T2.

Productivity

1. Productivity Definitions and Importance

Productivity is the fundamental driver of increases in per capita income. From a long-term perspective,
economic development is a matter of productivity change. Our measures of productivity goes hand in
hand with out measure of economic wellbeing.
𝑜𝑢𝑡𝑝𝑢𝑡
𝑝𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑣𝑖𝑡𝑦 =
𝑖𝑛𝑝𝑢𝑡𝑠
This leads to different measures according to the definition of outputs and inputs. Two standard
definitions:

• Factors (Labour, Capital) Productivity: Y/L; Y/K. How much product we generate for given
factors.
• Total Factor Productivity (TFP): Increase in production due to improvement in the combined
use of all factors. This idea is very much related to technical change, doing things with better
technology.
o TFP is defined as a residual: measure the contribution to growth of capital and labour.
The remaining unexplained part is TFP’s contribution. What is not due to using more
capital or labour is going to be an improvements in TFP.

Labour productivity (apparent labour productivity) is the most used definition because:

− It is the main source of income per capita growth

− If the labour market works in a competitive markets equilibrium wage = marginal productivity
of labour.

But TFP and labour productivity are related to each other. To see how, we need to decompose GDP
growth into its determinants.

2. Growth Accounting Methodology

Original idea by Solow (1957) then, developed by Jorgenson and Griliches (1967). This did not exist
since the beginning of time, it’s something relatively recent and the debate is still ongoing.

Main idea: break down observed economic growth into the contribution of each factor (capital &
labour). In this way, the relative contribution of each factor and its productivity can be measured. The
residual is TFP, which can be caused by as efficiency gains or technical change.

Because TFP calculations are not part of official statistics we are going to find the results of projects
that try to measure this productivity with different methodologies. It is a concept subject to applied
and theoretical research in economics.

GROWTH ACCOUNTING

Take a production function and we assume that they have constant returns to scale (Cobb Douglas,
CRS: α+β=1)
𝛽
𝑌𝑡 = 𝐴𝑡 𝐾𝑡𝛼 𝐿𝑡

A: Total Factor Productivity (TFP), aka Solow’s residual.

Divide both sides by L, and define y=Y/L & k=K/L.

𝑌𝑡 = 𝐴𝑡 𝐾𝑡𝛼
Labour productivity growth can be expressed as:

∆𝑦𝑡= ∆𝐴𝑡 + 𝛼 · ∆𝑘𝑡

(growth rate = derivative of logarithm)

Labour productivity is going to increase by the amount that technical change increase + capital
multiplied by alpha.

Therefore, changes in labour productivity depend on:

− Changes in the ‘capital deepening’ (K/L) : α·Δkt

− Changes in Total Factor Productivity (TFP): ΔAt

Two uses of this model:

− What explains growth? Since α <1, in the long run the capital/labour ratio will have a limited
impact on y. So, labour productivity growth depends on TFP growth
− Empirical measurement of growth. We can observe Y, L and K, estimate the value of the
coefficients α and β, and therefore measure A as a residual. In this way we can measure each
element’s contribution to growth.

MEASURING TFP

Rewrite the production function in terms of growth rates (takes logarithms on both sided and multiply
by the exponential):

∆𝑌𝑡= ∆𝐴𝑡 + 𝛼∆𝐾𝑡 + 𝛽∆𝐿𝑡

Solve for ΔAt:

∆𝐴𝑡= ∆𝑌𝑡 − 𝛼∆𝐾𝑡 − 𝛽∆𝐿𝑡

∆𝐴𝑡=Solow residual = change in TFP = technical change = observed increase in GDP – contributions of
capital – the increase in labour + beta

The value can be negative, it means that the production function is shifting downwards. If it goes down
it means that what was possible to do at one point it no longer possible the next period.

3. Issues on the Measuring of TFP

TFP measures are the result of applying a ‘growth accounting methodology’ with several underlying
assumptions. Some of those assumptions are discussed under two areas:

− Function specification bias: have all relevant inputs been included in the production function?
(omitted variable bias)
− Measurement errors: any mistake in quantifying the variables will result in an error captured
by A, and thus influence the value of TFP.

The main discussions focus on the role of intermediate consumption, labour heterogeneity and
capital.

A. INTERMEDIATE CONSUMPTION

Production includes value added. Therefore, to be more precise, the role of intermediate consumption
(M) should be made explicit. Then:
𝛽 𝜑
𝑌𝑡 = 𝐴𝑡 𝐾𝑡𝛼 𝐿𝑡 𝑀𝑡

and now the Solow residual is: ∆𝐴𝑡= ∆𝑌𝑡 − 𝛼∆𝐾𝑡 − 𝛽∆𝐿𝑡 − 𝜑∆𝑀𝑡

So, not taking intermediate consumption into account biases the TFP measurement upwards.
B. LABOUR

Labour is very heterogeneous, mainly due to the effect of human capital.

This can be included in the model in the following way: labour = hours worked (H) * quality measure
of human capital (N):

𝐿𝑡 = 𝐻𝑡𝑁𝑡

then: 𝑌𝑡 = 𝐴𝑡𝐾𝑡 𝛼 (𝐻𝑡𝑁𝑡)𝑡 𝛽𝑀𝑡 𝜑

so: ∆𝐴𝑡= ∆𝑌𝑡 − 𝛼∆𝐾𝑡 − 𝛽∆𝐻𝑡 − 𝛽∆𝑁𝑡 − 𝜑∆𝑀𝑡

This makes it possible to observe the difference between the contribution to growth of human capital
accumulation (ΔN) and that of the TFP.

