In economics, productivity refers to how muchoutput can be produced with a given set ofinputs. Productivity increases when more outputis produced with the same amount of inputs orwhen the same amount of output is producedwith less inputs.

There are two widely used productivity concepts.

Labour productivityMultifactor productivity (MFP)

This Explainer outlines how productivity ismeasured, what drives productivity growth andhow productivity growth contributes to theeconomic prosperity and welfare of all Australians.


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How is productivity measured?

In Australia, the Australian Bureau of Statistics (ABS)produces measures of output and inputs fordifferent industries, sectors and the economy as awhole. Productivity is not measured directly butis calculated by dividing a measure of output by ameasure of inputs.

Output

Output refers to a quantity of goods and servicesproduced in a given time period. Output for anindustry or sector is usually measured by grossvalue added (GVA), which is the total value ofgoods and services produced less those goods andservices used in the production process (known asintermediate consumption). Output for the wholeeconomy can be calculated by summing GVA acrossindustries. Alternatively, adding the value of taxesto GVA and subtracting the value of subsidies onproducts gives gross domestic product (GDP) (seeExplainer: Economic Growth).

Inputs

Labour and capital are the two main types ofinputs.

Labour input

Box: Calculating Labour Productivity – An Example

Labour productivity is defined as output produced per unit of labour input.


Suppose a person is employed for 40 hours a week in a toy factory. In a given week, the workerproduces 120 dolls. The productivity of the worker in that week is 3 dolls per hour.


Suppose the factory produces a range of toys, including dolls, miniature cars, card gamesand board games. In a given week, the gross value added of these goods is $5 million, using125,000 hours of labour. Labour productivity for the toy factory in that week is $40 per hour.


Box: Calculating Multifactor Productivity (MFP) – An Example

Most businesses produce output using a combination of labour and capital inputs. MFP iscalculated as a measure of output divided by a measure of combined inputs. Both the denominatorand numerator are usually represented by indexes, which is a useful way of comparing changes ineconomic time series relative to a base period. The value of the index in the base period is usuallyset to equal 100.


Because of the use of indexes, MFP is usually analysed in terms of growth rates rather than levels.

Suppose that a factory uses a combination of labour and capital to produce dolls, board gamesand other toys. Suppose that year 1 is the base year when an output index and a combined inputindex for the toy factory are both set equal to 100. In year 2, the output index increases to 107while the combined input index increases to 105. The MFP index for the toy factory in year 1 is100 and the MFP index in year 2 is 101.9.

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Year 1100100100
Year 2107105101.9

The growth in MFP between year 1 and year 2 is 1.9 per cent.


Capital input

MFP uses a measure of combined labour andcapital inputs, where each input receives a weightreflecting its costs to Australian businesses.

Measurement difficulties

There are a number of challenges associated withmeasuring productivity. For example:

Output in non-market industries is difficultto measure:Estimates vary with time periods:Some inputs and outputs are not measured:

What drives productivity growth?

In economics, the production possibility frontier(PPF) is used to show all possible combinationsof goods and services that can be produced witha given amount of inputs and technology, whenall inputs are used to their full capacity. The PPFcan apply to any number of goods and servicesproduced in the economy. However, it is usuallyillustrated in two dimensions for two goods andservices and is useful for showing two ways inwhich businesses can increase productivity –by operating more efficiently or by expandingproductive capacity. Productivity improvementscan also have spillover effects for other firms.

Efficiency improvements

A business is producing on its PPF if it is notpossible to produce more of one good or servicewithout producing less of another. Economistscall this ‘technical efficiency’. If production is insidethe PPF, moving closer to the PPF represents anincrease in productivity, as more output can beproduced with the same inputs.

Suppose a business produces two goods, X and Y.All possible combinations of X and Y that achievetechnical efficiency for some amount of inputs andtechnology is given by PPF1 in the diagram below. Ifthe business is initially producing at point A, whichis inside PPF1, then it is not technically efficient. Ifproduction moves from point A to point B, whichis on PPF1, the business can achieve technicalefficiency and higher productivity, as more outputcan be produced with the same inputs.

One way to improve technical efficiency is throughmicroeconomic reform. Australia's microeconomicpolicies – such as those related to competition,trade, tax and market regulation – have played animportant role in supporting productivity growthover the past few decades by creating incentivesfor businesses to operate more efficiently.


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Expanding productive capacity

A business can also improve its productivity byexpanding its potential production, represented byan outward shift in the PPF. In the diagram above, anexpansion in potential production would allow thebusiness to move from point B on PPF1 to point C onPPF2 and produce more of both types of goods.

An expansion in potential production can occur asa result of innovation and advances in technologythat allow a business to produce more output withthe current level of inputs. Such technologicalprogress is often embodied in capital inputs likefaster computers or more powerful machines,but can also occur through improvementsin knowledge that allow more output to beproduced without investing in new capital.

Productivity spillovers

Spillover effects between businesses can furtherincrease the overall level of productivity in theeconomy. For example, the sharing of knowledgebetween businesses can generate positiveproductivity spillovers. Knowledge sharing mayoccur through direct channels (such as industryinnovation hubs) or indirect channels (such asworkers changing jobs).

Benefits of productivity growth

Productivity growth is important for maintainingthe economic welfare and prosperity of allAustralians. Productivity growth can contribute toone or a combination of the following:

Higher wages: Lower prices:Higher profits: Stronger economic growth: