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What is total factor productivity growth and why is it important?

Definition of TFP

Define and Explain the difference of A vs K & L

Use some ideas found in Paul Krugman article

Illustrate some examples and the rationales and importance of TFP (especially on A) as a force for sustainable growth.

Explain why K & L fail to drive an economy towards long term sustainable growth

## Discussion

Total factor productivity (TFP) is that portion of output that is not explained by the amount of input that is used in the production process. Concept of total productivity is considered critical for economic growth, economic fluctuation and differences in the cross country per capita income. The growth in TFP results due to endogenous innovation decision having considerable implication for business cycle. Solow residual measures total factor productivity that presumably changes over time. The factor productivity refers to how intensely and efficiently inputs are used in the process of production. TFP growth represents the growth in output (Ashraf et al. 2016).

An organization converts inputs into outputs using several combinations of material, labour and capital. The relationship between the inputs used in the production process and the resulting output is described by the production process. The highest amount of output that can be produced by the firm using wide variety of inputs is indicated by the production process (Bagger et al. 2014). Production function is depicted by focusing on two inputs that is labour and capital and the equation can be written as:

Q= f (A, K, L)

Output of the firms can be produced in many ways because the production function can be allow the inputs to be produce by combining the input in varying proportions. Considering the above production function would indicate that using more capital would mean using less labour and vice versa. It can be explained with the help of an example, suppose for the construction of building, there can be way of constructing in labour intensive way that is using more of labours and in a capital intensive way by using more capital and less of labours (Chou et al. 2016).

The equation helps in explaining the relationship between the quantity of tow inputs that is labour and capital in determining the level of output. In the equation, K represents capital and L represents labour. The above equation contains another component that is A and it applies to given technology. It indicates a given state of knowledge about several methods that might be used in transforming inputs to outputs. K and L are the inputs that are considered as the factor of production and it would include anything that is used by firms in producing the output. Therefore, the difference between K and L vs A is that the former are inputs to production and A is the total factor productivity measured by technological factor. TFP is improved by change in technology, innovation, research discovery and efficiency (Edquist et al. 2017).

As there is a change in production function and technology is becoming more and more advanced, it is possible for the firm to produce more amount of output for given amount of inputs in the production process. This can be explained with the help of an example; a hardware manufacture can produce high speed customers in a given period of time using a faster assembly line. When the firms are operating efficiently, production function describes the technical feasibility and it is regarded as the fact that they are using the inputs as efficiently as possible (Rodrik 2014).

## Importance of TFP as a Force of Sustainable Growth

The presumption is that production is consideration of production function as technically feasible does not always hold. However, it is reasonable to expect that the firms that are profit seeking will not be wasting resources. Outputs and inputs are regarded as flows, the reference of time is ignored in the production function, and it is referred only to amount of labour, capital and output.

A large portion of growth in total factor productivity is caused by endogenous innovation decision that has considerable implications in the business cycle. Market value of innovation is provided by non technological shocks, low persistence that leads to the generation of pro cyclical fluctuations. A is regarded as the component of TFP that is linked to innovation. The determinants of technology adoption are essential for explaining the cross country variations in the TFP. There is increasing number of technologies that is linked to the adoption of technologies in the role of institutions (Sheng et al. 2016). The rate of growth in TFP in the above equation may not represent technological change at all.

Growth rate of TFP incorporates measurement errors in human capital and output.

Now taking some ideas from Paul Krugman article, it is viewed that economic expansion represents the sum of two sources of growth. One side is related to increase in inputs growth in employment and the other is related to stock of physical capital. Labour is one of the input that are capable of producing more not because of better technology or better knowledge but because they are using better machinery (Greiner et al. 2016). For the process of economic growth, only if there is a rise in per unit of input, the per capita income of any nation can have sustained growth. Referring to the article, it is said that advanced nations have been able to achieve sustainable growth in per capita income for over the past 150 years. This is so because there has been a continuous increase in total factor productivity due to technological advances. For each unit of input, the national income has been continuously increasing. There have been long-term rise in per capital income of US and this has been due to technological process that accounted 80% of rise. At the same time, there was only 20% increased investment in capital (Gal 2013). Two factors are responsible for capitalist growth and this involves efficiency and inputs.

Efficiency is regarded as the main source of rising income and soviet growth is based in rapid growth in inputs. However, the rate of growth in efficiency was much below the rates that are achieved in the western economies. Growth process driven by input factors is inherently limited and successes of economies of countries are driven by three propositions. This includes losing of the traditional advantage by western countries and major diffusion of world technologies. Second proposition involves shifting of economic centre of gravity of world to Asian nation of western pacific. Monetary view is regarded as the third proposition.

Technology has been increasingly flowing across the borders and this has enabled the new economies to match the established economies productivity.

## Examples and Rationales of TFP as a Force for Sustainable Growth

The potential and past economic performance of the countries is measured by way of TFP and estimating the TFP is production function that represents the combination of inputs for producing outputs. It is difficult for countries to measure the growth rate of capital and labour and they are the estimated of growth of total factor productivity. Assumptions are made about depreciation rates and initial stocks and the robustness of conclusion on growth of TFP needs to be checked against all the assumptions (Erken et al. 2016). Estimates of growth of TFP are also very sensitive to assumptions about degree of scale of economies. In order to measure the likelihood of sustainable growth of TFP, it is important to identify the distinction at various level of development. At low level of development, there are increasing returns to scale and at high level of development, there are decreasing returns to scale. The interpretation for the measurement of growth of TFP becomes difficult when growth is reflected by factors other than technical change (Van 2014).

