Energy and Productivity - Part 1: What is productivity and why should we care?

The word ‘productivity’ gets thrown around quite a bit by policymakers and economists, but is it really that important to our everyday lives? The media certainly seems to believe so. A simple search on productivity and we are hit with the latest updates on productivity trends and theories for such trends. Why though?

Simply put, productivity growth can be generalised to represent the growth in our standards of living. Higher productivity means that things can be produced at a cheaper rate. If these savings are then passed on to consumers - which would naturally occur with high levels of competition – then consumers’ effective income increases. This is then spent elsewhere, resulting in gains for the entire economy (Statistics Canada, 2011).

William Nordhaus for example, found that in the 1800s a day’s wages could purchase 5 hours of light, compared to the average person’s wages today earning enough to pay for around 20,000 hours of light. This productivity growth puts the numbers on why today we can live better lives than kings of old, it is therefore worth striving to understand what productivity really is.

Productivity and pancakes

Fundamentally, productivity is a measure of efficiency. At the national level, it indicates how efficiently inputs – such as labour or raw materials – are being utilised to produce outputs – what we consume. This is different from raw output growth as productivity accounts for large increases in inputs that may drive growth in output.

Think of it like this: we decide to make pancakes. On one day we make twelve pancakes, on the following day we make twenty-four. This would represent a doubling in output but if we were merely working twice as long with twice as many ingredients, no productivity growth occurs. Just because we now have more pancakes doesn’t necessarily mean we are better off, especially if we don’t even have time to eat them!

Productivity growth, boiled down to its core components, is essentially growth in outputs minus the growth in inputs plus the growth in efficiency of those inputs. Economists simplify inputs down to labour (people) and capital (stuff).

Using the example of pancakes again, one could change the amount of ingredients they are using – as explored above – or the amount of labour they put in, creating input growth. On the other hand, one could also attempt to make the process more efficient – make more pancakes with same amount of inputs. This gain in efficiency could be because you have made pancakes so many times in your life that you have come up with your own practiced method or it could be because you bought an electric whisker instead of mixing the ingredients by hand.

These residual factors economists lump into a third term coined total factor productivity. These efficiency gains capture factors outside of your control that influence productivity, which could be as simple as living in an area which has rule of law or certain technological developments. It could also be that you are benefiting from economies of scale - this is where it is faster for you to make pancakes for the whole family instead of everyone taking turns to make their own.

Productivity and other measures

There is a difference between changes in the inputs versus changes in the underlying efficiency. In certain instances, shedding labour (and also the total number of hours worked), can create surges in measured productivity. Arguably, however, these increases can be seen as mostly superficial, particularly if the gains are temporary. We shall therefore not only look at trends in productivity but also what is driving those trends.

Productivity, by definition, is a key driver of GDP growth and vice versa. The relationship of the two, however, is not  straightforward. On the time scale of decades, a clear correlation between the dips in output growth and productivity growth is evident. However, merely moving the timeframe into a half-decade perspective, this correlation begins to break down as the troughs in GDP no longer line up with lowest points in productivity growth (Steindel & Stiroh, 2001). This phenomenon is illustrated by Figures 1 & 2, where zooming in Figure 2 highlights the time disconnect. Despite this, the intuitive link between output growth and productivity is a key starting point for understanding why productivity matters.

 Figure 1: Thomas & Dimsdale, (2017).

Figure 1: Thomas & Dimsdale, (2017).

 Figure 2: Thomas & Dimsdale, (2017).

Figure 2: Thomas & Dimsdale, (2017).

The relationship between income and productivity on the other hand is often simplified by economists, and assumed to be equal (Steindel & Stiroh, 2001). This simplification, however, is founded on a few strong assumptions. Generally, when looking at the data, the two tend to follow each other in the long term. However, short-term correlations are generally fairly weak, due to the inflexibility of wages and the pervasiveness of unemployment. This is illustrated in Figure 3, where nominal wage follows productivity growth fairly closely until the financial crises whereupon the relationship begins to break down. 

 Figure 3: Nominal Wage: ONS; ‘EARN01’, 2018. Productivity: TED, 2017.

Figure 3: Nominal Wage: ONS; ‘EARN01’, 2018. Productivity: TED, 2017.

Productivity is also strongly linked with other basic measures of welfare, such as mortality rates and life expectancy - these relationships are demonstrated in Figures 4 and 5. The strongest of these correlations, however, tends to stem from developing countries where the marginal rate of return on supplying an extra unit of electricity tends to be quite high.   

