Productivity primer

How does economy grow?

David S. Dahl - Regional Economist

Published April 1, 1995  |  April 1995 issue

"Productivity isn't everything, but in the long run it is almost everything." Paul Krugman,
The Age of Diminished Expectations
, 1990

Between fiscal years 1998 and 2005, Minnesota state and local governments face a looming budget gap of $2.5 billion, according to Within Our Means: Tough Choices for Government Spending, a recent study prepared by the Minnesota State Planning Agency. A per capita personal income increase of 1.5 percent annually between 1993 and 2005 is implicit in the study's personal income and population projections.

To increase the growth of per capita personal income, more of the state's population could work, but demographic projections suggest labor force growth will decline over the forecast period.

Alternatively, per capita personal income could grow faster than projected if the output per worker, that is productivity, grows faster than the study implicitly assumes. In fact, if the productivity of Minnesota's workers could be improved so that per capita personal income rose 1.8 percent, 0.3 percentage point faster than forecast, the budget gap disappears.

This arithmetic is not intended to impugn the study's findings and recommendations, but rather to demonstrate productivity's power to enhance living standards and to address problems, like emerging budget deficits.

Taproot of economic well-being

Productivity is the amount of output per unit of a particular input. Output can be anything from bushels of corn to the number of telephone calls, but often it is some measure of aggregate output such as gross domestic product (GDP) or its major components. GDP is the total market value of all final goods and services produced annually within the United States. Inputs can be any factor in the production process, such as workers, equipment and buildings, but often number of hours worked are used. A frequently used measure of U.S. labor productivity is:

Labor Productivity = Non-farm Business Output / Hours Worked

Non-farm business output is GDP originating in the
non-farm business sector adjusted for price changes.

Multiplying both sides of the above equation by hours worked shows that output can grow in one of two ways—the number of hours worked can increase or labor productivity can expand.

Non-farm Business Output = Labor Productivity x Hours Worked

Population growth, people's desire to work and unemployment influence hours worked, and since 1963 hours worked have grown at about a 1.6 percent annual rate.

While counting the number of hours worked is straightforward, ascertaining output to compute productivity can be difficult. This is especially true in the services, which is a significant and growing sector of the economy but whose output is still difficult to measure. In many cases the productivity measurement problems are so daunting, surrogates are used. The Bureau of Labor Statistics, for example, does not compute output measures for banking, an industry where computer technology recently has had a big impact on productivity. Instead, the change in banking's real output is assumed to equal the change in hours worked in the industry, making productivity growth roughly equal to zero.

Labor productivity has declined. Between 1963-1972 and 1972-1992 it dropped from a 2.8 percent annual growth rate to 1.2 percent. Because of measurement problems "currently available official statistics probably understate the true rate of growth of productivity," concludes the 1995 Economic Report of the President.

But regardless of measurement problems, the decline in productivity illustrates how increasing output per worker is the primary way that an economy can enjoy sustained long-term growth in income and living standards. A marked decline in growth in median incomes, for example, accompanied the drop in productivity.

Workers' skills important

To understand what causes productivity growth or decline, economists look at productivity changes from three sources. One is the workers themselves. Part of their efficiency stems from the basic skills they acquire before entering the labor force. A proxy is average years of schooling per worker, and between 1963 and 1992 it increased by about two years. Another part is the skills that workers acquire on the job. A proxy is the average work experience of the labor force, and between 1963 and 1992 it declined slightly.

Since 1963, increases in educational attainment added about 0.3 percentage points annually to productivity growth, but this was partially offset by an approximate 0.1 percentage point decline attributed to the decrease in work experience, according to the Bureau of Labor Statistics. Thus, worker quality has only had a modest impact on workers' productivity.

Government, however, can help raise worker productivity. When firms train workers they may not capture all the benefits because workers may look for better jobs. Because firms cannot exclude other companies from benefiting from their education and training outlays, investment in them would be less than optimal. Thus, to enhance productivity, government investment in education is important.

Capital boosts output

A second source of productivity growth is capital, that is buildings and machinery used in conjunction with labor, including factories and office buildings, associated equipment, and roads, airports, bridges, canals, harbors and docks.

