Friday, 2 July 2010

What determines productivity?

A question that Don Brash is trying to answer, at least for New Zealand. A full, detailed and widely accepted answer to this critical question has thus far eluded the economic profession so it will be interesting to see how far Dr Brash gets. Productivity, after all, is a residual – the variation in output not explained by observable inputs. It is therefore something like a measure of our ignorance.

Chad Syverson has a column at in which he summarises the wealth of literature that tries to understand what determines productivity.

Syerson's survey offers two categories of explanations for inter-firm productivity differences.
  • One includes factors that operate primarily within businesses, be it at the firm, plant, or even production line level. These are potentially under the control of management or other economic actors inside the firm.
  • The second set contains elements external to the firm. The impact of these “environmental” factors might not always be direct, but they can affect producers’ willingness and ability to harness factors in the first set. They may also influence the amount of productivity dispersion that is sustainable in equilibrium.

The within-business determinants noted by Syverson are
Research has pointed to several within-business productivity drivers, which of each is, in essence, an input that is not measured or mis-measured in the standard data sets.

* Managerial practice/talent

Managers are conductors of an input orchestra, coordinating the application of labour, capital, and intermediate inputs. Just as a poor conductor can lead to a cacophony rather than a symphony, poor management can lead to discordant production operations.

* Higher-quality general labour and capital inputs

Quality differences in standard inputs like capital and non-managerial labour (coming from capital-embodied technology in the former case and human capital in the latter, for example) will lead to measured productivity differences if standard input measures don’t fully reflect quality differences.

* Information technology and research and development

It is arguably the general purpose technology of our time, and as such has great potential for broad productivity effects. R&D reflects investment in a knowledge stock that can raise productivity.

* Learning-by-doing

The very act of operating can increase productivity, as experience allows producers to identify opportunities for process improvements.

* Product innovation

While innovations in product quality may not necessarily raise the physical quantity of output a firm obtains from a given set of inputs, they can enhance productivity on a quality-adjusted output basis.

* Firm structure decisions

The organisational structure of the firm’s production units – the vertical and horizontal linkages between the industries they operate in, their relative sizes, etc. – can affect the productivity levels of the firm’s component business units.
As for ‘Environmental’ determinants, these are
The second set of productivity factors, so-called environmental determinants – affect productivity in two ways. Either they incentivise individual producers to become more efficient, or they foster Darwinian selection that shifts economic activity toward more efficient producers.

* Productivity spillovers

These across-firm externalities are often discussed in the context of classic agglomeration mechanisms like thick-input-market effects and knowledge transfers. Note that the latter, in particular, does not need to be tied to any single geographic market.

* Competition

Pressures from threatening or actual competitors – whether from other producers in the same market or foreign competitors operating through trade channels – affect productivity levels within an industry. Competition fosters efficiency-based selection as lower-cost producers take market share from their less efficient competitors. Competition also raises the productivity bar that new producers must meet to successfully enter the market. More directly, heightened competition can induce firms to make productivity-raising efforts that they may otherwise not.

* Deregulation or proper regulation

Poorly regulated markets can create perverse incentives that reduce productivity. Deregulating or reformatting to smarter forms of regulation can reverse this.

* Flexible input markets

Just as one can think of competition as flexibility in product markets, more flexible input markets can also raise productivity levels. Indeed, there are almost surely complementarities between product- and input-market flexibility. When consumers want to reallocate purchases across producers, firms need to be able to easily reallocate inputs to meet the new demand pattern.
Importantly one of the questions Syverson points out is still unanswered is
How can government policies encourage productivity growth?
This question is particularly applicable to the environmental set of productivity drivers, since the government can do little about the factors that operate primarily within firms. The environmental factors are by their very nature the easiest to manipulate via government policy but also have less direct effect. Thus we need to know more about what kinds of reforms are most effective for different types of markets or frictions, and their optimal size and timing.

I would argue that one important issue for New Zealand is Robert Higgs's notion of regime uncertainty. The general attitude towards private property rights shown by most governments in New Zealand seem to be designed to inhibit productivity enhancing long-term private investment. I would also argue that most of the big government productivity enhancing policies have already been enacted in developed countries like New Zealand, this is part of the reason they are developed! So any additional policy changes are likely to have marginal effects at best.

Thus I wish Dr Brash luck.

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