1. Why is productivity growth so vital? To see more of our products visit our website at www.anforme.co.uk Ruth Tarrant, Head of Economics and Politics, Bedales School.

2. According to the Office for National Statistics “increasing productivity is generally considered to be the only sustainable way of improving living standards in the long term.” C Technically, productivity refers to the ratio of outputs to inputs, but governments are usually most interested in ‘output per worker’. C In the UK, productivity is measured by the ONS in two ways. C What is productivity and how is it measured? One method is to divide the total output of the economy (i.e. GDP) by the total number of hours worked, to get ‘output per hour of labour’. C The second method is to divide total output by the number of workers employed. C The two numbers can be quite different, as they reflect different working patterns i.e. the second method gives a lower number when there are more part-time than full-time workers. C

3. Figure 1 shows that productivity growth in the UK has been very poor, not only in the two years shown but as far back as 2007. C In 2012, the UK’s output per hour was 16 percentage points below the average of other industrialised economies. C In terms of output per worker, the UK’s performance was even worse, at 19 percentage points below the average of other industrialised countries. C The productivity picture in the UK 1 This amounted to the UK having the widest productivity gap with other industrialised countries since 1994. C The ONS estimates that the UK’s productivity is 15 percentage points lower than it would have been without recession, and says that the slow rate of UK economic growth is due to sluggish productivity growth. C

4. Many economists in the past year or so have been perplexed by the UK’s so-called ‘productivity puzzle’, in which more people have been getting jobs yet output has barely risen. C This is in stark contrast to previous UK recessions, in which productivity picked up again quite quickly after the trough of the slump, causing rising GDP and a return to greater economic prosperity. C The Figure below illustrates this point and helps to explain the current even greater concern over the impact of poor productivity in the UK. C The productivity picture in the UK 2

5. Productivity growth should mean, in a competitive labour market, that workers receive higher wages, and that businesses enjoy falling average costs which can increase their profitability. C Wages are determined at the point where demand for labour is equal to the supply of labour. C The demand for labour is determined by the Marginal Revenue Product (MRP) of workers, which is the extra revenue generated by employing one more worker. C The importance of productivity Growth – the microeconomics dimension 1 Businesses will only pay a worker a wage that is equal to, or less than, the worker’s MRP. C MRP is calculated by a worker’s Marginal Physical Product (MPP) multiplied by the price of the products they make. C MPP is the extra output made by an additional worker, and is effectively a measure of their productivity. C Therefore, if the productivity of workers rises, their MRP rises, and so their wage rate rises. C

6. The impact of productivity growth on businesses is also important. C Higher output per worker is the same as an increase in productive efficiency. C This should reduce a firm’s average costs (costs per unit). C If the firm is able to continue selling its products at the same price, then this cost reduction will lead to an increase in profits. C The importance of productivity Growth – the microeconomics dimension 2

7. Profits are important to businesses for a number of reasons. C Profits provide businesses with a source of funds for buying new capital which means that businesses can invest and grow. C This may mean they become more dynamically efficient (producing better quality or better designed products, or develop a better production process) and can employ more workers. C Also, profits may be given out to shareholders in the form of dividends, which often leads to rising share prices and a more valuable business. C This can make it easier for businesses to raise future funds from shareholders, providing a more sustainable future source of finance. C The importance of productivity Growth – the microeconomics dimension 3

8. Rising productivity can be expected to prompt non-inflationary economic growth, the ‘holy grail’ of economic policymakers. C This is because it can cause a simultaneous increase in both Aggregate Demand (AD) and Aggregate Supply (AS). C Workers may benefit from higher wages, if their productivity, and therefore MRP, rises. C The importance of productivity growth – the macroeconomic dimension 1 Rising income is likely to cause an increase in consumer spending, the largest component of AD in the UK. C Also rising productivity can lead to higher profits for businesses, encouraging more investment. C This increase in both consumer spending and investment should cause AD to increase. C The size of the increase in AD depends on the size of the multiplier effect and confidence levels. C

9. Since productivity growth means that more output is being made with the same number of factors of production, this will increase AS in an economy. C The size of the increase depends on whether rising productivity has been achieved by equipping existing workers with better capital or whether some workers have been replaced by capital. C The macroeconomic impact is an increase in GDP as a result of simultaneous increases in both AD and AS which allows many of the government’s macroeconomic objectives to be achieved. C If the number of workers in the economy remains constant, higher real GDP should mean higher GDP per capita and therefore higher living standards. C Higher living standards might also be achieved if workers are able to earn the same level of income by working fewer hours and therefore enjoy more leisure time. C The importance of productivity growth – the macroeconomic dimension 2

10. Also, the price level remains stable, which reduces inflationary expectations and is likely to mean that interest rates will remain the same, promoting confidence. C The economy also remains close to full employment, reducing the need for government spending on benefits and allowing them to reduce the size of the budget deficit. C Furthermore, if the price level remains constant and inflation is low, then the country’s international competitiveness should improve relative to other countries. C Rising competitiveness should lead to an increase in demand for exports, reducing the size of the current account deficit and boosting AD. C This is important in terms of the sustainability of economic growth rather than just growth itself. C Rising productivity is effectively the same as increased productive efficiency – getting more out of existing resources should mean that fewer resources are wasted. C The importance of productivity growth – the macroeconomic dimension 3

11. Increasing productivity is relevant to both employees and companies and also the nation as a whole in terms of macroeconomic objective. C Thus higher productivity is a desirable win-win target. C This is where supply-side policies are relevant. C Conclusion 1 This involves investment in both human and physical capital and also measures to make product markets more competitive. C

12. Productivity growth really is vital for helping economies to grow sustainably. C By raising wages, encouraging investment and boosting output, living standards should rise. C Achieving productivity growth, however, is not easy and depends on getting many factors right. C Governments should encourage greater competition between firms, provide incentives and opportunities for workers to get the right skills and ease the process for businesses to carry out investment. C They should also encourage research and development and innovation, and reduce unnecessary regulations and restrictions on businesses. C Conclusion 2