The productivity riddle

There is daily clamour in the media about lifting Australia’s productivity. The rate surged in the 1990s but has now fallen well back in world rankings, according to the Productivity Commission. Employers are agitating for action to improve Australia’s performance. Talk of boosting efficiency through labour flexibility has unions worried about another push for individual contracts that cut wages and the return of tougher industrial relations laws, similar to WorkChoices, the controversial legislation introduced by the previous federal government in 2006 that has since been dismantled.

Sceptics claim the frequently discussed decline in productivity is a pseudo-crisis aimed at encouraging Australians to work harder for less. But the ongoing debate highlights the need to determine proven ways of boosting productivity, and prompts the question: Whatever happened to the productivity summit to work out a consensus that the government proposed before the last election?

A forum was recommended in the April 2010 report of the Inquiry into Raising the Productivity Growth Rate in the Australian Economy, conducted by the House of Representatives Standing Committee on Economics. Its time is due, says Kevin Fox, head of Economics at the Australian School of Business. The report raised questions about Australia’s glum productivity outlook.”It looked at what we are measuring, and showed that mining companies’ productivity fell due to [its increased] investment in exploration, which might not come on line for 20 years. There is a similar pause due to high gas and electricity investment, and [also the after-effects of] the long drought. Taking out these investment lags, Australian productivity does not look so bad,” insists Fox.

Typically, productivity is measured as the growth in outputs that cannot be explained by the growth in inputs and consequently has been facetiously called “an index of ignorance”. Evidence of what drives productivity in Australia is required “so we understand how to increase it”, says Fox, a member of the Australian Bureau of Statistics (ABS) Productivity Measurement Reference Group, which examines approaches to quantifying productivity.

Budget constraints appear to prevent the collection and analysis of more detailed data.”If we want to know what’s driving productivity, we need to be able to measure it accurately,” Fox points out.”The increasing importance of the ‘hard to measure’ sectors in the economy, such as services, means that the measurement challenges appear to be growing more quickly than the resources being dedicated to addressing them. Improved data and accompanying analysis has the potential to significantly inform and enhance the quality of productivity-related policy formulation.”

Identifying Causes

An outspoken sceptic about Australia’s productivity boom and bust is economist John Quiggin, author of Zombie Economics: How Dead Ideas Still Walk Among Us. In his submission to the parliamentary inquiry, Quiggin said Australia’s “surge” of productivity in the 1990s was a statistical illusion that has now disappeared. It came from people working harder (such as by giving up tea breaks), but that reversed when people reclaimed some of their lives.”The measured rate of productivity growth has declined since the 1990s, although growth has remained positive,” Quiggin argued. “Productivity trends in Australia have been broadly similar to those in other OECD (Organisation for Economic Co-operation and Development) countries.”

However, the assertion that Australia’s productivity surge in the ’90s was an illusion is unproven, according to Saul Eslake, director of the Productivity Growth Program at the Grattan Institute, a non-aligned think tank. In a recent ABC debate, both economists agreed that improving productivity is not about working harder or doing unpaid overtime, and it’s unsustainable to increase production by getting more out of the working population, increasing migration or relying on improved prices for raw materials, they concurred.

Organising the use of labour and capital more efficiently – doing more with less – is the only sustainable source of improvement to material wellbeing and increasing Australia’s GDP, says Eslake. He supports the view that Australia’s productivity growth fell in the past five years and is negative for the first time since the 1960s, having deteriorated in all but three of 16 sectors.”As we got to full employment, we have used less productive labour and capital. But things may be about to turn,” Eslake notes.”Sectors suffering from the high dollar are now starting to implement productivity-enhancing organisational changes in the workplace. This is not pleasant when it comes to job cuts in manufacturing and services. If Australia is serious we need regulatory reform, and investment in skills, education and infrastructure.”

The House of Representatives’ report also accepted there was a surge in the mid-1990s, averaging 2.3% productivity growth annually (Australia ranked second among OECD countries at the time). Since then, productivity growth has declined to 0.4% in the current incomplete cycle from 2003-04 to the present.

The high per-capita incomes now enjoyed by Australians can be attributed to favourable commodity prices and thus strong terms of trade. The committee recommended the government introduce a national productivity growth agenda and a target for the medium term to 2030. It also called for more research by the Productivity Commission (PC) and the Australian Bureau of Statistics, with a cost-benefit analysis for any policies on productivity growth.

Bringing on Reform

The Productivity Commission’s submission to the inquiry argued that 70% of the recent rapid decline in the productivity cycle ending in 2003-04 was due to mining, with declining resource quality and large capital investment that has not yet translated into output. Utilities – electricity, gas and water – have been affected by reduced capital investment and reduced rainfall; and agriculture, by drought. Low spending on infrastructure, education and training, or research and development (R&D), were unlikely causes of the productivity dip, although they are important in the long run, the commission said.

A reform program is needed not only to improve the allocation of resources across the economy, but also to heighten the performance incentives for employers, while helping to enhance their organisational flexibility and capability.”All three need to be attended to in a policy framework that promotes a focus on productivity and innovation by organisations, and diffusion of best practices among them,” the commission’s submission noted. “Australia’s own history of decades of relatively weak innovation and productivity growth coinciding with a relatively highly educated workforce illustrates this interdependence among the three policy dimensions.”

