What Is Total Factor Productivity Growth And Why Is It Important?

Total Factor Productivity

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Total factor productivity is a neo classical concept. The conventional growth model describes the output growth assuming constant return to scale with given technology. Total factor productivity was first accounted in Solow growth model. In Solow model, it is taken as a residual term that is portion of output that remains after considering the contribution of all other factors. The focus of the essay is to define total factor productivity and to explain its importance for the economy.

Total Factor Productivity captures all the unexplained factors affecting output growth. In today’s world, it has become a key determinant of economic growth. Most of the developed countries have accounted a higher rate of productivity growth. Even for developing nations, the contribution of Total Factor Productivity is notable. In this context, the development issues in Asia are discussed. After the global financial crisis, Total Factor Productivity contributed significantly in recovering the crisis.

The growth of East and Southeast Asian countries accounted for huge growth rate in the late 1990s. The essay examines whether factor productivity is the driving factor for speculative growth experience in these countries.

Production Process comprise of utilizing the factor of production in the best efficient ways. The level of output depends on the scale of production. Total Factor Productivity (TFP) shows the production relation not in terms of quantity but in terms of quality (Van Beveren 2012). The amount of output depends on not only the quantity of input but also on how efficiently they are being used. It actually explains the residual output that is output beyond the quantity of input.

There is a positive functional relation between the output of an economy and the physical and human capital invested in the production process. The future growth rate is computed by the observed growth of physical and human capital given the technology. The standard assumption of growth forecast is that the production function exhibits constant return to scale and there is perfect competition in the factor market. Mismatch between actual output and that is predicted is either due to violation of the standard assumption or due to change in the unexplained factors like institutional change, changes in the technology and so on (Erken, Donselaar and Thurik 2016). These deviating factors are together called growth in Total Factor Productivity.

Measure of Total Factor Productivity

Measure of Total Factor Productivity

Total factor Productivity traces out the contribution of technological progress in total output. This can be understood by using the following production function:

Y = AF (L, K)

Y= total output

L= amount of labor input

K= amount of Capital

A is the technology used in production process. It is the measure of factor productivity.

Economic growth is indicated by the growth of total output. The growth accounting expression looks as follows           

Growth in Output = Contribution + Contribution + Growth in Total Factor

                            Of Capital        of Labor                Productivity

This equation identifies three sources of economic growth; proportionate change in Capital, Proportionate change in Labor and change in factor productivity.   α and (1-α) is the share of Capital and Labor in the production process following a Cobb-Douglas production function.

Total factor Productivity cannot be measured directly. Cross Country, data are available on output growth, participation of labor, investment in capital. Using this information the growth of total factor productivity is calculated as output growth less the contribution of labor and capital. Thus, it gives an indirect measure of Productivity growth. A/A is the change in output that the physical factors fail to explain (Acs 2013) It is computed as a residual that is the proportion of output growth that is left after considering all the other components that can be observed directly.

Importance of Total Factor Productivity

The concept of Total Factor Productivity is crucial for growth accounting analysis. Nations with increasing factor productivity are able to attain a higher economic growth even when other factors remain constant (Van Ark 2014). Improvement in factor productivity can be achieved for various reasons. The most accounted reason is the change occurred from technological progress. With increasing knowledge about production technique, the factors can be used more productively. Apart from technological progress, there are other factors as well that can contribute to higher productive growth. Government intervention can increase or decrease total factor productivity. For example, if government raises its spending to improve the quality of education then the labor force become more productive and contribute to a higher output (Fontana and Setterfield 2016).On the other hand if the objective of the government is to protect the environment or to increase the workers safety then reverse result can be obtained. In this situation, government implements some law that forces the firms to invest more capital to reduce the pollution or to improve workers safety. Here, despite increase in capital investment output does not change. Hence, implies constant or decreasing total factor production.

Importance of Total Factor Productivity

TFP provides explanation of short run and long run economic fluctuation, long run economic growth and Cross-country income differences (Fontana et al. 2016) The literature of real business cycle indicates a strong correlation of the productivity growth with the output and labor hours. The relation between TFP and long run growth is first traced by the growth accounting model developed by Robert Solow. In this model, technological progress is treated as exogenous. The effect of technological progress is captured with a slight extension of Solow growth model named as endogenous growth model where technology is taken as an endogenous factor affecting long run growth. By linking TFP with technological innovation, this has significant implication for business cycle fluctuation (Kurz and Salvadori 2014)

Total Factor Productivity has become an important determinant of steady long run economic growth (Benigno,Ricci and Surico 2015).Economic growth is defined as a continuous increase in the per capita income, which in turn depends on the total output. A steady growth in output actually indicates Economic growth. Greater the return from the input higher is the output. Return from the invested input depends on the technology. Better technology means higher output per unit of input. Installation of advanced technology produces higher return from invested capital stock.TFP is also important in determining the output per worker. Change in the output per worker depends on the input per worker and growth in factor productivity. In Western and Southern Europe the combine, growth of measured input and Productivity is responsible for significant growth there ( Tung 2016).

