Total Factor Productivity
Total factor productivity (TFP) is a measure of the efficiency with which an economy or firm converts inputs—such as labour and capital—into output. It captures the portion of output growth that is not explained by increases in the quantities of inputs, and is often interpreted as a measure of technological progress and efficiency.[1]
Definition
TFP is calculated as the ratio of output to a weighted combination of inputs. In the standard framework, output growth is decomposed into the contributions of labour, capital, and a residual known as TFP:
- Output growth = α × Capital growth + (1 − α) × Labour growth + TFP growth
where α is capital's share of income. Because TFP captures what is left over after accounting for inputs, it is sometimes called the Solow residual.[1]
Sources
| Source | Description |
|---|---|
| Technological progress | Improvements in production techniques and technology. |
| Efficiency gains | Better use of existing resources. |
| Institutional quality | Improved governance and organisation. |
| Human capital | Better-educated and skilled workers. |
Importance
TFP is widely regarded as the most important source of long-run economic growth, because the accumulation of capital and labour is subject to diminishing returns, whereas improvements in productivity can continue indefinitely. Differences in TFP are a major explanation for differences in income per capita across countries. Its measurement is difficult, however, and the residual may capture not only technology but also measurement error and unobserved factors.[1]