The quality as well as the quantity of capital, however, influence productivity, and quality changes are closely tied to research and development outlays. "For example, output per hour in the telecommunications industry increased an average of 5.5 percent per year between 1969 and 1989, as the industry invested heavily in satellite, cellular and fiber optic technologies," according to the 1995 Economic Report of the President.

Moreover, productivity increases through capital investment have often involved exploiting economies of scale, that is the forces that reduce the average cost of producing a product as the firm expands the size of its plant. In the United States, which has large-scale breweries in contrast to Germany, which has small breweries, productivity of US brewery workers is more than twice as high as German brewery workers, according to a 1993 study by McKinsey & Co.

To increase capital investment contribution to productivity, the United States should increase savings. "Historically, nations that have saved the most have also invested the most, and investment has been strongly correlated with productivity," says the 1995 Economic Report of the President. From the early 1970s to the early 1990s public and private savings in the United States declined relative to GDP. While economists do not necessarily know how to induce the public to save more, it is clear that reducing the federal budget deficit would augment public savings.

Management has strong role

Most of the things that determine productivity come down to managerial choices, such as industrialist Henry Kaiser building Liberty Ships in World War II. An irrepressible industrialist, he had been involved in building Boulder Dam, Grand Coulee Dam and the Oakland-San Francisco Bridge. "Under Kaiser's leadership, the average time to deliver a ship was cut from 355 days in 1940 to 194 days in 1941 to 60 days in early 1942," writes historian Doris Kearns Goodwin in No Ordinary Times. Although economists have attributed much of these gains to shipyard workers learning by doing, they would not have occurred without Kaiser's management vision and prowess.

To bring out this prowess in managers "we find that the intensity of competition to which managers are exposed and, more specifically, the degree to which they are faced by direct competition from producers on the leading edge, matters a great deal," reports McKinsey.

Countless decisions by businesses and individuals to use new ways and technologies for producing goods and services will decide the pace of future productivity growth. Government's role is primarily to ensure those decisions occur in open and competitive markets. These decisions, however, can wipe out existing jobs, and the explicit goal of many government regulations and other policies is to protect jobs. If protecting jobs keeps an economy from adopting new production techniques and technologies, growth suffers.

However, no trade-off exists between productivity and employment; instead, higher productivity should lead to greater employment growth. Faster output growth creates additional jobs, and workers idled by productivity increases will generally find other jobs in a dynamic and growing economy.

Keep markets open and competitive

And if jobs are protected through barriers to foreign trade and investment, productivity is affected. "In Japan, for example, a worker in the highly protected and fragmented food-processing industry—which employs more workers than the auto, computer, consumer-electronics and machine-tool industries combined—produces $39 worth of food in an hour compared with an American counterpart's $119," reports the New York Times.

An even greater spur to productivity growth than eliminating trade barriers, McKinsey found, was allowing highly productive foreign companies to establish plants. "Transplants from leading edge producers:

  1. directly contribute to higher levels of domestic productivity,
  2. prove that leading edge productivity can be achieved with local labor and many local inputs,
  3. put competitive pressure on other domestic producers, and
  4. transfer knowledge of best practices to other domestic producers through the natural movement of personnel."

Largely because of competition from Japanese auto plants in the United States, "Ford and Chrysler, and to a lesser extent General Motors, have made great strides in adopting the new (Japanese) methods in their factories," and "the productivity level and output quality of Ford plants in the United States are now equal to those of the Japanese transplants in the United States," write economists Thomas Holmes and James Schmitz Jr. in the latest Minneapolis Fed Quarterly Review.

Recent corporate restructuring suggests managers are responding to competitive pressures, for productivity growth rose at a 2.2 percent annual rate during the last three years, up from a 1.2 percent rate between 1972 and 1994. Part of the recent gain in productivity growth, however, undoubtedly reflects a cyclical rebound from the 1990-91 recession.

These recent improvements in productivity brighten prospects for future income gains. Moreover, keeping markets open and competitive, supporting education and research and development, and boosting savings would further improve the prospects for productivity, which is the only way to achieve sustained, long-term growth in living standards.

The two major sources in preparing this article were:

Chapter 3, "Expanding the Nation's Productive Capacity," Economic Report of the President, 1995.

"Manufacturing Productivity," McKinsey Global Institute, Washington, D.C., October 1993.