CHAPTER

46
Growth Growth Accounting
INTRODUCTION
Growth accounting refers to the breaking down the rate of growth of total output of an economy into contributions from the growth of such inputs as capital and labour, and technological growth. Growth accounting also relates to the sources of growth. Modern growth theory groups the sources of economic growth into two parts : First, increase in factor inputs through changes in the quantity of factors and their composition, i.e. number of labour hours used in production and the size of the capital stock. Second, increase in total factor productivity due to technical progress, i.e. amount of output per unit of factor inputs, such as capital and labour. The total factor productivity (TFP) has been called the residual. The residual is the difference between the measured growth rate of inputs and that of output. Kendrick, Solow, Denison, and Jorgenson and Griliches are the leading economists who have measured the contribution of the residual to the overall growth rate of the US economy. We discuss below the sources of growth analysed by Solow, Denison and Jorgenson-Griliches.

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SOLOWS SOURCES OF GROWTH

In 1957, Solow1 estimated the contribution of technical change to the overall growth rate of the US economy. For this, he separates variations in output per head due to technical change from those due to changes in the availability of capital per head. Solow treats technical change as disembodied where capital is assumed as homogeneous and technical changes as exogenous. Disembodied technical change is capital augumenting in which existing capital is, by one means or another, made more productive. This productivity depends upon the amount of capital stock and not on its age. Solow uses the aggregate production function for such technical change as Q = F (K,L,t) ...(1) where, Q represents output, and K and L represent capital and labour inputs, and t represents technical change. Taking Hicks-neutral technical change as the basis, Solow postulates the production function in the special form as Q = A(t) F (K,L) ...(2) where, A(t) is an index of technical change which is called total factor productivity. Differentiate equation (2) totally with respect to time and divide by Q

& & F K L L Q A = +A . +A . K Q F Q Q A

...(3)

where dots indicate time derivatives. Under the assumption of constant returns to scale, the capital share and the labour share add to 1. If (t) is the capital share, the share of labour is 1- (t). By substituting these values in equation (3), we have Solows fundamental equation

& & & & L Q A K = + (t ) + [1 (t )] Q A K L

....(4)

& This equation tells that the growth rate of output ( Q / Q) is equal to the rate of technical change & ( A /A) plus a weighted average of the growth rate of capital ( /K) and the growth rate of labour ( /L). This residual factor from equation (4) can be written as ....(5)
& Thus the residual ( A /A) can be measured by subtracting from the rate of change of output that part of the growth rate which is accounted for by a weighted sum of the rates of change of capital and labour factor inputs. Relying on the United States time series where capital and output grew at approximately the same rate, Solow proceeds to focus on the rate of technical change. By using data on the share of capital and labour, and the rates of growth of capital per head and output per head, the contribution of the residual is obtained after calculating the contribution of capital. This residual
1. R.M. Solow, Technical Change and the Aggregate Production Function, R.E.&.S., August, 1957.

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is attributed to technical progress. Solow comes to the conclusion that during 1909-49 the average growth rate of output per head in the United States can be attributed 12.5 per cent to the increase in capital per worker and the residual 87.5 per cent to technical change. ITS CRITICISMS Solow has been criticised for his method of measuring the residual and for his estimates on the following grounds : 1 . His estimates undermine the role of investment in contrast to technical change in the growth process. According to Phelps, The results of this approach produced a wave of investment pessimism. 2. Economists were sceptical about such a large size of the residual. Abramovitz admitted it as a measure of our ignorance. While according to Rosenberg, it provided a wide response, on the part of economists wakened, as it were from their dogmatic slumber. 3. Griliches observed that the residual approach is not of much use in understanding the growth process because it is based on the concept of a production function which is not very useful if it is not a stable production function and if there are very large unexplained shifts in it. 4. Critics pointed out that Solow demoted the role of capital by assuming disembodied technical progress, whereas the most significant advances in technical progress require capital embodiment. Solow himself admitted it and presented an alternative model in 1959 on the assumption of embodied technical progress in new investment. 5. Solow further admitted that there are index number problems involved in the measurement of each of the variables in his measurement of the residual. 6. Solows approach is based on the unrealistic assumptions of perfect competition, constant returns to scale and complete homogeneity of the capital stock. 7. Solows approach ignored such components as improvement in the skill and quality of the labour force, return to investment in research and education, improvement in techniques within industries and changes in the industrial composition of input and output, etc. Conclusion. Denison, Jorgenson and Griliches and others have tried to quantify and break down the residual into further components. They contend that the residual is not a catch-all and that changes in output are due to changes in the quantities and qualities of inputs, in economies of scale and advances in knowledge rather than the result of technical change, assuming a stable production function.

