The McKinsey Global Institute report argues that individual companies should strive to improve their labor productivity. Increased productivity will directly result in improved profitability for the company that achieves it, but the relationship between productivity and profit is more complicated over the long term.
The relationship between productivity and profitability can best be explained with a hypothetical example. Imagine a situation where two companies compete in the same regional market with access to the same input factors. Both have similar levels of productivity and profitability. If one company manages to increase its productivity, it will by definition be able to produce the same quantity of goods and services at the same quality level with less input, thereby enjoying a cost advantage.
The company then can use the resulting profit for new investments, or it can distribute profit to shareholders as dividends. The company may also choose to offer lower prices in order to gain market share or pay higher wages in order to attract higher-skilled labor.
A one-time increase in productivity, however, will usually not lead to a sustainable profitability advantage. In order to stay in business, the other company will have to follow suit and improve its productivity. Once the two competitors reach the same productivity levels, they will start to compete on price until the original profitability advantage has disappeared.
In the competitive environment described, the most sustainable source of profitability is constant productivity improvement. In other words, profitability is the fleeting reward of productivity improvement.
This dynamic also holds true in more complex market situations. Two companies that are located in different regional environments, but which compete directly in a global market may face different input factor costs (i.e., higher wages or cost of capital). In a state of equilibrium, the company that faces higher input factor costs will be able to compensate for this disadvantage through higher productivity. Higher wages, for example, reflect the greater productivity of the labor force in that region.
In a competitive environment, where there is a level playing field, an increase in productivity by one company will start the same process as described above, where the company's competitor is forced to make productivity improvements. In fact, this process may eventually lead to a convergence in input factor costs between the two countries.
