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AS Market Failure

Productivity

The American economist Paul Krugman once said that “productivity isn’t everything, but in the long run it is almost everything.” We take a look at productivity in this chapter.

The advantages of higher productivity for a business and for the economy

Higher productivity can provide the economy with a number of advantages over time

1. Lower average costs: Improvements in labour and capital productivity allow businesses to produce output at a lower average cost. These cost savings might be passed onto consumers in the form of lower prices, encouraging an expansion of demand, higher output and possibly an increase in employment.
2. Improved competitiveness in international markets: Productivity growth and lower unit costs are key determinants of the competitiveness of British firms in domestic and overseas markets. From improved productivity, businesses can develop a competitive advantage in markets where there is intense price and non-price competition from overseas suppliers.
3. Higher profits: Efficiency gains resulting in rising productivity are a source of larger profits for companies which might be re-invested to support the long term growth of the business
4. Higher real wages: In the long run there is a positive relationship between improvements in labour productivity and the real wages paid to labour as a factor of production. Put simply, businesses are better able to afford higher wages when their labour force is more efficient
5. Economic growth: Our capacity to produce goods and services depends on the stock of factor resources available plus the productivity of those factors. If the British economy can raise the rate of growth of productivity then the trend growth of national output can pick up. This has implications for living standards, unemployment and tax revenues and government spending in future years

The productivity gap

The level of GDP per worker and GDP per hour worked in the UK is well below that of the United States, France and Germany. Evidence on the productivity gap is shown in the previous chart and in the table below.  Some progress has been made in closing the gap but there is still much work to do.

Factors explaining the productivity gap

No one factor on its own is sufficient to explain the differences in efficiency. Some of the more widely quoted reasons are summarized below:

1. Relatively low rates of capital investment – the government believes that the productivity gap is partly the result of a long-term investment gap, i.e. the failure of the economy to invest and thereby to raise the stock of physical capital available to the workforce
2. Low rates of spending on research and development – The percentage of GDP allocated to R&D spending has been on a downward trend for some years. The UK now devotes much less of GDP to research spending than other nations and this impacts on the pace of innovation and the speed with which new technology is incorporated into production
3. Skills of the labour force – there are long-standing concerns about the educational skills of the UK labour force including basic literacy and the quality of job specific training. Although governments have made numerous attempts to reform the education system over the last two decades, and have pumped increasing resources into improved vocational and academic education, Britain still has one of the highest rates of functional illiteracy among adults, together with fewer workers with higher skills (at degree level or above) compared to the United States and fewer workers with intermediate and vocational skills compared to Germany and Japan.
4. Over-regulation of industry and commerce and a lack of competition – the 1999 McKinsey Report highlighted a lack of competitive pressures in some industries (notably retailing) as a source of inefficiency and low productivity growth. Opening up markets to the discipline of competition was seen by the McKinsey study as a necessary supply-side economic strategy to bring new businesses into markets and weed out inefficiencies.

Productivity in the UK Car Industry

A good example of the differences in productivity between the UK and our European competitors is shown by the annual assessment of productivity in the automotive industry.

Britain has some of the most efficient car plants in the EU – but also some of the worst. This two speed car industry suggests that there are structural reasons behind productivity differences. Nissan has remained at the top of the European productivity league for each of the last seven years.

Those industries with the most up-to-date capital machinery, together with advanced managerial skills and highly qualified and well-trained workforces tend to achieve much higher levels of productivity. The availability of large-scale green-field, full-integrated production plants and good industrial relations are also at the heart of achieving year on year improvements in output per person employed.

The strength of demand also affects productivity. When demand is high and production plants are running close to full capacity, then output per worker employed is likely to be rising because factor resources including labour and capital are being used to their full extent. In contrast, during a recession or a slowdown in demand, the utilisation of labour and capital falls. Productivity growth often slows down during a period of weak demand and falling output.