In economics, productivity refers to how muchoutput can be produced with a given set ofinputs. Productivity increases when more outputis produced with the same amount of inputs orwhen the same amount of output is producedwith less inputs.
There are two widely used productivity concepts.
- Labour productivity is defined as output perworker or per hour worked. Factors that canaffect labour productivity include workers'skills, technological change, managementpractices and changes in other inputs (suchas capital).
- Multifactor productivity (MFP) is definedas output per unit of combined inputs.Combined inputs typically include labourand capital, but can be expanded to includeenergy, materials and services. Changes inMFP reflect changes in output that cannot beexplained by changes in inputs.
This Explainer outlines how productivity ismeasured, what drives productivity growth andhow productivity growth contributes to theeconomic prosperity and welfare of all Australians.
How is productivity measured?
In Australia, the Australian Bureau of Statistics (ABS)produces measures of output and inputs fordifferent industries, sectors and the economy as awhole. Productivity is not measured directly butis calculated by dividing a measure of output by ameasure of inputs.
Output refers to a quantity of goods and servicesproduced in a given time period. Output for anindustry or sector is usually measured by grossvalue added (GVA), which is the total value ofgoods and services produced less those goods andservices used in the production process (known asintermediate consumption). Output for the wholeeconomy can be calculated by summing GVA acrossindustries. Alternatively, adding the value of taxesto GVA and subtracting the value of subsidies onproducts gives gross domestic product (GDP) (seeExplainer: Economic Growth).
Labour and capital are the two main types ofinputs.
- Labour input can be measured as either thenumber of employed persons or the numberof paid hours worked by employees. Hoursworked measures are typically preferred becausethey capture changes in standard working hours,leave, overtime and flexible work arrangements.The ABS also reports hours worked that havebeen adjusted for ‘quality’, meaning that theytake into account changes in the level ofeducation and experience of the labour force.
Box: Calculating Labour Productivity – An Example
Labour productivity is defined as output produced per unit of labour input.
Labour productivity=OutputLabour input
Suppose a person is employed for 40 hours a week in a toy factory. In a given week, the workerproduces 120 dolls. The productivity of the worker in that week is 3 dolls per hour.
Labour productivity=OutputHours worked=120 dolls40 hours=3 dolls per hour
Suppose the factory produces a range of toys, including dolls, miniature cars, card gamesand board games. In a given week, the gross value added of these goods is $5 million, using125,000 hours of labour. Labour productivity for the toy factory in that week is $40 per hour.
Labour productivity=OutputHours worked=$5 million125,000 hours=$40 dolls per hour
Box: Calculating Multifactor Productivity (MFP) – An Example
Most businesses produce output using a combination of labour and capital inputs. MFP iscalculated as a measure of output divided by a measure of combined inputs. Both the denominatorand numerator are usually represented by indexes, which is a useful way of comparing changes ineconomic time series relative to a base period. The value of the index in the base period is usuallyset to equal 100.
MFP index=Output indexCombined input indexx100
Because of the use of indexes, MFP is usually analysed in terms of growth rates rather than levels.
Suppose that a factory uses a combination of labour and capital to produce dolls, board gamesand other toys. Suppose that year 1 is the base year when an output index and a combined inputindex for the toy factory are both set equal to 100. In year 2, the output index increases to 107while the combined input index increases to 105. The MFP index for the toy factory in year 1 is100 and the MFP index in year 2 is 101.9.
The growth in MFP between year 1 and year 2 is 1.9 per cent.
MFP Growth =MFP Year 2 - MFP Year 1MFP Year 1x100 =(101.9 - 100100)x100 =1.9%
=MFP Year 2 - MFP Year 1MFP Year 1x100
=(101.9 - 100100)x100
- Capital input is a measure of capital services(a flow). It describes the benefits obtained fromthe productive assets held by a business, anindustry or an economy (a stock). These assetscan include physical capital, like equipment,machines, structures and vehicles, as well asintangible capital such as intellectual property.The value of the stock of productive assetsis adjusted to account for their decliningusefulness over time.
MFP uses a measure of combined labour andcapital inputs, where each input receives a weightreflecting its costs to Australian businesses.
