How to determine economic growth of a country using total factor productivity? – Answered!

Growth in Gross Domestic Product (GDP) depends on supply of resources such as labour, capital, natural resources.

Many economists use production function approach to explain the importance of various factors for determining growth rate. The following type of production function has been used to measure the contributions of different factors to economic growth.

Y = AF (L, K, N)

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where Y = Gross domestic product (GDP)

A = Total factor productivity

L = The quantity of labour input

K = The size of capital stock

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N = The quantity of natural resources.

In the studies of sources of growth, the natural resources are taken as constant and human capital is added as a separate factor for determining growth in Gross Domestic Product. With these changes then the production function becomes

Y = AF (L,K,H)

where H represents the quantity of human capital.

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An important way to assess the contribution of a resource to the production of goods and services is its productivity. By productivity we mean the ratio of output produced to the quantity of input used to produce it. We can measure productivity of a single factor such as labour or capital. To measure the productivity of all inputs together the concept of total factor productivity (TFP) is employed.

The total factor productivity means the ratio of output produced to the amount of all inputs used. Total factor productivity is index of overall productivity of the economy. In fact, technical progress in the economy is measured by the annual increase in total factor productivity.

Now, the economic growth depends on the increase in factor inputs and technological progress that is taking place in the economy. Improvement in technology makes factor inputs or resources more productive. If the quantity of resources is increasing and total factor productivity is rising, then output would grow faster than the increase in the quantity of resources.

Therefore, rate of economic growth achieved will depend on the growth in resources (i.e. factor inputs such as labour, capital and the rate of increase in total factor productivity. Thus

Economic growth = growth rate of supply of resources + rate of increase in total factor productivity

Now, the amount by which output increases due to the increase in labour input depends on the contribution of labour to it. Similarly, the amount by which output increases due to accumulation of capital depends on the contribution of capital to it.

Assuming no change in natural resources and taking two factor production function, then the growth in real output resulting from the increases in labour and capital inputs can be obtained from multiplying the increases in labour and capital by their respective contributions to the production of output.

Following the neoclassical economists such as Solow, and Meade the economists generally use the shares in national income (GDP) of labour and capital to measure their contributions to output. From the recent production function studies conducted for the US economy it has been found that labour’s share is about 70 per cent and capital’s share is about 30 per cent of national income. We can obtain the growth in output, (i.e. GDP) by using the following growth equation.

% ∆GDP = % ∆TFP + 0.70 (% ∆L) + 0.30 (% ∆K)

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where

GDP = Gross Domestic Product

∆TFP = Change in total factor productivity

∆L = Increase in the quantity of labour

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∆K = Increase in the capital stock

The above growth equation shows how growth in GDP depends on changes in total factor productivity (TFP) and changes in quantities of factors such as labour and capital. Recall that change in total factor productivity measures technological progress that is taking place in the economy.

Technical progress, that is, changes in total factor productivity is a crucial factor in determining growth of output. For example, if total factor productivity is increasing at the rate of 2 per cent per annum, then even with capital stock and labour force being held constant, gross domestic product (GDP) will increase at the rate of 2 per cent per annum.

If labour input increases by 2 per cent and capital stock increases by 3 per cent per annum each, then applying the above growth equation:

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%∆GDP = 2 + 0.70 (2) + 0.30 (3)

= 2 + 1.40 + 0.90 = 4.3

Thus, GDP will grow at the rate of 4.3 per cent per annum.

It is worth noting here that higher growth rate achieved by Japan in the past was not only due to rapid growth rate of capital stock but also because of relatively higher growth rate in total factor productivity (TFP), that is, technological progress.

Further, from 1973 to mid nineties, lower growth rate in the United States has been due to slowdown in growth in total factor productivity. It may be further noted that differences in growth rates across countries can be explained in terms of differences in growth rates of capital stock and of total factor productivity.