Why is productivity growth important?¹

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Productivity growth is closely related to growth in our standards of living. Output growth must come either from growth in inputs and/or from growth in productivity. Indeed, this is the principle that underlies the basic method of estimating productivity growth. Productivity growth is the growth in output in excess of that of inputs, like labour.

Figure 1 contains the average annual growth of real gross domestic product (GDP) in the business sector² over the 1961-to-2005 period and its various sub-periods, reflecting different economic cycles. Over the whole period, economic growth increased at 3.9% per year on average. Economic growth was quite high during the 1960s, averaging 5.6% annually. Beginning in the 1970s, economic growth has experienced a steady slowdown, from 4.1% during the 1970s, down to 3.3% in the 1980s and 3.0% in the 1990s.

Figure 1
Trend in real gross domestic product, labour productivity and hours at work, business sector

Output growth can be driven by the increase in the resources devoted to production or the efficiency with which these resources are employed. Consider the case of labour input. Output will increase if there are more total hours worked or if workers produce more per hour worked (if labour productivity goes up):

GDP = (GDP/ Hours) *(Hours) (1)

where Hours is the total number of worker-hours.

Figure 1 depicts changes in each of these components over time. For the entire 1961-to-2005 period, labour productivity advanced at a 2.1% annual average, accounting for slightly more than half of the increase in GDP growth. The rest is attributed to hours which increased at 1.7% per year on average.

Aggregate GDP measures the returns to both labour and capital. Distributional concerns lead to questions about whether the share going to labour increases over time and, in particular, how productivity growth is related to real income.

It is often claimed that productivity growth raises living standards. But how does this actually come about? The most direct way in which productivity improvements benefit people is by raising their real incomes. If higher productivity means lower costs and these savings are passed on in lower prices, consumers will be able to purchase goods and services at lower cost. The increased spending that these higher real incomes allow produces flow-on effects throughout the economy.

To see the relationship, Figure 2 compares the trend in labour productivity and real hourly labour compensation over time.³ The picture that emerges from Figure 2 is that real hourly labour compensation and labour productivity are closely related in the long run. Most of the increase in productivity was passed through to an increase in real hourly labour compensation during the 1960s, 1970s, 1980s and 1990s.⁴ The deterioration in labour productivity over time translated into a slowdown in the growth in real hourly labour compensation.

Figure 2
Growth in labour productivity and real compensation, business sector

 

1. For a more extensive discussion of the issues in this section, see Statistics Canada 2007b.

2. The business sector is the total economy excluding non-commercial activities and the owner-occupied proportion of residential housing.

3. Real hourly labour compensation is derived from the System of National Accounts concept of labour compensation divided by the gross domestic product implicit price deflator for the business sector.

4.See also Baldwin, Durand and Hosein 2001 for a study on how productivity growth at the industry level is passed on to product prices.