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What’s it: Total factor productivity quantifies the share of economic growth not explained by increases in labor and capital when both are used together in the production process. We also often refer to it as the residual Solow model or multifactor productivity.
There are various explaining factors for total factor productivity. One of them is technological advancement. Advances in technology make workers more productive. For example, they can learn from the internet to acquire new skills or find ways to do their jobs faster.
Advances in technology are also responsible for increasing business output significantly. With more sophisticated machines, manufacturers can produce the same output but faster than before. Or, they can also produce more output using the same quantity of input because machines are more efficient.
Calculating total factor productivity
Take the Solow growth model. The aggregate economic output formula is as follows:
- Y = A Kα Lβ… Equation 1
Where
- Y = Aggregate output
- L = Workers
- K = Capital
- A = Total factor productivity (TFP)
- α = Output elasticity of capital (α <1)
- β = Output elasticity of labor (β <1) and α + β = 1
We can rewrite equation 1 above as output per worker. The results are as follows:
- Y/L = A (K/L)α… Equation 2
Where
- Y/L = Output per worker or worker productivity
- K/L = Capital per worker
From the first and second equations, we can take three critical points:
First, labor and capital face diminishing marginal returns (you can see that α and β are less than 1). Thus, in the long run, labor and capital contribution to output is at a decreasing rate.
Second, investing in capital deepening – which increases the capital-power ratio – is not the solution to sustaining long-term growth. The capital-power ratio has a decreasing rate of return. Thus, when it is high (K/L), the addition of capital investment only contributes less significantly than when it is low.
Third, the only way to sustain economic growth in the long run (potential GDP) is to increase total factor productivity (A) through technology.
Technological advances will result in an outward shift in the production function. In the production possibilities curve, it is reflected by shifts in the curved lines to points outside the curve. More advanced technology allows the economy to produce greater output even though labor and capital are fixed.
Measuring total factor productivity growth
Furthermore, from the previous Equation 1, we can also rewrite it to measure aggregate output growth. The results are as follows:
- ∆Y/Y = α*∆K/K + β*∆L/L + ∆A/A… Equation 3
Where:
- ∆Y/Y = Aggregate output growth rate
- ∆K/K = The rate of capital growth
- ∆L/L = Growth rate of labor
- ∆A/A = Total factor productivity growth
Equation 3 above shows a regression model. ∆K/K and ∆L/L represent the independent variables (predictors), where α and β show the impact of growth in capital and labor on aggregate output growth. Meanwhile, ∆A/A represents the model’s residuals.
Thus, to obtain total factor productivity growth (∆A/A), you must have data for ∆K/K, ∆L/L, and ∆Y/Y. Then, you regress ∆K/K and ∆L/L against ∆Y/Y. You will get the error or residual from the regression, and that’s ∆A/A.
Some agencies also provide data. For example, you can find it on the Federal Reserve Bank of St. Louis website for the United States private business sector. You can also get it on the OECD website, which covers several countries other than the United States.
Importance of total factor productivity
The source of growth. As I explained earlier, total factor productivity is the key to long-run economic growth because labor and capital have a decreasing marginal return. It becomes even more critical when the capital per worker ratio is high, as in developed countries.
The gap between developed and developing countries. Now ignore total factor productivity. Since the capital per worker ratio has a decreasing return rate, the deepening effect of investment has a more significant impact when the ratio is low. In this case, it represents a developing country. They should enjoy high growth, as well as their GDP per capita.
On the other hand, developed countries—with high capital per-worker ratios—benefit less from capital deepening. As a result, their economic growth and GDP per capita are also low.
In the long run, because the GDP per capita in developing countries grows higher than the GDP per capita in developed countries, the two will converge at the same point (convergent, often called the catch-up effect). In the end, developing countries will enjoy the same prosperity as developed countries.
However, you can see that the gap between the two is still huge. The key to the answer is total factor productivity. That explains why the two don’t converge. GDP per capita in developed countries is still much higher than GDP per capita in developing countries.
While developing countries still rely on agriculture and manufacturing, developed countries have relied on services, especially in technology, to spur growth. The emergence of giant companies like Microsoft and Google is an example.
Factors affecting total factor productivity
While technological innovation is a major engine of TFP growth, it’s not the only factor at play. Here’s a deeper dive into other crucial determinants that influence how efficiently existing labor and capital are used:
Research and development (R&D): Investing in R&D fuels innovation, leading to the creation of new technologies, processes, and products. This can significantly improve efficiency and productivity across various industries. Imagine a company developing new software that automates tasks, allowing employees to focus on more complex activities. This would lead to a significant increase in their output.
Management practices: Effective management practices are essential for maximizing TFP. This includes strategies like implementing efficient workflows, optimizing resource allocation, and fostering a culture of continuous improvement. By streamlining processes and eliminating inefficiencies, a well-managed company can squeeze more output from its existing workforce and capital.
Production techniques: The adoption of new and improved production techniques can significantly enhance TFP. This could involve implementing lean manufacturing principles, utilizing automation technologies, or simply redesigning production lines for better flow. Think of a factory that upgrades its assembly line with robots, reducing human error and increasing production speed.
General knowledge: A skilled and educated workforce is crucial for utilizing technology effectively and adopting new processes. Investing in education and training programs equips workers with the knowledge and skills needed to contribute to higher productivity. A more knowledgeable workforce can adapt to new technologies and continuously improve their efficiency.
Network effects: In today’s interconnected world, network effects can play a significant role in TFP growth. As more users join a platform or adopt a technology, its value and efficiency often increase. Imagine a social media platform – the more users join, the more valuable the network becomes for everyone involved. This can lead to increased communication and collaboration, ultimately boosting productivity.
Increased competition: A competitive market environment incentivizes businesses to innovate and improve their efficiency to stay ahead constantly. This can lead to the development of new technologies, better management practices, and a continuous drive for optimization. When companies compete fiercely, they’re forced to find ways to produce more with less, ultimately boosting TFP.
While these factors seem diverse, economists often categorize them under the umbrella term “technological factors.” This broad term reflects the idea that these elements contribute to advancements in knowledge, processes, and overall economic efficiency – the very essence of TFP growth.
