Productivity Is Very Important; Except When It Isn’t

Paul Krugman once said,

“Productivity isn’t everything, but in the long run it is almost everything.”

From a theoretical perspective, this is absolutely true. Every widely accepted model of economic growth from Solow onwards, has at its heart the concept of productivity. While you can get away with just adding inputs like capital or labour to increase output, sooner or later you run into diminishing marginal returns. In the long run then, the only source of real growth is productivity.

Intuitively, productivity is hardly controversial either – the more you make and sell from the same set of inputs, the more profits and wages and earnings you can make. Common sense, right?

That’s why headlines like this tend to scare people (excerpt):

MPC: Productivity levels much lower than those of benchmark countries

PETALING JAYA: Malaysians work longer hours than their counterparts in many benchmark countries, but produce less than them.

According to the Malaysian Productivity Corporation, our employee productivity levels are a lot lower than those of countries like the United States, Japan, United Kingdom, South Korea and Singa-pore.

MPC director-general Datuk Mohd Razali Hussain, citing the 2011 Productivity Report, said Malaysian workers had a productivity value of RM43,952 a year.

“But compared with Singapore, Hong Kong, Taiwan, South Korea, Japan and the United States, we are still far behind,” Razali said.

He added that the country was still recording an average productivity growth of 4.5% annually, which was lower than that of Indonesia and India.

Labour productivity levels are measured by the real gross domestic product over the number of workers in the country…

…According to the report, which analyses information from the Department of Statistics, workers in the top benchmark countries outperformed Malaysian workers almost six times over.

…In 2011, Malaysia had a productivity growth rate of 4.55%, which MPC said was on track for the country in becoming a high-income nation by 2020 with a productivity level of RM87,500.

However, Malaysians lost out to several benchmark Asian countries like China, which had a growth rate of 8.7%, Indonesia (5%) and India (4.8%)…

Cue complaints about low-wage foreign labour and poor quality employees.

Nevertheless, the essential point is that we are a middle income country because we have middling productivity levels. Logically therefore, to become a high income nation we need to improve and increase our productivity levels.

However…a funny thing happened on the way between theory and practice.

Productivity is actually bloody hard to measure, and there’s no single standard.

Take for instance the main metric used by MPC – real GDP per worker. Our income level (as measured by GDP) is lower than that of the benchmark countries because our productivity level (as measured by GDP) is lower. That’s tautological. It’s like saying Usain Bolt is the fastest man alive because he runs faster than anybody else. Um...doh!

But even when we look at some of the more advanced methods for calculating productivity, there is the issue of what we are measuring and why – the OECD manual lists five broad types categorised as single or multi-factor productivity and either at gross or value-added levels. As they say, the nice things about standards is that there are so many of them.

Productivity as a concept also has some practical issues, especially in the context of development and growth.

There isn’t that big of a problem when dealing with physical commodities or goods, such as in manufacturing or agriculture. While we do have an aggregation problem – if our production of apples increases 10%, is that equivalent to increasing our production of oranges by 10%? – there are broadly accepted methodologies for dealing with it, similar to how national accounts are compiled.

The main hurdle here is with measuring the output of intangibles i.e. services. Some services are standardised (think, an airline flight on a popular route), but many are not (think for comparisons sake, a private helicopter or jet service). That’s one reason why services output lends itself to being measured by its monetary value, rather than quantities. I might add that government services have neither a monetary measure or quantitative measure of output, which makes measuring productivity even tougher.

But this raises another problem – if demand is inelastic, even in just the short term, higher “productivity” can be achieved by simply jacking up prices. The more heterogeneous the service, the more likely demand will be inelastic – think Adele, or Daniel Day Lewis or Tiger Woods, then think of the price tag of getting these individuals to sing at your function, to act in your movie, or to appear in your golf tournament. For individuals with unique abilities or characteristics, demand can be very, very inelastic indeed.

But this increase in earnings doesn’t imply any increase in output in any qualitative or quantitative sense. For another example of this, think of the excess profits made by US and European investment banks in the run-up to the Great Recession. These would have appeared as “productivity” improvements insofar as GDP and earnings increased relative to the number of workers within that sector. But does anybody really believe that to be true?

More broadly, this measurement issue applies to most non-tradeable services – “productivity'” under these conditions loses a lot of its conceptual economic underpinnings as well as its intuitive meaning.

None of the above is to say we don’t need to worry about our level or growth rate of productivity. It is still a valid theoretical construct, and perhaps more importantly, an economic concept that is easily grasped by the non-technical public.

Just bear in mind that the aggregate productivity numbers generated by us or anybody else needs to be taken with a grain of salt and a prayer.

Technical Notes:

"Measuring Productivity: Measurement Of Aggregate And Industry-Level Productivity Growth", OECD Manual, 2001 (warning: pdf link)