There are a number of challenges associated withmeasuring productivity. For example:
- Output in non-market industries is difficultto measure: The ABS only estimates MFP for16 market industries in which prices reflectunderlying demand for and supply of output.The ABS does not provide MFP estimatesfor non-market industries, namely publicadministration and safety, education andtraining, and health care and social assistance.
- Estimates vary with time periods: In theshort run, it can be difficult for a businessto change the amount of inputs it uses inresponse to changes in demand. This meansthat productivity tends to decline in a downturnbecause output declines by more thaninputs, while productivity tends to increase ina boom because output increases by morethan inputs. Due to the potential volatility ofshort-run estimates, economists often analyseproductivity over long periods of time thatinclude a number of economic cycles.
- Some inputs and outputs are not measured:For example, some natural resources andintangible capital inputs are particularlydifficult to measure well and some may not bemeasured at all. Where actual inputs changebut have not been measured, estimates of MFPwill be distorted.
What drives productivity growth?
In economics, the production possibility frontier(PPF) is used to show all possible combinationsof goods and services that can be produced witha given amount of inputs and technology, whenall inputs are used to their full capacity. The PPFcan apply to any number of goods and servicesproduced in the economy. However, it is usuallyillustrated in two dimensions for two goods andservices and is useful for showing two ways inwhich businesses can increase productivity –by operating more efficiently or by expandingproductive capacity. Productivity improvementscan also have spillover effects for other firms.
A business is producing on its PPF if it is notpossible to produce more of one good or servicewithout producing less of another. Economistscall this ‘technical efficiency’. If production is insidethe PPF, moving closer to the PPF represents anincrease in productivity, as more output can beproduced with the same inputs.
Suppose a business produces two goods, X and Y.All possible combinations of X and Y that achievetechnical efficiency for some amount of inputs andtechnology is given by PPF1 in the diagram below. Ifthe business is initially producing at point A, whichis inside PPF1, then it is not technically efficient. Ifproduction moves from point A to point B, whichis on PPF1, the business can achieve technicalefficiency and higher productivity, as more outputcan be produced with the same inputs.
One way to improve technical efficiency is throughmicroeconomic reform. Australia's microeconomicpolicies – such as those related to competition,trade, tax and market regulation – have played animportant role in supporting productivity growthover the past few decades by creating incentivesfor businesses to operate more efficiently.
Expanding productive capacity
A business can also improve its productivity byexpanding its potential production, represented byan outward shift in the PPF. In the diagram above, anexpansion in potential production would allow thebusiness to move from point B on PPF1 to point C onPPF2 and produce more of both types of goods.
An expansion in potential production can occur asa result of innovation and advances in technologythat allow a business to produce more output withthe current level of inputs. Such technologicalprogress is often embodied in capital inputs likefaster computers or more powerful machines,but can also occur through improvementsin knowledge that allow more output to beproduced without investing in new capital.
Spillover effects between businesses can furtherincrease the overall level of productivity in theeconomy. For example, the sharing of knowledgebetween businesses can generate positiveproductivity spillovers. Knowledge sharing mayoccur through direct channels (such as industryinnovation hubs) or indirect channels (such asworkers changing jobs).
Benefits of productivity growth
Productivity growth is important for maintainingthe economic welfare and prosperity of allAustralians. Productivity growth can contribute toone or a combination of the following:
- Higher wages: Productivity growth enables firmsto increase wages for workers. Unit labour costs(ULCs), which measure the labour costs associatedwith producing one unit of output, decreaseas labour productivity increases, meaning thatfirms can offset the effect of wage increases onprofits with productivity improvements.
- Lower prices: Businesses can pass onproductivity improvements to consumersthrough lower prices without reducing profitsor wages. This also makes Australian businessesmore competitive in global markets.
- Higher profits: In response to an improvementin productivity, businesses can increasetheir profits as it now costs less to producea given level of output. These profits canbe distributed to the business owners orshareholders, or reinvested into the firm.
- Stronger economic growth: Labourand capital inputs tend to be subject todiminishing marginal returns. In other words,holding other inputs constant, the addition ofone more unit of labour or capital will lead toa smaller and smaller addition to output. Thisleaves productivity growth as the main driverof higher living standards in the long run.