Economic Development and Productivity: The Crucial Linkage of Inclusive Growth

August 12, 2015

By Yuwa Hedrick-Wong

It is commonly acknowledged that poor countries are poor because they suffer from generally low level of productivity. In poor countries individuals, businesses, and even entire industries are often stuck in low productivity activities.

This is due to the absence of many critical conditions that would have enabled workers to learn new skills and get better jobs; small businesses to expand, and bigger firms to finance acquisition of productive assets and to access new and promising markets and customers and so on.

Traditional remedies tend to focus on providing what people, firms, and industries in poor countries need immediately in order for them to be more productive. Poor farmers are provided with tools, seeds and livestock;  microfinance agencies offer loans to poor households and small businesses; subsidized project loans are provided for industries deemed important for development, and structural reforms are introduced to ease conditions for doing business. The track record of these efforts is mixed, to say the least.

One problem has to do with missing the really important target; total factor productivity (TFP).

A focus on education may enhance labor productivity, provided that the education offered actually enables better skill development, which is not always the case. Improving access to business finance and liberalizing markets could increase the productivity of capital, allowing businesses, large and small, to earn higher returns on their investment.  These are the usual targets of traditional remedies in development. However, while increasing labor and capital productivity is important, it is ultimately insufficient.  What is needed is an increase in TFP.

TFP refers to the ability to produce more output with less input, so it is all about efficiency, which in turn has to do with better ideas of how to do things, and how such better ideas can be diffused rapidly to more market participants[1]. In other words, with strong growth in TFP, economic growth can continue indefinitely even if there is no further increase in inputs in labor and capital. Recent and thought provoking research points to the overwhelming importance of TFP in explaining why some countries are rich and others are poor.

For example, the GDP per worker in China and India are estimated to be respectively 86.4% and 90.4% lower than the GDP per worker in the US. Traditional development remedies would have China and India focus on raising their labor and capital productivity. And it would not be wrong for them to do so, but they are not going to get very far on that alone. It turns out that a whopping 82.9% of the difference in GDP per worker between the US and China is due to China’s much lower TFP compared with the US. And in India it is 67.0%. A similar pattern can be observed across the entire spectrum of developing countries; differences in TFP are the biggest contributor to differences in income. In cross-country analysis covering both rich and poor countries, the correlation between TFP and GDP per worker is an almost perfect fit of 0.96.[2]

TFP is notoriously difficult to measure, unlike labor and capital productivity which can be more directly observed. But recent research is providing tantalizing new clues on how lack of social and economic inclusion at the micro level shows up as a reduction in TFP at the macro level. For instance, household surveys from 35 countries show that returns to experience vary hugely across countries, with poor countries having much flatter age-earning profile.[3] This suggests that in spite of gaining more experience and getting better at what they do, experienced workers in poor countries are less able to move onto more productive jobs with better pay.

In other words, the huge potential of raising TFP from deploying the more experienced and skilled workers in positions where they can be more productive is left untapped in poor countries. Obviously many factors are at work, but there is little doubt that lack of social and economic inclusion is very much at the crux of the problem.

A parallel situation can be found at the level of the firm. In the US, firms get much bigger as they age; firms that are more than 35 years old have eight times the employment than firms in the same sector that are less than five years old. Older firms are those that have survived the test of competition and have evolved to become more productive and efficient; in other words, they have higher TFP. And as they expand their employment, they are also creating opportunities for more workers to function at their optimal level of productivity.

In contrast, firms that are over 35 years old in Mexico have only twice the employment than firms that are less than five years old. And in India, there is virtually no difference in employment between the older and younger firms.[4]  Again evidence points to the lack of social and economic inclusion as the smoking gun. This is also corroborated by research evidence showing the lack of access to financial services in general and credit in particular being a major cause of loss in TFP.[5] Whether it is due to monopolistic practices, restricted access to finance, collusion of vested interests, or stifling regulations (most likely some combinations of them), the most productive firms are prevented from growing in size, which reduced their potential growth of productive employment, leading to lower TFP in the economy.

Inclusive growth is often presented as something that is “nice to have”. We all feel better when more people benefit from an expanding economic pie. Through the lens of TFP, however, inclusive growth is a prerequisite for the economic pie to grow in the first place. Low level of inclusive growth leads to low TFP, which leads to low GDP per worker.

For poor countries aiming to close the gap with the developed countries, focusing on inclusive growth is the best way forward.

 

 

[1] This hinges on how useful information is being shared, and through widespread sharing, re-produces itself in ever more useful new forms. See Cesar Hidalgo, Why Information Grows: The Evolution of Order, from Atoms to Economies. 2015. New York: Basic Books.

[2]  See evidence assembled by C.I. Jones, “The facts of economic growth”. Stanford GSB and National Bureau of Economic Research, working paper draft version 0.4. April 6, 2015.

[3] Lagakos, D., Molls, B., Porzio, T., Qian, N. and Schollnian, T, “Experience matters: Human capital and development accounting”. National Bureau of Economic Research Working Paper 18602, December 2012.

[4] Hsieh, C.T. and Klenow, P.J., “The life-cycle of plants in India and Mexico”. Quarterly Journal of Economics. 129 (3), 1035-1084.

[5] Midrigan, V. and Xu, D.Y., “Finance and misallocation: Evidence from plant level data”. American Journal of Economic Review. February 2014: 104 (2), 422-58. Also see Moll, B. “Productivity loss from financial frictions”. American Journal of Economic Review. September 2014: 104 (10), 3186-3221.

 

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