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I would like to know more about the mechanisms through which higher labor productivity would translate into higher living standards for a population in a given economy.

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In economics we measure living standards by the amounts of goods and services people can consume. Increasing labor productivity allows us to produce more goods and services and thus also consume more goods and services, hence it improves the living standards.

For example consider classic Cobb-Douglas production function:

$$ Y = K^{\alpha} (AL)^{1-\alpha}$$

in this production function $A$ can be viewed as a productivity of labor (or technology that makes labor more effective). In the equation above $Y$ is income or output (i.e. amount of goods and services) $K$ capital and $L$ labor supply.

Even if everything stays constant (meaning economy does not have more capital or people dont work more hours and so L is also constant), but the labor productivity increases ($A$ goes up) the output of economy goes up as well. Higher output means that there are more goods and services for people to enjoy and in economics we would count that as an increase in (material) living standards.

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  • $\begingroup$ Thanks. You say that “higher output means that there are more goods and services for people to enjoy”, but isn’t this only true if certain conditions are met? It’s not clear to me how the purchasing power of consumers would increase thanks to increases in productivity. For example, what if companies keep salaries the same and charge the same price as before the productivity boost for the goods and services it sells..despite the increases in productivity? $\endgroup$ – StatsScared Jan 25 at 21:39
  • $\begingroup$ @StatsScared in equilibrium in competitive markets people are paid their marginal product. Also, my answer above gave you the mechanism because that was your question. This being said empirically of course this does not hold perfectly. You can have years when there is clearly increase in productivity but wages stagnate. However, when you look at empirical studies of this over long periods of time wages and output are moving more or less close together. Of course, in real life any relationship due to random chance and other influences outside the model (regulation taxes etc) won’t be perfect $\endgroup$ – 1muflon1 Jan 25 at 22:13
  • $\begingroup$ Just to add to my previous comment. In long run in competitive industries firms can’t really choose any wages or prices they want. They have a choice in a sense that the owner of company could set any price or wage she or he wants, but it’s choice as choosing whether to eat or not eat... in the end in long run in competitive markets if you dont pay wage at least equal to marginal product other firms will lure all workers away from you. Same if you try to charge above equilibrium prices. Even in non-competitive labor market you can’t set any wage you want and marginal product will affect wage $\endgroup$ – 1muflon1 Jan 25 at 22:23

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