Output of economy is a positive function of capital given the technology and growth rate in output is calculated by assumptions of competitive market forces and constant return to scale and 90% of growth in output is associated with growth in total factor productivity.

Across all the countries, growth in TFP is not an important part of average growth in output.

Weighted average growth in TFP is only about 0.13 a year and this is about eight percent of growth in output per year.

The growth is suggestive of the technological factors and one of the recent histories is the technological progress. Decline in TFP is mostly due to armed conflicts and institutional regressions. Technological progress is the main driver of long-run growth both empirically and theoretically. As per the law of diminishing marginal returns, holding other input constant, output will fall due to addition of an extra unit of labour or capital. As a consequence of this, it is not possible for country to maintain long run growth by accumulation of labour or capital. Therefore, the driver of long run growth has to be the technological progress. The per capita output growth is broken down into the respective contributions from labour inputs, capital stock and technological advancements (Murray 2016).

Sustainable economic growth is dependent upon productivity growth of labour. When a country spends a growing share of national income towards capital gains then it leads to decline in higher income, this can weaken demand with the investments. Income inequality has risen in many countries. This is so because capital income is less evenly distributed across the household compared to labour income. At the top of distribution, the decline n the share of labour concentrates the labour income. It is suggested by some evidence that falling share of labour are correlated with the increasing inequality in income. Declining share of labour has played certain role in growing wage inequality and it is the main reason behind the growing inequality of income (Chun 2016).

Growth within the economy and between the economy and rest of the world is dependent on the division of labour. There are some specific skills that each workers are required to be expected to have. Productivity of each worker is enhanced by such proficiency that leads the whole work with synergy effect and ultimately the nation’s economic performance.  The participation of labour force of East Asian economies have not increased rather there have been dramatic improvement in educational levels. Part of overall national growth is due to an increase in the value of goods produced by labour and partly due to growth in labour supply. Efficiency is regarded as the main source of rising income rather than inputs to the production process. Long-term growth of an economy driven by inputs is inherently a limited process (Edquist et al. 2017).

Conclusion:

The sustainable rate of economic growth is measured by potential Gross domestic product and rate of increase in economic productivity. When the rate of growth of labour is lower that rate of growth capital, capital deepening arises. There is a shift in entire production capacity if there is an increase in total factor productivity. Economic growth is driven by quality and quantity of supply of labour and capital along with technological change. In the nutshell, it can be said that the major determinant of TFP is technology and TFP is regarded as the main factor influencing the long-term and sustainable economic growth of developed countries.

References:

Ashraf, Ayesha, Dierk Herzer, and Peter Nunnenkamp. "The Effects of Greenfield FDI and Cross?border M&As on Total Factor Productivity." The World Economy 39, no. 11 (2016): 1728-1755.

Bagger, Jesper, Bent Jesper Christensen, and Dale T. Mortensen. "Wage and labor productivity dispersion: The roles of total factor productivity, labor quality, capital intensity, and rent sharing." In 2014 Meeting Papers. 2014.

Chou, Yen-Chun, Howard Hao-Chun Chuang, and Benjamin BM Shao. "The impacts of information technology on total factor productivity: A look at externalities and innovations." International Journal of Production Economics 158 (2014): 290-299.

Chun, L. I. N. "Research on the Influence Factors and Convergence of Total Factor Productivity of Financial Industry in China——Based on the Provincial Panel Data Analysis." Journal of Huazhong University of Science and Technology (Social Science Edition) 6 (2016): 021.

Edquist, Harald, and Magnus Henrekson. "Do R&D and ICT affect total factor productivity growth differently?." Telecommunications Policy 41, no. 2 (2017): 106-119.

Erken, Hugo, Piet Donselaar, and Roy Thurik. "Total factor productivity and the role of entrepreneurship." The Journal of Technology Transfer (2016): 1-29.

Gal, Peter N. "Measuring total factor productivity at the firm level using OECD-ORBIS." (2013).

Greiner, Alfred, Willi Semmler, and Gang Gong. The forces of economic growth: a time series perspective. Princeton University Press, 2016.

Murray, Alexander. "Partial versus Total Factor Productivity Measures: An Assessment of their Strengths and Weaknesses." International Productivity Monitor 31 (2016): 113.

Pietrzak, Michal Bernard, and Adam P. Balcerzak. Quality of Human Capital and Total Factor Productivity in New European Union Members States. No. 23/2016. 2016.

Rodrik, Dani. "The past, present, and future of economic growth." Challenge 57, no. 3 (2014): 5-39.

Sheng, Yu, Tom Jackson, Shiji Zhao, and Dandan Zhang. "Measuring Output, Input and Total Factor Productivity in Australian Agriculture: An Industry?Level Analysis." Review of Income and Wealth 63, no. s1 (2017).

Van Ark, Bart. Total factor productivity: Lessons from the past and directions for the future. No. 271. Working Paper Research, 2014.

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