You’ll have no doubt heard economists talk about productivity. But what is it? And why are economists so concerned about it?
The reason that economists are so interested in productivity is because in a country like the UK, it’s the main way in which our economy can grow. It’s also the key avenue through which our living standards improve over time. By being able to provide more or better quality goods and services for the same amount of effort, we all become better off.
So boosting productivity can be a good thing. But weak productivity growth can also be a concern. The last decade has been characterised by weak productivity growth in the UK, and we have all suffered the consequences with low wage growth and limited improvements in living standards.
What is productivity and how do we measure it?
Productivity is sometimes considered a buzzword which means different things to different people. This is further confused by the presence of different measures of productivity. Before diving into these, it is worth considering what we mean by productivity in the first place.
Factors of Production
Every business and indeed nation has different factors of production at their disposal such as labour (mental or physical) and entrepreneurship ability, land (raw material), and capital (machines, tools, and infrastructure).
Capital is a special factor of production in that it must lead to an increase in output when combined with the same amount of labour or generate the same output with less labour. To illustrate, imagine a fruit harvesting organisation invests in new fruit-picking technology. The machine is capital in that it will increase outputs (it will allow more fruit to be picked) with less input (less employee time is required to pick the same amount of fruit with the machine than to pick fruit bare handed). This logic holds for production of kitchen worktops, iPhone, aeroplanes or digital services. Businesses combine human effort, capital, land and entrepreneurship to produce either goods or services.
Productivity indicates how efficient businesses are at producing outputs given their limited resource (inputs). In other words, productivity measures the effectiveness of a business in converting inputs into outputs. Businesses and nations alike aim to produce more outputs as these increase profitability and enhance living standards.
There are two ways they can do this:
- Partial Productivity
Businesses can directly increase output by increasing factors of production, that is, employing more labour, capital, and land to produce more output. The output associated with each of these inputs is called partial productivity. For instance, labour productivity can be measured as an output per unit of labour. Often, due to the absence of information on hours worked and quantities of output, a monetary equivalent or total revenue (sales) per worker is used.
- Total Factor Productivity
The second way to increase output is through an increase in total factor productivity (TFP). TFP refers to an increase in output that cannot easily be explained by an increase in inputs. So, output could increase without a corresponding increase in factors of production. As Nobel Laureate Paul Romer stated, “economic growth springs from better recipes, not just from more cooking”. Economists consider TFP a measure of their ‘ignorance’ since they are not sure where it exactly comes from.
To illustrate TFP, imagine a local stonemason can consistently produce 10 bespoke kitchen work-tops in a day, although the average for similar stonemasons working with identical tools is 9 worktops a day. The extra 1 worktop produced by the local stonemason above what we expected is TFP. It may be the result of better management, higher skills, or better organisation to name but a few reasons. This logic can easily be extended to an individual worker, region or country.
Why does productivity matter to businesses?
Productivity matters for businesses as it is highly correlated with their profitability. First, productivity indicates the ability of a business to produce more using limited resources. This means a firm can increase its revenue without incurring additional cost. Second, higher productivity also means a firm can produce the same amount of output using less resource. Thus, a firm incurs a lower cost at a given level of output. This implies that a firm’s profit increases and it will have a competitive edge over others locally, nationally and internationally.
What can we do to influence productivity?
Recent studies suggest that at a business-level, organisations can improve their productivity by adopting better technologies, improving their management practices and maintaining a healthy and engaged work force.
At national level, the main source of growth in the UK and other advanced economics is expected to come from TFP growth. The upside of TFP growth is that it will allow us to continue to grow even after our limited resources have been fully utilised. This is why researchers put forward skill upgrade, innovation, better management and infrastructure investment as preferred remedies for solving the productivity puzzle.
For more on the evidence behind this blog, check out:
Bloom, N., Eifert, B., Mahajan, A., McKenzie, D., Roberts, J., 2013. Does management matter? evidence from india. The Quarterly Journal of Economics 128, 1–51.
Ebert, P., Freibichler, W., 2017. Nudge management: applying behavioural science to increase knowledge worker productivity. Journal of Organization Design 6, 1–6.