Thursday, October 25, 2007

Measuring The Contribution of Labour and Capital to Growth

"When we analyse the source of economic growth, we include the capital stock (K) and the labour supply (N), and total factor productivity (A). Sometimes adjustments are made to K and N, reflecting changes in quality or prices. Should such adjustments be made?" - Candy

You're referring to growth accounting- using a simple production function to figure out how much of economic growth is due to growth in the labour supply, how much is due to growth in the capital stock, and how much cannot be explained by growth in these most basic factors of production. This final left over part may be thought of as a measure of how efficient the economy is, and it is variations in this variable (A) that explain the huge variation in economic wealth between poor and rich countries.

Often we do adjust measures of the capital stock and measures of the labour supply. Whether this is a good idea or not depends on the source of the adjustment, and what exactly we're trying to measure. Sometimes the adjustments are due to measurement problems, and should rightly be made. For example, when we measure the capital stock, ideally we want a measure of the total physical quantity of capital that is used in production. We can't easily measure this; instead we measure the market value of the capital stock. But the market value can change because of a change in the quantity of capital, or a change in the price of capital. Clearly correcting our measures of capital for changes in the price of capital is a good idea.

Similar adjustments in the labour supply may also be warranted. For example, as the demographic structure of the economy changes, measuring the total number of workers or the total number of hours worked may be a poor measure of the total contribution of the labour force to production. If more experienced workers are replacing less experienced ones, then ignoring this fact will exaggerate the rate growth rate of A, the part of economic growth that is not due to labour or capital.

But some adjustments might not be a good idea, because the quality of labour or capital is itself an endogenous variable that responds to the growth of the economy. For example, as the economy's growth rate increases, workers are induced to increase their level of education and learn new skills to take advantage of new job opportunities. Is this an increase in the level of the labour supply (N) or an increase in productivity (A)? In truth, it is both. A similar argument can be made for capital. There are greater incentives to buy better quality capital the more developed the economy is, and the greater are the possible returns to using high quality capital.

So I end up sitting on the fence. If you want to know how much of the growth of the economy cannot be explained by labour and capital, maybe you should adjust away to your heart's content. If instead you want to know how much of the growth of the economy is "endogenous" - i.e. not directly due to changes in the quantity of the factors of production, you should limit adjustments to correcting more meaurement errors, and not quality changes.

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