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What Drives Productivity

Raj Nallari's picture

Productivity is the efficiency in converting inputs to outputs. It is also called TFP (total factor productivity) and measured as a residual – the difference between outputs and a set of inputs (e.g. labor, capital, and intermediate goods, including energy, land and buildings). Measurement problems plague both inputs (e.g. how do you account for quality of labor or capital) and outputs.

To wit, managers with MBAs, flexibility in labor and capital markets, fuel efficiency, relatively higher spending in IT (computers) and R&D, and policies that promote market competition, trade liberalization, deregulation of energy, and encouragement of foreign direct investment that brings in technical progress and leads to learning (catch-up) is shown to contribute to higher productivity. Exporting firms tend to have higher productivity. Inefficient firms can still survive in stable industries where technology is static, and where market competition is limited by a variety of local factors and relationships (e.g. China where the protection is afforded by local governments).

Here are some details:

From macroeconomic theory, productivity differences explain per capita income differences across countries. From microeconomic theory, we know that firms maximize profits while minimizing costs. How and why do plants in the 90th percentile in an industry produce twice as much output (with same amount of inputs) as the plant in 10th percentile in the same industry in the United States (Syverson 2009). Hsieh and Klenow (2009) estimated productivity differences of almost 5:1 among plants in India and China between the higher-productive plans and the least-efficient ones. It is because cost-minimizing model is static whereas plants are dynamic as there have moving targets, and over time inputs are combined in an ideal combination of operations to maximize output.

Internal factors: Managers drive productivity differences, but how do we measure management? In studies, it is found that managers with MBAs do better than others, experience helps, but an organization that has efficient operations and monitoring, targets and incentives for better performance do better as well. How does the organization promote employees, their ideas and best practices? Brazil, China and India have a large tail in such studies, implying that there are many more poorly managed plants in these developing countries, and that on an average these plants have lower productivity than US plants.

Fuel efficiency is an important element that differentiates the higher-productive from the lower productive. Labor quality (in terms of higher education, training and tenure at the firm) and capital quality (e.g. recent vintages of machinery, and higher investment in IT, especially on account of organizational decentralization and decisions to adopt new technologies), firms with R & D spending and learning-by-doing (i.e. innovation and new processes) all do better. Vertical integrated firms are more productive but usually higher-productive plants are integrated in vertical structures. Narrowly specialized firms do better.

External factors: Spillovers from strong input markets, agglomeration effects, and knowledge transfer (e.g. a domestic industry leader is emulated as catching-up is important, but ironically a global industry leader is not) positively affect productivity. Export firms have higher productivity relative to firms operating only in domestic markets. Foreign direct investment and use of newer ‘foreign’ technologies, and heightened market competition as reflected by a large number of firms in inputs and outputs also have a positive impact. It will be interesting to see if public sector’s infrastructure investment (in power, roads, ports, etc.) coincides with higher productivity in private firms located along these power grids, transport and seaport facilities. Similarly, is productivity higher in countries where government’s credibility in policy reforms is higher as was hypothesized in the 1997 WDR?

Theoretically models using heterogeneous productivity firms (Melitz 2003 and Eaton & Kortum 2002) show that trade policy has an impact across producers and depends on their productivity levels. For example, trade liberalization in 1970s in Chile shows a substantial jump in productivity at the micro-level. Similarly, deregulation of electricity showed a 15% increase in productivity in Romanian plants. Labor market flexibility (lower unionization) shows a positive impact on productivity.

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