The inter country difference in per capita income is also explained by the Total Factor Productivity. Two nation endowed with same amount of natural resources may have different output growth. This is due to different return from input, which implies different factor productivity.

Increasing total factor productivity growth is becoming a crucial factor for development of Asian economies especially after the global financial crisis recovery. Total Factor Productivity has increased significantly in the phase of recovery (Anand et al. 2014).Investment in human capital has improved the quality of labor force and hence productivity. The decision to open up the economy in different spheres and effective government intervention contribute positively to productivity growth. Most of the countries shifted their focus from physical capital accumulation to the growth of TFP. Previously the economy was suffering from a deficiency of capital and low per capita income. With the new strategy, it now shifted to middle-income group nations. The increasing stock of capital helped to handle the problem of diminishing marginal return to capital. Prior to 1990 capital accumulation was the driving factor of growth in Asia. Until 2002 this trend continued. Major shift in structural composition had taken place around 2002 (Imai et al 2014). Since then the importance of TFP in growth accounting started increasing. Prior to 2000 capital accumulation was significantly higher in Asia and the contribution of TFP was not that much. This is shown in the following table:

Development issue in Asia and Total Factor Productivity

Table 1: Average growth of output and input in Asia during 2000

(Source: Economic Planning Unit)

Nations growth depends on both the manufacturing and service sector growth. The contribution of Total Factor productivity in development of service sector is also important. In this context, the case of Malaysia where service sector plays a dominant role in considered (Sufian and Habibullah 2014). The growth of service sector in Malaysia is primarily based on increasing efficiency. However, output growth in the concerned sectors and sub sectors are resulted from considerable technological progress along with labor and capital growth. As a result productivity growth is primarily targeted in different Malaysian plan.

The targeted Factor Productivity Growth in 8^th and 9^th Malaysian plan is shown in the following table:

Table 2: Contribution of Factors of Production

(Source: Economic Planning Unit)

The increasing focus in TFP has proved fruitful for Malaysia (Lee and McKibbin 2014). The service sector growth is positive because of improvement in technical efficiency. The growth in sub industries is also contributed from the improved technical efficiency. Two sub sectors where TFP is a significant determinant of growth are real estate agents and advertising agencies. Though it is difficult for Malaysia to make its own technological innovation, focus should be given to the adaption of imported advance technology.

Evidence from East Asia

In the history of Asian growth experience, the speculative growth of some East Asian countries such as Hong Kong, Singapore, South Korea, and Taiwan needs analysis. Given the importance of TFP growth, it is assumed that the main driving factor should be TFP growth. However, result turns to be opposite. Empirical evidence suggest that TFP growth of these countries was not that much high. In fact, it is zero for some countries. The growth resulted from rising capital accumulation. This gives a contrasting result to that fact that higher capital accumulation leads to technological enhancement (Gereffi and Wyman 2014).

The evidence of output growth cannot be ignored for these East Asian Tigers. The growth of per capita income during 1960-1990 was even greater than that in United States. This moves the countries from world poorest countries to the world richest one (Jia and chao 2016). Detail study on the growth data found that increasing growth rate for East Asian Tigers is resulted from the massive increase in measured factor input. Participation of labor force, capital stock and educational attainment all increase simultaneously. For example, South Korea Investment GDP ratio reached 30% from a mere 5%. The percentage of working population having minimum high school education increased almost three fold from 26% to 75% (Cooke and Jiang 2017). Hence, most of the output growth is explained by the component of traditional growth theory like labor, capital stock and human capital.

The special case of zero productive growth in Singapore is due to its own policy set up (Samaniego and Sun 2016). The government forced people there to save a significant portion of their income. Thus, the national saving is increased. Problem was in their way to adapt foreign technology. They skip several stages before launching the new technology to avoid cost. Hence, the ultimate result was a technological failure and zero productive growth. On the other hand, for China, Taipei a significant portion of overall growth is accounted by TFP.

Conclusion

The concept of Total Factor Productivity is important not only in explaining growth but also in explaining other important macroeconomic aspects. The long-term growth of nation is greatly influenced by the factor productivity. Business cycle fluctuation, inter country income differences are well explained with the help of total factor productivity.

In neo-classical growth model, (Solow model) total factor productivity is computed as a residual term from the growth accounting equation. Later on, development of endogenous growth model made this concept clear by linking it with R&D. With improvement in technology, factor productivity increases and hence output. Not only developed countries but also the developing countries are showing progress in technological front either directly investing in R&D or imitating foreign technology. TFP has contributed a significant portion of output in Asian countries. Most of them have successfully adapt advanced technology by following learning by doing. Exception has obtained only in case of East Asian Tigers. Their higher growth rate is not resulted from high growth of productivity but it is explained by the accumulation of physical and human Capital. Special case is observed in Singapore that accounted virtually zero productive growth.

As a whole Total Factor productivity is important for growth. Government should give increasing focus for the improvement in productivity growth by increasing investment in education, technology and the like to improve the growth scenario.

References

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