EconomicGrowth&Productivity

Economic growth is defined as the percentage change in an economys GDP or GNP values.
Therefore, growth measures the change in an economys total value of goods and services
produced during a given period of time. Economic growth is anindicatorofeconomicprogress.
Growth rates vary substantiallyfrom countrytocountry.TheFigurebelowshowsquarterlyGDP
growthratesasofJune2014for51countrieswhereIndiaranks46.

Source:TradingEconomics.com

A closely related concept is the growth rate of output per person which determines the rate at
which a countrys living standards are improving. A growth in per capita output leads to rising
average income. TheratiosofGrossNationalIncome(GNI)PercapitatoGrossNationalincome
for 2013for43countriesare plottedinthediagrambelow.Itshowsthatdespitehavingvery high
GDPgrowthrates,IndiaandChinahavethelowestGNIPercapitaamongtheselectedcountries.
Economic growth occurs when a countrys production possibility frontier (PPF) shifts outward.
The PPF shows the maximum quantity of goodsthatcanbeproducedefficientlybyaneconomy
given its technological knowledge and the quantity of available inputs. If we assume there are
two commodities (or commodity baskets) that an economy wants to produce, then PPF shows
variouscombinationsofbothproductsthatcanbeproducedwiththeavailableresources.


Source:WorldBank.org

PPF

The two intercepts show two possibilities where the economy produces only one of the two
commodities. Along the curve we have various combinations of both commodities produced
using all the resources. Any point below the curve represents under utilization of resources and
any point above the curve is not an attainable levelofproductionforthecountry. Anincreasein
inputs or technologicalimprovements,indicatingeconomicgrowth,enablesacountrytoproduce
moregivenotherresources.Therefore,thePPFshiftsoutward,shownbythedashedlineabove.
If the two commodities can be considered as public and private goods, then a poor country
having limited resources, can hardly afford public goods like public health, education,
infrastructure facilities etc. They will devote most of their resources for producing goods of
private consumption like food, clothing etc. If
X and
Y are goods of public and private
consumption, respectively, then a poorer country will produce a combination close to the
x
axis

while a more developed country will operate near the

y
axis. There can be other alternatives of
considering the two commoditiesasluxuryandnecessarygoods,orconsumptionandinvestment
goodsetc.
The variations in growth rates across countries are primarily explained by productivity.
Productivity is defined as the ratio of output to a weighted average of inputs. Productivity
depends on four factors, namely human resources, natural resources, capital resources and
technological change and innovation. With technological advancement diminishing returns can
beavoidedandproductivitycanbeincreased.
Consider an aggregate production function (APF) as
Q = A F
(
K, L, R
) where
A represents
technology,
K capital resources or physical capital,
L human resources or human capital and
R
natural resources. Following neoclassical growth model,
R can be dropped from the function.
Neo classical model assumes that
L grows at a given rate while most important factor for
economic growth is capital and technological innovation. An important componentofeconomic
growth process is
capital deepening, defined as the capitallabourratioor quantityofcapitalper
worker.Ascapitalperworkerincreasesoutputperworkerhasseentogrowenormously.
Let us draw the APF below with output to labour ratio on the vertical axis and capitallabour
ratio on the horizontal axis. The curve shows that as capital deepening takes place for a given
technology, the increase in outputlabour ratio becomes smaller because of diminishing returns
to capital.Inthelongrunwithoutatechnologicalchange,thecapitallabourratiowillstop rising,
the economy will enter a steady state in which capital deepening ceases, real wages stop
growing, capital returns are constant. So, this essentiallyshowsthatifeconomicgrowthconsists
of only accumulating capital with existing methods of production, without any technological
change,theneconomicgrowthwillstagnateandthestandardoflivingwillstoprising.
Q/L
Q/L
1

Q/L
0

Q/L
i

APF/

APF

K/L

iK/L

K/L

Only with technological change shown as a shift in the

APF
curve upward to
APF/
can
reinvigorate the growth process by increasing outputlabour ratio with a change in the
capitallabourratio.
The production function most commonly fitted to aggregate data to distinguish empirically
betweenthethreebroadsourcesofgrowthhasbeenthe
CobbDouglas
productionfunctiongiven

by
Qt
= Tt
Kt
where
t denotes time period,
Q
is real output,
T
,
K and
L are indices of
Lt

technology, capitalstock (inrealterms)andlabourinput(intermsofmanhours),respectively

is the partial elasticity of output with respect to capital,

is partial elasticity of output with
respect to labour. When
+

> 1 we have increasing returns to scale, constant returns to scale
for
+

= 1, and decreasing returnstoscalefor
+

<1.Nowthatwhenexpressedintermsof
growthratestheCobbDouglasProductionfunctiontakesthefollowingform:
dlnQt
dlnT t
dlnKt
dlnLt
dt = dt + dt + dt
Or

g
g
denotesgrowthrates
Q=g

T
K+

L where

For a given technology the function takes the form of usual neoclassical production function
with two inputs,
K
and
L. However, the change in output caused by change in technological
innovation is called total factor productivity (TFP). Alternatively, TFP is defined as the portion
of output not explained by the amount of inputs used in production. TFP growth is usually
measured by the Solow residual. The Solow residual accurately measures TFP growth if (i) the
production function is neoclassical, (ii) there is perfect competition in factor markets, and (iii)
thegrowthratesoftheinputsaremeasuredaccurately.
Sometimes, the CobbDouglas production function is estimated with the assumption ofconstant
returns to scale, so that the model has a constraint of
+

= 1. Now,
=1

.Thisiscalleda
constrained CobbDouglas production function. Let
gQ
denote the growth rate of aggregate
output,
gK
the growth rate of aggregate capital,
gL
the growth rate of aggregate labor and alpha
thecapitalshare.TheSolowresidualisthendefinedas
g

(1

)
g
Qg

K

L.

The Figure below shows changes in Indias TFP over the years 1994 till 2012. The situation
warnedofadecliningTFPwhichimpliesadeclineinthecompetitivenessofaneconomy.


The reasons for slowdown in TFP are many including administrative and bureaucratic tangles,
poor infrastructure, barriers to investment, unskilled labour force, lack of innovation, persistent
inflation, current account deficit, and slow growth in private investment. The diagram below
showsthepatterninthechangeinsavingsandinvestment.

AnnualGrowthRateofTFPbyBroadSector,19802008
BroadSectors
TotalFactorProductivity
Agriculture,Hunting,Forestry,Fishing
1.68
Mining&Quarrying
0.17
Manufacturing
1.30
Electricity,Gas&WaterSupply
2.62
Construction
3.31

Services
TotalEconomy

2.07
1.74

RBIs report on productivity growth in the Indian context shows that TFP growth has been
negative for construction and mining and quarrying see above table. One ofthemost important
structural constraints has been low agricultural productivity growth. India also has a sizeable
informal sector which suffers from low productivity because of lackofeasyaccesstocreditand
technology.
An alternative view however, claims that TFP, at constant price with 2005 as the base year, is
continuouslygrowinginIndiaasshowninthefollowingfigure.