The mystery of the missing productivity - Part I

Expectations of enjoying a higher standard of living than our parents

Throughout my lifetime, there has been an unwritten, and rarely spoken about, expectation that my generation would enjoy a higher standard of living than our parents. This was not a baseless expectation, but the continuation of a well-established trend over many generations. This expectation was also important as the prospect of higher real wealth tomorrow allowed me to borrow and invest confidently against the future thus further propelling my prosperity.

However, I am not so sure that my children share the same expectation of growth in living standards, and unfortunately, this is increasingly being reinforced by the data. The elixir of my confidence in growing prosperity was growth in real wages – courtesy of growing productivity. Growth in real wages has manifested in three ways in my ability to buy; cheaper goods and services, higher quality goods and services, and entirely new goods and services. In each of these three ways, productivity growth has increased my purchasing power and standard of living.

This article is Part I of a two Part series. Part I focuses on exploring a range of causal drivers for missing productivity gains through the lens of macro, micro, and behavioural economics, while Part II focuses on meaningful ways that productivity can be improved at individual, firm, and national levels.

Productivity is the efficiency of using labour, capital, and ideas to convert inputs into outputs

At its simplest level, productivity is the efficiency that labour, capital, and innovation work together to convert inputs into outputs. Productivity improvement comes from one or a combination of; workers developing better skills, business or government investing in more technology and capital equipment, new ideas being developed, and the spread and adoption of good ideas such as management insights, technical knowledge, and new technology.

Productivity growth is at its lowest level in over 60 years

However, over the decade to 2020, average annual labour productivity growth in Australia was the slowest in 60 years, falling to just 1.1% compared with 1.8% over the 60 years to 2019-20. In addition, the productivity gap between Australia and the rest of the global economy is widening.

These poor productivity outcomes seem incongruous with a period in history of unprecedented technology advancement and high levels of education in the workforce.

This raises the valid question,?what has happened to productivity? Is it that these, and other advancements have not improved productivity, or that improvements in productivity have been eroded or offset in other way? Importantly, for the prosperity of individuals, companies, and Australia as a nation, what can be done about it? This article explores this question from the perspective of macro (Australian economy), micro (business or firm level), and behavioural (individual) economics. This enquiry is critical as unlocking the causes for our?missing productivity?holds the key to improving our individual and collective standard of living.

A measurement problem may result in standard of living improvement independent of real wages growth

A first possible cause for the missing productivity is a measurement problem, i.e., productivity improvement is in fact occurring but is not being fairly reflected in a broad and somewhat crude productivity measurement. Measurement error may exist by not picking up improvements in quality. Productivity improvements in the digital and services’ sectors may be enhancing customer experience, increasing personalisation, and/or improving the variety or novel products offered, more so than delivering real cost reductions. Equally, productivity growth could be directed to improving the quality of public goods, such as the environment, with investments in abatement technology reducing carbon emissions, but not being measured in gross domestic product (GDP) or business profits, thereby putting downward pressure on productivity – at least in the short term. These measurement shortcomings raise the possibility that improved standard of living is being achieved independent of real wages growth.

Productivity growth leakage when consolidating productivity at the national level

A second possible cause of the missing productivity is that improvement is being made in business productivity, but this is being eroded by other factors at the collective level of the national economy.

Over the past 70 years, the Australian economy has undergone a significant transition from producing goods to services with services increasing from 50% to the current 80% of the nation’s economic output. This shift is even more pronounced on the labour front with 9 out of 10 people in the labour force being employed in the service sectors reflecting the higher labour intensity of services relative to goods. This sector shift is important, as while some more capital-intensive sectors have seen huge technology transformation, innovation and productivity growth (such as mining, manufacturing, agriculture, and energy), this has not translated to the higher labour-intensive service sectors. Known as the ‘cost disease’, higher productivity market segments (such as goods) tend to shrink their share of the economy relative to the less productive (such as service) segments.?

Productivity improvement in services is hard. Services tend to be labour intensive, many are delivered in person, often bespoke, and hence not amenable to mass production. They are often hard to automate. This is further exacerbated by the increasing scope and reach of government non-market services as a share of the overall services sector. Government services are expanding disproportionately more quickly, and now account for over 25% of Australia’s economic activity (up from 10% 50 years ago) where measured productivity growth has been effectively zero over the past 20 years. Government services impact productivity in two discrete but related ways, in terms of whether spending is directed at services that will improve overall national productivity in and of itself, and whether the delivery of these services is productive. Productivity performance on both fronts is stagnant at best.

The slower release impact on productivity unravelling is a changing geopolitical context, a retreat from globalisation, and the reintroduction of trade barriers. A reduction in global trust and the resulting shift to domestic self-sufficiency, irrespective of global relative competitive advantage, will be an increasing drag on productivity; both at home and abroad.

Productivity growth leakage when consolidating individual productivity at the level of the firm

A third possible cause for the missing productivity is that improvements in productivity are happening at the individual level, but these improvements are being eroded at the collective level of the firm or business.

Productivity erosion at the level of the firm may be an outcome of reducing economies of scale. Technology advancement has enhanced market accessibility for firms which has led to an explosion of consumer choice, and subsequent fragmentation of the consumer market. These technology changes superimposed on services’ focused firms is leading to a proportionate reduction of mid-size firms in the market who are increasingly being consolidated into mega firms (prone to diseconomies of scale due to their mega size), and/or eroded by smaller emerging firms serving niche market segments (who tend to lack economies of scale).

Equally, productivity at the level of the firm may be an outcome of ineffective integration of technology, and physical and human capital, resulting in the productivity of the whole being less than the sum of its parts. This may be an outcome of bespoke technology advancements that are valuable but lack integration. Alternatively, it may be that reskilling of labour has lagged the investments in capital and technology that is dampening the release of productivity benefits.

Finally, benefits of the improved productivity may be captured by the consumer and/or employees and redirected to alternative non/less productivity pursuits. Increased competitive intensity may result in the benefits of the productivity release being captured by the consumer in terms of improved quality and personalisation of service delivery, rather than being captured in the productivity of the firm. Alternatively, productivity benefits may be captured by an employee who decides to reduce their labour input and redirect time released due to productivity gains to other leisure or less productive pursuits.

Productivity not improved at the individual level

A fourth plausible cause for the missing productivity is that, despite unprecedented advancements in technology and education, improvements in individual productivity has not occurred.

There are a range of reasons why individual productivity may not be improving that include factors such as; increased distractions (due to a broad range of social issues) and decreased clarity of focus in work output, excess and ineffective team interactions and meetings, breakdown in social and learning dynamics of work teams with increased working from home, increased mental health issues due to dealing with change, and a mismatch between human capabilities and the needs of a changing work environment.

Productivity growth should be sharing the podium of national debate

As with most systems, it is likely that poor translation of unprecedented technology and education advancement into productivity gains is the result of the interplay of all four causes outlined above. Given the far-reaching implications of poor productivity growth on living standards, it is surprising that productivity growth is not sharing the top podium of debate with other key issues such as the climate transition, indigenous recognition, diversity and inclusion, and regional security.

I look forward to you joining me for Part II of this productivity series, where I will focus on practical levers that can be pulled at the individual, firm, and national level to improve productivity growth.