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Putting Productivity First - TPRP 08/01

Evidence points to five areas that drive productivity

Productivity theory and evidence, policy analysis, and the New Zealand context suggest that a number of factors are critical for improving New Zealand’s productivity growth.

A stable base to encourage investment is fundamental…

The basis for robust productivity growth rests on a stable and certain macroeconomic platform and on the quality of New Zealand institutions. A stable macroeconomic environment, underpinned by well-designed fiscal and monetary policies, provides the base required for economic agents to make decisions, to invest, innovate and undertake new ventures, with the certainty that their returns will not be undermined by a weaker future economy.

Quality institutions, such as the structure of property rights and the existence of well-functioning markets, are a prerequisite. The quality of institutions is a central explanation of the differences in income and growth rates among countries. Institutions provide a basis for many of the drivers of productivity. For example, secure property rights are a prerequisite for investment in capital and innovation.

…underpinned with microeconomic policies to provide flexibility and support

Macroeconomic stability and sound institutional arrangements provide the core on which individuals and firms can plan and invest. Effective microeconomic policies are also necessary to create a business environment that rewards enterprise and innovation and provides the resources and flexibility for firms to identify economic opportunities and to move to take advantage of them.

While many factors impact on productivity, evidence suggests that skills, innovation and investment are particularly important in determining productivity performance. In addition, given New Zealand’s reliance on the primary sector, the sustainable management of natural resources is important in meeting both economic and environmental objectives. These factors do not impact on productivity in isolation, but are interrelated; advances in one area will alter the returns and incentives for activity under the other drivers of productivity. Ultimately, it is the entrepreneur who combines these factors of production, new ideas, skills and capital, in order to drive productivity growth.

Skills play a fundamental role in raising labour productivity

Human capital accumulation is important for productivity in its own right, and also has a key role in innovation and technological progress. Evidence is becoming increasing clear that a large proportion of the differences in GDP per capita growth between countries can be explained by differences in human capital achievement. Education and training have been emphasised as central to the accumulation of knowledge and ideas; higher skills foster greater levels of innovation and entrepreneurship and increase the ability of the economy to absorb, implement and adapt ideas generated by others. The appropriate skill mix in part depends on a sector’s distance from the technology frontier, with a decision on whether to create innovation or to absorb and adapt knowledge from abroad. Skill formation is a cumulative process over the life course. The greatest returns come from improving the quality of education in the early years but this needs to be maintained by ongoing quality in later years.

Technological progress relies on investment in innovation, capital and skills

Advances in knowledge, new products and processes and organisational technologies are central to long-run growth; this progress occurs through innovation and decisions made at the firm level about how capital and labour are combined to make output through the entrepreneurial process. Technological progress is, in part, determined by the level of investment in innovation, capital and skills. Innovation and knowledge spillovers, whereby the discovery or demonstration of a technology is adopted by a wider set of firms, are increasingly considered to be highly important for productivity growth. The rate of return to society from R&D activities is typically in the order of 90 to 100 per cent, well above the private return of 20 to 30 per cent.[6]

The business environment should support enterprise and innovation

Firm turnover drives productivity growth. New firms seek out and develop new profitable ventures: well-performing firms grow and increase their market share and poorer-performing firms exit the market, and their resources are reallocated to more productive uses. The OECD suggests that this turnover results in up to 50 per cent of a country’s labour productivity growth.[7] Creative destruction requires a business environment that supports enterprise and innovation. Entrepreneurs drive this creative destruction because of their role in demanding factor inputs, determining the balance between factors, and driving the efficiency with which they are combined.

Regulatory frameworks encourage sustainable use of natural resources

Regulatory and economic frameworks that encourage sustainable investment over time, and quick responses to emerging resource constraints and new opportunities to invest in natural resources are critical for productivity. As environmental considerations may constrain growth in some sectors, it will become increasingly important that the frameworks for managing environmental constraints are consistent with resources being applied in their most productive use. An increased scarcity of natural resources combined with rising concern for the natural environment also indicates that good management of natural resources will be critical for future economic success. However, it is important to note that sustainable natural resource management need not be at the cost of economic growth. Growing environmental pressures can be managed in such a way as to achieve both environmental and economic goals.

Five drivers of productivity

From this consideration of the process of economic growth, five broad drivers of productivity emerge. These drivers provide a useful way to assess and develop policies to improve the productivity performance of New Zealand. In summary, they are:

  • Enterprise – Entrepreneurs identify and realise new market opportunities, create investment opportunities and drive innovation.
  • Innovation - Innovators generate, adopt and adapt new ideas and create investment and entrepreneurial opportunities.
  • Skills – Skills enhance labour’s contribution to growth, improve the economy’s ability to innovate and adopt new ideas and increase investment opportunities.
  • Investment - Investment improves and enlarges the capital stock, is an input in the entrepreneurial process and increases the returns to skill acquisition.
  • Natural Resources - Sustainable resource management increases the opportunities and mitigates the risks associated with the increasing cost and declining availability of natural resources and with consumers’ growing demand for environmentally sustainable products.

The remainder of the paper focuses first on the importance of international connections across all of these drivers and on a deeper discussion of each driver in turn.

Notes

  • [6]Blakeley, Nic, Geoff Lewis and Duncan Mills “The Economics of Knowledge: What makes Ideas Special for Economic Growth” New Zealand Treasury Policy Perspectives Paper 05/05.
  • [7]Ahn, Sangoon, “Firm Dynamics and Productivity Growth: A Review of Micro Evidence from OECD Countries”, OECD Economics Department Working Papers No. 297.
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