that many  firms 
would  exceed  their  base period  margins  even though  their  price  increases 
since  the  base  period  have  not exceeded  the  trend  growth  of their  costs.  And 
this makes  the profit  margin  ceiling  a very  clumsy  substitute  for the pro- 
ductivity  rule in enforcing  price  standards. 
1. See "Statement  of George  L. Perry,"  in The Wage-Price  Issue: The  Need  for Guide- 
posts, Hearing  before  the Joint Economic  Committee,  90 Cong. 2 sess. (1968),  pp. 12-19. 

Controls and Income Shares

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Controls and Income Shares

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