Understanding productivity

This blog is the third in our series on the key concepts to consider when thinking about local economic growth policies. We’re using the series to test-drive a way of explaining concepts in economic growth that we hope to use in new training and resources. We are keen to hear from readers, particularly those in local and central government, about whether they find these useful and accessible, and if there are other topics you would like to see us cover.

What is productivity?

Productivity measures how efficiently inputs are converted into outputs. For example, when buying a car, an important consideration for most consumers is the productivity of the engine measured, for example, by ‘miles per gallon’ the ratio between output (miles) and input (gallons of fuel).

When measuring economic productivity, the outputs are the goods and services produced (normally measured using GVA, discussed in the previous blog and the inputs are the ‘factors of production’ – the human capital (labour and skills), physical capital, such as building and machines, and intangible capital, such as design, branding, research and development (R&D), and software used to produce these goods and services. Organisation and technologies matter too. As high-value tradeable service sectors have become more important to the UK economy, skills and intangibles have become more significant drivers of productivity.

Why do we need to think about productivity?

Productivity is important to local economies for two reasons. Firstly, productivity underpins incomes and, by extension, living standards. For most people an important source of income comes from work. The relationship between productivity and earned income is complex – because money from selling outputs has to be shared across all inputs. But all else equal, if every hour a worker can produce goods or services worth £100, their employer can pay them more than if what they produce per hour is worth £20. However, if the person producing higher output per hour is using more technology or machinery or is producing a good that required extensive R&D to develop, then money must go to those inputs leaving less money for wages.

At the national level, many of these other inputs will be owned by residents and so national income and productivity move quite closely together. At the local level, that’s not always the case. For example, Sunderland has high productivity, in a large part due to the presence of Nissan and its supply chain, but incomes are relatively low because a lot of the money made from selling cars goes to Nissan and its suppliers for product development, investment in machinery, etc.

Secondly, productivity is key for growth and long-term prosperity. This is because higher productivity means more output is produced for a given set of inputs and because higher productivity encourages people to invest in skills, helps firms win business, and supports investment in capital and innovation. These feedback loops help explain why some areas grow while others do not.

In a market economy, competition between firms is an important way in which inputs get put to more productive use. If there are two firms producing the same good, but one can produce it with less inputs (for example, it takes two hours of staff time to produce rather than three), then this firm will be able to make more profit, while charging less for the good than the other firm, and consumers will switch to the lower cost supplier. Ultimately this can lead to the less productive firm going out of business or having to downsize, with the loss of jobs. At an economy level, having productive firms helps ensure existing jobs are sustained and new jobs are created.

How can we improve productivity?

Anything that increases the amount of capital per worker (human, physical or intangible capital) will increase output per worker. Organisational change and innovation can improve the efficiency with which all inputs are used and increase overall productivity (of all inputs). Examples include:

• Upskilling workers
• Increasing the amount of machinery or technology available to each worker
• Purchasing new, more efficient machinery or technology
• Improving the motivation of managers and workers
• Improving how work is organised
• Developing new higher-value goods and services that can be produced using existing inputs.

Many local economic growth policies aim to increase productivity. For example, apprenticeship programmes develop the skills of workforce (human capital), grants and loans help businesses to purchase new machinery (physical capital) or undertake R&D (intangible capital), and business advice improves firm leadership and management. Interventions do not need to be targeted at businesses to improve productivity. For example, area-based policies such as the roll-out of broadband or investment in new further education college facilities can also help improve productivity. Whilst the focus is often on government investment, it is as important to create conditions that encourage business investment.

What to consider when thinking about productivity?

Different measures of productivity are available – so it’s important to understand the measure being used. The most commonly used measures relate to labour productivity – i.e. the amount of output produced per worker or per hour worked. These measures are easy to understand and calculate as data is generally available on the number of workers or hours worked, but they only provide a partial picture as other inputs are not included in calculations. In the public sector, where it can be hard to value outputs, productivity is often measured by the wage paid to the public sector worker.

Total factor productivity is an overall measure of efficiency – the part of productivity that cannot be explained by human, physical and intangible capital inputs – with differences in total factor productivity arising because firms use different technologies or organisational practices, or because of different cultures.

For reasons discussed above, it’s important to distinguish between local productivity and local incomes. There can also be trade-offs between employment and productivity. For example, improving productivity through investment in new machinery or technology (such as AI or robotics) could lead to firms cutting jobs. Over the longer term, the evidence shows that innovation leads to higher employment, productivity, incomes and living standards but firms and local economies can lose out in the short term and managing these transitions can be challenging. Increasing employment can sometimes lead to lower productivity, if those joining workforce have lower skills than current workers.

As some sectors have higher productivity levels than others, the industrial composition of the local economy matters. For example, financial services is a high productivity sector, allowing workers to be paid high wages, and this has a positive impact on the London and Edinburgh economies which have concentrations of these jobs.

Whilst some sectors have higher productivity levels than others, it is also important to understand the role that a place plays in the ‘value-added’ chain. For example, for a manufacturing business (such as Nissan), R&D, engineering, design and head office functions have the highest productivity and, as a result, pay the highest wages, whilst a site that assembles products will have lower productivity and lower wages. The impact of attracting the employer will therefore depend on the functions located in the local area.

How can I learn more?

• The Productivity Institute produces research and insights on productivity in the UK.
• The ONS publishes data on productivity across a range of measures and geographies.
• The Economy 2030 Inquiry report Bridging the Gap considers how to narrow the UK’s productivity gap.

Up next

The next blog in our understanding key concepts in local economic growth series will be on spatial disparities. Sign up to our newsletter to get an update on our next blogs, briefings and events.