 Figure 4 & 5: Tenreyro, 2018.

Figure 4 & 5: Tenreyro, 2018.

Overall, productivity is a statistic that we should all pay attention to. It is certainly not the be all and end all, but it provides an interesting insight in how our lives are improving over time. Faraday Grid’s purpose is to deliver sustainable prosperity for everyone, a process in which it is important to see measurable improvements in measures of productivity for the UK and globally.

Productivity and energy

The following blog posts in this series will explore the relationship between productivity and energy – primarily, energy and its respective fuel sources. Why focus on this topic? Well, productivity growth across the globe has stagnated since the financial crisis in 2007. Germany has managed to return to pre-crisis growth rates, however, other countries have not fared as well – illustrated in Figure 6. The UK has fared especially poorly considering their strong pre-crisis growth rates, which is highlighted in Figure 7.

 Figure 6: Total Economy Database [TED], 2018.

Figure 6: Total Economy Database [TED], 2018.

 Figure 7: TED, 2018.

Figure 7: TED, 2018.

There have been a multitude of suggested explanations for this slowdown, ranging from labour hoarding, capital substitution explanations, financial sector slowdowns, inaccurate measurement to innovation/technological developments declining in effectiveness. The majority of such explanations, however, tend to fall short of explaining this stagnation, which has become known as the UK’s productivity puzzle.

At the same time electricity prices for the UK have risen 63% – in real terms – between 2004 and 2014, which is shown in Figure 8. When you consider that just about all businesses utilise electricity in some shape or form in their day to day activities, these price increases can drive up the cost of production without an associated increase in output, hence this provides a potential explanation for the stagnation in productivity. Despite this simple correlation very little of the discussion surrounding the UK’s productivity puzzle explores or even mentions this potential link.

 Figure 8: Ovo Energy, 2015.

Figure 8: Ovo Energy, 2015.

The link between energy and productivity is not a new topic, as early as 1960 Schurr noted the relationship between the falling use of energy in production process (energy intensity) and rising labour and total factor productivity (TFP) (Schurr & Netschert, 1960), however, little research has been added since. Energy’s relationship with output, however, has been explored further, particularly in reference to the links between oil price shocks and financial recessions.     

It is my aim over the next entries to explore the literature on this relationship and to add some thoughts to this ever-growing discussion.

Bibliography

House of Representatives Standing Committee on Economics, (2010). Productivity growth and its importance. In: Inquiry into raising the productivity growth rate in the Australian economy. Australia: The Parliament of the Commonwealth of Australia. p9-29.

Schurr, C. & Netschert, B. (1960). Energy in the American Economy, 1850 – 1975. Johns Hopkins, Baltimore.

Statistics Canada, 2011. “Why is productivity growth important?” [website] URL: https://www150.statcan.gc.ca/n1/pub/15-206-x/2008017/s4-eng.htm

Last accessed on the 23rd October, 2018.

Steindel, C. & Stiroh, K. J. (2001). Productivity: What Is It, and Why Do We Care About It? Federal Reserve Bank of New York.

Figures

Figure 1 & 2: Total Economy Database [TED]. (2017). Output, Labor, and Labor Productivity 1950-2017. available at; https://www.conference-board.org/data/economydatabase/index.cfm?id=27762

Last accessed on the 23rd October, 2018.

 

Figure 3: Ovo Energy. “What’s the average gas bill and average electricity bill in the UK?”

[website] URL: https://www.ovoenergy.com/guides/energy-guides/the-average-gas-bill-average-electricity-bill-compared.html

Last accessed on the 23rd October, 2018.

 

Figure 4 & 5: Thomas, R. & Dimsdale, N. (2017), "A Millennium of UK Data," Bank of England OBRA dataset, available at http://www.bankofengland.co.uk/research/Pages/onebank/threecenturies.asp

Last accessed on the 24th October, 2018

 

Figure 6: ONS. Dataset; ‘EARN01 (2018)’, Available at; https://www.ons.gov.uk/employmentandlabourmarket/peopleinwork/earningsandworkinghours/datasets/averageweeklyearningsearn01

Last accessed on the 24th October, 2018.

Figure also includes productivity data from TED as sourced in Figure 1 &2.

 

Figures 7 & 8: Tenreyro, S. (2018). The fall in productivity growth: causes and implications. Speech given at

Queen Mary University of London, London, available at;

https://www.bankofengland.co.uk/speech/2018/silvana-tenreyro-2018-peston-lecture

Last accessed on the 23rd October, 2018.