Moral and Hurtado (2003) measured this for the Spanish Economy (1987-2003): human capital
accounts for 47% of the computed change in TFP. The production function may shift a lot but its
because of the workers.

For the period 1850-2000, Prados de la Escosura and Rosés (2010) decompose labour productivity
changes considering education quality measures (H). The importance can be substantial in terms of
productivity, this should be taken into account.

C. CAPITAL

The main problem with measuring capital is that the services it provides are difficult to observe. So,
they are usually approximated by the capital stock. In a sense we are assuming that all computers are
used the same and count them the same.

This generates a set of different problems:

− How can we estimate a stock? Perpetual inventory method.

− Different rates of capital use, idle machinery, obsolescence…
− As labour, capital is also heterogeneous. Which weights should be used to aggregate the
different kinds of capital?

One sector where all these problems are very relevant: ICT.

− Difference between stock and services: hardware and software.

− Which value should be given to obsolete hardware?
− Is all software (and all data) equally productive?

D. OTHER ISSUES

Can we relax the Constant Returns to Scale (CRS) assumption? Yes, but it leads to other econometric
and interpretation problems.

Cyclical bias in capital: The use of the capital stock cannot be easily adjusted over the business cycle
(labour). This varying intensity of use should be taken into account in any long-run measurement.

TFG calculations at sector level:

− Are there relevant differences by sector?

− International national differences due to countries’ specialization in different sectors

4. Growth Accounting at Sector level

Recall the possibility to decompose per capita GDP. We can also add hours to get:
𝑅𝑒𝑎𝑙 𝐺𝐷𝑃 𝑅𝑒𝑎𝑙 𝐺𝐷𝑃 𝐻𝑜𝑢𝑟𝑠 𝐸𝑚𝑝𝑙𝑜𝑦𝑚𝑒𝑛𝑡
= ∗ ∗
𝑃𝑜𝑝𝑢𝑙𝑎𝑡𝑖𝑜𝑛 𝐻𝑜𝑢𝑟𝑠 𝐸𝑚𝑝𝑙𝑜𝑦𝑚𝑒𝑛𝑡 𝑃𝑜𝑝𝑢𝑙𝑎𝑡𝑖𝑜𝑛
so that the relative contribution of each element to observed GDP pc changes can be measured.
We want to measure the relative contribution of each of the elements to GDP and we compare it with
the average of the EU.

Cuadrado, Moral-Benito and Solera (2020) do this for Spain and compare the results with EU-12
average, France, Germany and Italy in 2000-2016. A number <1 means that Spanish level is below that
country’s.

Main ideas:

• No significant changes when comparing GDPpc in EU12 & Spain in 2000 to 2016. Spain around
85%. But, there is significant volatility: 90% (2007) to 81% (2013). This is because of labour
productivity
• Determinants: labour productivity and hours worked/worker relatively stable; employment
rate varies pro-cyclically.
• Convergence with Italy due to narrowing labour productivity gap.

SECTOR ANALYSIS OF PRODUCTIVITY

The answer could lie in sector’s productivity: Spain may be specialised in low-productivity sectors.
Eurostat data makes it possible to replicate the analysis at sector level (23 activities).

For total economy: 0.91 labour productivity in 2000 & 2016. Normally the public sector is eliminated
from these computations because the product it generates is not traded at market prices.

Only 4/23 sectors show labour productivity above EU average in 2000-2016: accommodation and food
services, agriculture, electricity & gas supply, I&T services.

The low productivity problem affects most sectors. We can measure how much of the productivity
difference is due to sector composition (shift-share decomposition).

Assume that the sectoral specialisation of Spain is the same as EU12 and use the sector productivity
levels to compute a national weighted average. The result would be a 0.94 productivity gap. Compare
with observed 0.91: aprox 1/3 of the productivity difference is due to specialisation in activities with
productivity below EU12 average.

GROWTH ACCOUNTING DECOMPOSITION

Application of the Solow model to growth contributions at sector level (ICT & non ICT sectors)

𝑌 = 𝑦 · 𝐿 ՜ ∆𝑌 = ∆𝑦 + ∆𝐿

GDP = labour productivity + hours worked

Δ𝑦 = Δ𝐴 +𝛽∆𝑁+ 𝛼·Δ𝑘

Labour productivity = TFP + Labour skills + K/L

K/L = (ICT K/h) + (non-ICT K/h)

Capital deepening= ICT & non ICT activities

Need of high quality detailed data at sector level (KLEMS database)

KLEMS DATABASE

A research project funded by EU. Not part of official statistics.

Detailed industry level data of GDP growth, productivity, employment and capital.

Available for EU countries & US since 1980

Variables to carry out growth decomposition:

• Sector level of labour skills & worked hours

• Physical capital decomposed between ICT & nonICT.
 • Market economy: public sector is excluded.

Δ Labour productivity = TFP cont. + Labour composition (skills) change cont. + capital deepening (K/L)
contribution (ICT, non ICT)

The problem of Spain is that its not increasing, we’re not catching up. Although we can see it has
positive and higher contribution in knowledge, its higher in Spain than in the average of the EU. In
Spain we have a negative TFP therefore, the technology is worsening.

SECTORAL DETAIL

Negative TFP contribution is equivalent to regressive technical change.

Although 2014-2016 figures show positive contribution, this is obviously a serious problem. There was
not a sector where growth was explained by new technology.

Services are very heterogeneous and the production function within a service activity is too different.