Productivity improvements in an economy can be more about raising the performance of companies that are productivity laggards – or their exit – than developing and implementing “cutting-edge” technologies, asserted the commission. Policies should favour an open and competitive economy, ongoing regulatory reform and efficient investment in human and physical capital. The first wave of market-opening reforms of the 1980s and 1990s removed many entrenched inefficiencies from the economy and provided ongoing incentives for productivity improvement. Still on the PC’s “to do” list are competitive reforms in areas such as coastal shipping and aviation. Continued tariff reductions and improved competition in pervasive small business areas such as pharmacies, taxis and newsagencies are also earmarked to stimulate innovation and lower costs.

Quiggin is sceptical about this approach for the 21st century, claiming the micro-economic reforms of the 1980s have been exhausted.”Technological progress is a long-term driving force that has improved our living standards,” he says.”What goes with that is a skilled and educated workforce that can take advantage of that technology”.

The Manager’s Role

Chad Syverson, an economist at the University of Chicago, explored why some businesses are more productive than others in the same industry and looked for proven ways to boost productivity in a recent paper, What Determines Productivity? Evidence that management and productivity are related is starting to pile up, Syverson concludes, although it remains unclear what levers management can pull to improve productivity within a company. More research is required, he says.”Important questions regard whether businesses have the ability to both identify and implement best practices in industry. If not, why? Is it lack of information or bad incentives? How costly is it to fix the problem? If there are information barriers stopping best practices from being identified, there might be a coordinating role for government in smoothing the process. Otherwise, government’s role should focus on setting an external environment that encourages efficiency. For example, making sure product markets are competitive, that regulations do not incentivise bad practice, and that input markets don’t present a lot of barriers to businesses with good ideas growing.”

Syverson’s survey of productivity studies indicates intense competition in a firm’s market is positively correlated with best-practice management. So does competitive pressure create good managers? Yes, but not always – management practice scores are lower in family owned firms run by the eldest son of the founder, for example. One study shows in electricity generation, the best managers can boost their power station’s fuel efficiency by more than 3%, saving millions of dollars of fuel costs per year.”Unfortunately, the data are less clear about what particular actions or attributes predict good plant management,” says Syverson.

On the other hand, poor management and labour relations affect productivity as shown by the second-hand price of equipment made at plants where mining and construction equipment manufacturer, Caterpillar, was experiencing labour strife during the 1990s. Compared to otherwise identical products made at plants or times without unrest, these products had about 5% lower resale values. The age of capital equipment is also relevant. Capital efficiency grows at between 5% and 17% per year, depending on the type of machinery.”These numbers are striking in their implications about how much productivity growth can come from investment alone,” Syverson points out.

There was a clear productivity impact when auto assembly plants shifted to”lean” technologies, which involves new capital and complementary practices such as teamwork and just-in-time ordering.”Both the entry of new lean plants and the transformation of earlier vintage plants are responsible for the industry’s acceleration of labour productivity growth during the late 1980s and early 1990s.This is also clearly related to the managerial practice discussion earlier,” Syverson says.

Clearly, technology has boosted productivity. Computer-aided design tools make it easier to make customised parts, and quicker setup times make multiple production runs less costly. Some studies”show US-based multinationals operating in the European Union (EU) are more productive than their EU counterparts, and this productivity advantage is primarily derived from IT capital”. Other research suggests that employment protection legislation such as firing costs makes exit more expensive and therefore reduces firms’ willingness to adopt IT. In countries with greater legal restrictions on firms’ abilities to close unsuccessful lines of business, IT-intensive sectors are smaller.

Action Learning & Forgotten Insights

“Learning by doing” increases productivity, Syverson’s research shows. In the 1970s, the labour hours aircraft manufacturer Lockheed needed to assemble its wide-body L-1011 TriStar were cut in half by the 30th plane, and halved again by the 100th. Yet forgetting is also quantitatively important – almost 40% of the “knowledge stock” depreciates each year.”This may not be literal forgetting but could instead primarily reflect labour turnover,” says Syverson.

The structure of companies affects productivity, according to some studies. For instance, airlines that own their regional affiliates experience shorter delays and fewer cancellations than those contracting with affiliated regionals at arm’s length. And conglomerates have higher permanent productivity levels than single enterprises. When a conglomerate diversifies, the plants it buys actually experience productivity growth, suggesting they are being reallocated to more capable management.

Yet improving productivity can come at a cost – a temporary period where expenses are actually higher than before any technological change was made.”Disruption could be due to installation issues, fine-tuning new technology, retraining workers, and so on,” says Syverson. In the face of such adoption costs, monopolies or producers facing less competition have less incentive to adopt the new technology.

The industry context may also affect its players. The practices of productivity leaders can have spillover effects on the productivity levels of other firms who seek to emulate them. One way is by knowledge transfers, as the word gets out on better techniques. For example, UK firms with a greater R&D presence in the US have faster overall productivity growth.”A US research presence [makes] it easier for firms to tap into the knowledge base of the US economy, which tends to be the technological leader in most industries. The precise mechanism through which this technology tapping occurs is unclear,” says Syverson.

Competition encourages productivity as it moves market share toward more efficient (lower-cost) producers. It also raises the productivity bar that any potential entrant must meet to successfully enter. Aggregate productivity growth in the US retail sector is almost exclusively through the exit of less efficient single-store firms and their replacement with more efficient national chain stores. Syverson ponders why within-store productivity growth is so small on average in retail, but not manufacturing, for example? “Answering questions like this would go a long way to developing our understanding of how micro productivity differences drive the aggregate productivity movements,” he says.