Total Factor Productivity: The Mystery Ingredient of Growth

What economists mean by total factor productivity, why it explains so much of the difference between rich and poor countries, and what raises it.

Economies grow by using more inputs, such as workers and machines, and by using them better. The second part is called total factor productivity, or TFP.

Growth accounting

Economists break down growth into contributions from:

Labour: more workers or more hours.
Capital: more machines, buildings and infrastructure.
Human capital: better-educated workers.
TFP: everything else, the growth in output not explained by more inputs.

Because TFP is calculated as what is left over, it is also called the Solow residual, after economist Robert Solow, who showed in 1957 that most of U.S. growth per worker in the early 20th century could not be explained by more capital alone.

What TFP captures

Technology: new inventions and better methods.
Efficiency: how well resources are allocated between firms and sectors.
Management: well-run firms get more from the same inputs.
Institutions: rule of law, competition and good policy.

Why it matters

Studies of development find that differences in TFP explain a large part of the gap in income per person between rich and poor countries. Poor countries don’t just have fewer machines; they often use their resources less efficiently.

Misallocation

Economists Chang-Tai Hsieh and Peter Klenow estimated in 2009 that if capital and labour in India and China were allocated as efficiently across factories as in the United States, manufacturing TFP could rise substantially. Barriers such as credit constraints, regulations and favouritism keep resources in less productive firms.

Raising TFP

Competition that pushes firms to improve or exit.
Openness to trade and foreign technology.
Better management practices.
Research and innovation.
Efficient financial markets that move capital to productive firms.

Two textile factories

Two factories have the same number of workers and machines. One uses modern management, maintains machines well and organises work efficiently, producing 30 percent more cloth. The difference in output from the same inputs is higher productivity, the kind TFP measures.

Thinking growth only comes from investing more

Using resources more efficiently through technology, management and better allocation is a major source of growth.

Key takeaways

TFP is growth in output not explained by more labour or capital.
It is also called the Solow residual.
TFP differences explain much of the income gap between countries.
Competition, openness, management and efficient allocation raise TFP.