Productivity is a concept often misunderstood by politicians

POLITICIANS often confuse the ratio of output to inputs with labour-force participation.

AT the beginning of the year, Kevin Rudd made a number of speeches about productivity, arguing that "we must take decisive action to drive productivity growth forward to improve living standards: to deliver better services, while keeping the budget on a sustainable footing, and to improve Australia's international competitiveness".

Productivity is a concept often misunderstood, particularly by politicians who often confuse it with labour-force participation.

Productivity is simply the ratio of output to inputs.

The best measure is multifactor productivity (the ratio of output to both capital and labour inputs) but because of difficulties in estimating the ratio in the non-market sector, it is common to quote figures for the market sector only.

So how has Australia been going on the productivity front? In a word, abysmally.

Between 2003-04 and 2007-08, market-sector multifactor productivity fell by an average of 0.2 per cent per year.Since then, the decline has been even greater, at 2.7 per cent.

More generally, the performance in the first decade of this century has compared very unfavourably with the performance in the 1990s, when annual average multifactor productivity grew about 2 per cent per year.

So what explains the superior performance of the past decade? And what explains the recent poor performance?

It is now generally agreed the combined impact of freeing up product, capital and labour markets (principally the result of explicit government policy changes) created both commercial pressures on, and the capability for, managers to improve productivity of their operations.

As well, the effect of the policy changes was to redirect resources in the economy to their best uses, hence improving the macro-level outcomes on productivity.

Fortuitously, the widespread take-up of the new information and communication technologies (including falling costs of these technologies) added momentum to the growth in productivity.

What accounts for this decade's dismal performance? It is important to look beyond the macro figures, in particular the performances of three sectors: mining, agriculture and electricity, gas and water, which have been pulling down the figures.

In the case of mining, the surge in capital expenditure has meant higher inputs without commensurate outputs as projects take time to complete.

But when these projects come on stream, productivity in mining should pick up.

High commodity prices have led to poorer quality ore bodies being exploited which, in turn, has dragged down productivity in the mining sector.

Agriculture was badly hit by drought through much of the decade and lack of water has adversely affected electricity, gas and water.

Construction of large projects in this sector (desalination plants for example) has also dragged down productivity in this sector.

By excluding these sectors, the overall movements in productivity do not look as bad, although productivity growth is still negative on the 2008-09 figure.

In a recovering economy, it is reasonable to expect a pick-up in multifactor-productivity growth in coming years, but whether there will be a return to the higher trend rates of growth in the 1990s, is a moot point.

The lack of any real reform zeal on the part of federal and state governments for the past decade or so has meant the conditions that underpinned the higher-than-trend growth rates of the 1990s are now largely absent.

When considering determinants of productivity growth, it is important to distinguish between underlying and immediate influences.

A fair portion of the human capital story (improving literacy and numeracy, for example) will raise productivity, but only down the track. Similarly, well-conceived infrastructure spending should lead to higher productivity, but with a lag. Moreover, these are areas that require large up-front expenditure.

On the other hand, other government policies can negatively influence productivity: throwing money at the car industry and the associated costly distortion in resource allocation, for instance.

The immediate determinants of productivity growth are bound up with the commercial and competitive pressures experienced by key economic factors and the decisions that are made in relation to capital spending, adopting new technologies, rationalising operations, workplace practices and the like.

A final point to note is the very significant gains that could be made through higher productivity in the large sectors of education and health, both with their private and public components.

Accounting for less than one-fifth of the economy, major improvements to the productivity of the delivery of services in health and education would feed through to higher per capita incomes.

Productivity is a means not an end: is the major source of improvements to living standards.

But there are no magic bullets that, in the short term, can deliver sustainable gains.

Government policy can just as easily detract from the productivity challenge as it can help.

Professor Judith Sloan is Honorary Professorial Fellow at the Melbourne Institute of Applied Economic and Social Research at the University of Melbourne