The Importance Of Total Factor Productivity In Estimating Long-term Economic Growth (Essay Sample)

THE IMPORTANCE OF TOTAL FACTOR PRODUCTIVITY IN ESTIMATING LONG-TERM ECONOMIC GROWTH
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Total Factor Productivity Growth and its Importance
Also known as multi-factor productivity, Total Factor Productivity (TFP) is a variable in economics that accounts for the percentage of output overlooked by the quantity of inputs used in production. It is an economic variable that assesses for the total growth in output compared to the growth recorded by conventionally measured inputs of labor and capital. As such, TFP is an excellent indicator of the efficiency employed in the utilization of raw materials during production and is, therefore, a measure of the competitiveness of a business or company. The measurement of TFP involves an accurate measure of the output and input used in the production process. Since TFP is controlled by the dynamics of the production process, it is imperative for one to understand the fundamental elements of production such as output and input to have a sound assessment of TFP and its importance. In particular, output is given by the quantity of goods and services produced by a firm, industry, or country over a given time frame. Inputs, on the other hand, refer to resources such as energy, raw materials, information, labor, and finances that are utilized in a system to obtain the desired output. TFP plays a fundamental role in estimating economic growth and fluctuations, and in the determination of per capita income differences.[Kato, Hisakazu. 2016. Theoretical and Empirical Analysis of Population and Technological Progress. Springer.]
Firstly, TFP is utilized by almost all countries in measuring economic growth of the macroeconomy since it is the only indicator that captures technological progress in the production process. In particular, MFP growth is preferred as an indicator of economic growth since it represents an increase in the GDP of a country that is not embodied in the growth of capital and labor input. Gross domestic product calculated using MFP growth is, therefore, preferred as a true measure of the economic growth or fluctuation of a country since MFP ensures that factors of production such as labor and capital are utilized efficiently through improved production processes, innovation, and organizational change.
TFP is preferred by many countries for growth accounting since it incorporates technological developments in production- an important engine of economic growth and source of human progress. As such, it captures the effect of production-related factors such as technology, skill, and management that are not included in official measures of capital and labor. At the economy level, TFP ensures that more aggregate outputs per aggregate inputs. As a result, greater returns are realized for the total inputs, which in turn improves the come and ultimately the living standards of people in a country. At the industry level, TFP growth makes it possible for an industry to compete for labor, capital, and raw materials with other sectors of the economy. TFP is equally important at the firm level since it gives firms a competitive advantage in the industry by paying higher wages and salaries to employees, giving fair returns to shareholders, and providing the firm with more funds for investment.[Productivity Growth and Its Importance. 2012. Ebook.] [Comin, Diego. 2006. "Total Factor Productivity". Undergraduate, New York University.]
Moreover, TFP growth is important in explaining the difference in per capita incomes for different countries. Notably, TFP expounds on why some countries are richer than others and why some countries have a higher per capita output than others. Average incomes in developed nations such as the United States are more than ten times greater than in the worlds’ poorest countries such as Niger; where the output per worker is 35 times lower than that of the average worker in the U.S. Notably, the difference in per capita income between third-world and developed nations does not arise from the changes of labor and capital, but from the dissimilarities in the effectiveness of the factors of production explained using total factor productivity. TFP is closely linked to technology and innovation, elements that influence the production process and ultimately per capita income of a country. Notably, developed countries have an abundance of skilled labor and their governments provide subsidies for research and development (R&D). Consequently, such countries have a lower marginal cost of production and a high rate of innovation. For this reason, developed nations record a higher TFP growth than their counterparts in third world regions. Due to low levels of technology, lack of innovation and enough funding for R&D, poor nations record lower outputs per worker and ultimately a lower income per capita. Under those circumstances, it is clear that a majority of the gap in per capita income between countries is closely associated with the differences in TFP.[Baier, Scott, and Gerald Dwyer. 2017. How Important Are Capital And Total Factor Productivity For Economic Growth? PDF.]
Measuring TFP
With an accurate estimate of outputs and inputs, it is possible to determine the TFP. The TFP of a country is the ratio of the real output produced over a period of time to the actual input used by the production process over the same period. However, it is particularly challenging to accurately define what real outputs and inputs are due to their diverse nature. Consequently, TFP growth is measured using the index number theory that utilizes output growth and input growth between any two consecutive periods or between a current fiscal year and a base period. Developed by Robert Solow in 1956, the Solow-swan model is used to measure TPF growth in the framework of neoclassical economics and is based on technological progress, capital growth, and labor growth. The Solow residual relies on a set of stringent assumptions. Some of the postulations made in the model include a perfect competition market structure, constant returns to scale, full utilization of factors of production, and costless adjustments of the factors of production. The model can be expressed mathematically using the formula illustrated below:[Wörz, Julia, and Robert Stehrer. 2012. How Important Is Total Factor Productivity For Growth In Central, Eastern And Southeastern European Countries? Latvijas Banka.] []
Y (t) = K (t) α {A (t) L (t)} 1- α
Y (t) represents the total production, K (t) is the capital stock, L (t) the labor force, and A (t) the efficiency of the labor force. α, on the other hand, represents the elasticity of output with respect to capital while (t) is the continuous time about which the factors of production are measured. The Solow- Swan model gives a good measurement of the effects of technological change on capital and labor, and, therefore, economic growth. Solow’s model provides a reliable theoretical framework for understanding economic growth and the consequences of long-run changes in the economic environment.[Johansson, Erik, and Erik Tretow. 2015. "Modeling Economic Output and Economic Growth With Respect To Economic Freedom". Undergraduate, Royal Institute of Technology.]
Relationship of TFP to Long-term Economic Growth
Many developing countries ignore productivity and do not realize that Total Factor Productivity (TFP) plays a central in the economic growth and development of any nation. Their argument is that productivity is not everything; but what they fail to realize is that in the long-run, productivity is almost the only thing that determines the success of a country. For this reason, any country looking for a way to improve the living standards of its citizens in the long-run must be willing to make substantial investments on its ability to raise its output per worker. The contrast between the U.S and Vietnam in the aftermath of World War II provides sufficient evidence that productivity growth is closely related to economic growth and by extension better living standards for citizens. On the one hand, U.S war veteran went back home and worked hard enough to improve the productivity of America by more than 100 percent in the next 25 year. As a result, they were achieved living standards that their predecessors could never have imagined. Vietnam veterans, on the other hand, did not focus on the right elements of improving their nation. Consequently, they only managed to improve the productivity of their country by a measly 10 percent in 15 years; and their living standards worsened than that of their parents. Under those circumstances, it is clear that Total Factor Productivity is a primary driver of long-term economic growth.[Productivity Growth and Its Importance. 2012. Ebook.] [Productivity growth and its importance]
Notably, long-term economic growth is influenced by the accumulation of capital, increase in labor inputs, and technological changes. The measurement of TFP, also known as growth accounting, focuses on the contribution of capital, labor, and technology on the economy. Consequently, TFP makes it possible for a country’s long-term growth to be determined and explained in terms of labor, capital, and technology. Although economic growth can be achieved by increasing the amount of labor and capital in the production process, it is important to note that these parameters cannot be used to realize long-term economic growth. For instance, if all other factors are held constant it is impossible to steer a country to economic growth using capital and labor since these elements depreciate with time in accordance with the law of diminishing returns. As a result, technological progress is the only production element that guarantees long-term economic development. As can be seen, both long-term economic growth and TFP growth focus on the same parameter...