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Study notes

Productivity and Economic Growth

  • Levels: AS, A Level, IB
  • Exam boards: AQA, Edexcel, OCR, IB, Eduqas, WJEC

What is productivity?

Productivity is a measure of the efficiency with which a country combines capital and labour to produce more with the same level of factor inputs.

Output per hour worked in the UK was 15.9% below the average for the rest of the G7 advanced economies in 2015; this compares with 15.8% in 2014.

Output per worker in the UK was 16.6% below the average for the rest of the G7 in 2015.

Productivity growth in the UK 2018 - Revision Video

Revision Video: Productivity Growth in the UK 2018
  • We commonly focus on labour productivity measured by output per person employed or output per person hour.
  • A better measure of productivity growth is total factor productivity which takes into account changes in the amount of capital to use and also changes in the size of the labour force.
  • If the size of the capital stock grows by 3% and the employed workforce expands by 2% and output (GDP) increases by 8%, then total factor productivity has increased by 3%.

Why is productivity important?

Productivity is an important determinant of living standards – it quantifies how an economy uses the resources it has available, by relating the quantity of inputs to output. As the adage goes, productivity isn't everything, but in the long run it's almost everything.

Higher productivity can lead to:

  • Lower unit costs: These cost savings might be passed onto consumers in lower prices, encouraging higher demand, more output and an increase in employment.
  • Improved competitiveness and trade performance: Productivity growth and lower unit costs are key determinants of the competitiveness of firms in global markets.
  • Higher profits: Efficiency gains are a source of larger profits for companies which might be re-invested to support the long term growth of the business.
  • Higher wages: Businesses can afford higher wages when their workers are more efficient.
  • Economic growth: If an economy can raise the rate of growth of productivity then the trend growth of national output can pick up.
  • Productivity improvements mean that labour can be released from one industry and be made available for another – for example, rising efficiency in farming will increase production yields and provide more food either to export or to supply a growing urban population.
  • If the size of the economy is bigger, higher wages will boost consumption, generate more tax revenue to pay for public goods and perhaps give freedom for tax cuts on people and businesses.

The Productivity Gap

What are the main determinants of productivity in a country?

  • Access to Hard Technology
  • Skills of Labour Force
  • Quality of Management
  • Training and Education Standards
  • Competition within markets
  • Cultural Factors such as attitudes and aspirations
Van Reenen: what determines productivity?

Productivity improvements in China

China has achieved impressive gains in productivity in recent years and is catching up towards levels for the East Asian and Pacific region and middle income countries such as Malaysia.

What has driven these improvements in Chinese total factor productivity?

  1. Resource shifts: There has been a huge shift of resources out of relatively low productivity agriculture into more productive work in manufacturing industry and construction. Over half of the Chinese population now lives in urban areas.
  2. New technology and innovation: The willingness of Chinese businesses to adopt new production technologies and process innovations. Mobile telephony has expanded at a rapid rate
  3. FDI effects: High levels of inward FDI have boosted productivity – new manufacturing capacity and technology has lifted efficiency and led to productivity spill over effects among supply-chain businesses. For example, in 2012, Samsung Electronics, the world's biggest memory chip maker, unveiled plans to invest $7bn to build its first chip factory in China.
  4. Openness and global competition: The Chinese economy has become more open – trade is accounting for a rising share of national income – global competition is a stimulus for efficiency improvements
  5. Better infrastructure: Heavy state spending on critical infrastructure has improved the overall efficiency of the economy for example in reducing transport delays and increasing communication speeds
  6. Management: Restructuring of state-owned businesses has been a factor behind better productivity. The Economist magazine reported recently that “sophisticated methods of control, more productive use of assets and rapid globalisation have boosted productivity"
  7. Improved wages: There is strong pressure for mean wages to rise in China especially as the latest Five Year Plan emphasises the need to boost domestic demand. Will a number of years of rapid wage acceleration provide a boost to worker productivity?

Although China's productivity improvements are impressive, the process of catch-up with advanced nations still has a long way to go. China's labour productivity is about 12 per cent of that of the USA

Productivity and economic growth using an AD-AS diagram

Analysis Diagram

Productivity gains are vital to long-term growth, because they typically translate into higher incomes, in turn boosting demand

Michael Spence, Project Syndicate (Feb 2015)

Improving Productivity in Agriculture – Focus on the Indian Farm Sector

For India, despite attempts at land reform to boost incentives for farmers, agricultural value added per worker expressed in real US dollars has grown slowly. The divergence between India and South Korea is striking.

The virtuous circle of rising agricultural productivity

  • Higher farm output per worker
  • Increased incomes
  • Higher savings
  • Creates funds for capital investment
  • Frees up labour for urban areas
  • Surplus output exported

In 2011, nearly 70% of Indians still live in the countryside and over half work on the farm but many are tenant farmers operating with short-term leases on their land and with little incentive to invest in machinery to improve farm yields and incomes. For example, annual rice yields in the Indian state of West Bengal remain at about half China's level and below yields in Indonesia, Taiwan and Vietnam. Productivity is further hampered by inadequate infrastructure including poor roads and vulnerability to external climatic shocks such as droughts and floods.

Critics of India agriculture argue that whereas China has liberalized farming markets and encouraged farmers to build up surpluses to sell in local and regional markets, the India government spends too much money subsidizing fertilizer, power and water and price supports for certain farmers that have done little to stimulate diversification among rural producers.

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