DENISONS SOURCES OF GROWTH

Denison in a number of studies2 for the United States identifies a number of sources of growth and estimates the portion of the growth rate attributable to each. He divides the sources of growth into four main categories : (1) the contribution of two factor inputs, labour and capital, adjusted for quality changes but not dependent on technical change; (2) advances in knowledge which is a true measure of TFP (total factor productivity), obtained as a residual;
2. E.F. Denison, The Sources of Economic Growth in the U.S. and Alternatives Before U.S., 1962; Also Why Growth Rates Differ : Post-War Experience in Nine Western Countries, 1967.

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(3) improved resource allocation; and (4) economies of scale. In his study The Sources of Economic Growth in the U.S., Denison estimated the contribution of different resources with the help of Cobb-Douglas type production function. He kept all inputs together. He took two factor inputs, labour and capital. He derived an index of the stock of inputs on the basis of a particular base year, 1929. In order to construct this index, he took data of different inputs and multiplied them with their relative contribution to output which were estimated by the relative shares of income in the base period. In calculating the contribution of education to output, Denison treated workers of different educational categories as different inputs. Then the growth rates of the number of workers in different educational categories were aggregated into an index of the growth rate of total labour input according to their shares of total labour hours. In preparing the index of capital input, four types of capital inputs were taken : non-farm residential structures, other structures and equipment, inventories, and US international assets. Each was weighted by its own base year returns in estimating its contribution to growth. The index of the contribution of increase in output per unit of input comprised advances in knowledge, resource shift from agriculture to industry and economies of scale. Table 1 : Sources of Growth of Real National Income of the US: 1929-57 Source of Growth 1. 2. Real National Income Increase in Total Inputs (a) Labour Employment Hours (adjusted for quality change) Age-sex composition Education Others (b) Capital (c) Land Increase in Output per unit of Input (a) Advance in Knowledge (b) Resource Shift (c) Economies of Scale (d) Irregular Factors Percentage Points in Growth Rate 2.93 2.00 1.57 1.00 (-) .20 (-) .01 0.67 0.11 0.43 0.00 0.93 0.59 0.07 0.34 (-) 0.07 Percent of Growth Rate 100.0 68.3 53.6 34.1 (-) 6.8 (-) 0.3 22.9 3.75 14.7 0.00 31.7 20.1 2.4 11.6 (-) 2.4

3.

Table 1 reveals that the growth rate of real national income was 2.93 per cent per annum for the period 1929-57 in the US. The growth rate is calculated from the net national product at factor cost measured at base year prices. Of the 2.93 per cent growth rate, 2 percentage points are accounted for by increase in total inputs and 0.93 percentage points by increase in output per unit of input (or productivity). Of the 2.0 percentage points, 1.57 percentage points are accounted for by labour and 0.43 percentage points by capital. Labour Input. Increase in labour input by 1.57 percentage points or 54 per cent per annum was adjusted for quality changes which include increase in employment by 1 percentage point

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(or 34 per cent) and the effect of shorter hours on the quality of a man-years work as (-) 0.20 percentage point. The effect of hours worked is shown as a negative item because labour hours had decreased since 1929. The contribution of education to the annual growth rate was 0.67 percentage point (or 23 per cent), and 0.11 percentage point contribution of increased experience and better utilisation of women workers. Another item in labour input is changes in age-sex composition of labour force, shown as (-) 0.01 percentage point. Capital Input. The contribution of capital input to the US growth rate was 0.43 percentage point or 15 per cent. Denison takes four types of capital input which are non-farm residential structures and equipment with a contribution of 0.05 percentage point; other structures and equipment with 0.28 percentage point; inventories with 0.08 percentage point; and US international assets with 0.02 percentage point (not shown in the Table). Output Per Unit of Input. The contribution of increases in output per unit of total input to the US growth in national income was 0.93 percentage point or 32 per cent. This is the residual factor, according to Denison. He divides the increase in output per unit of input into three main components which include advance in knowledge, resource shifts from agriculture to industry, and economies of scale. Thus of the 0.93 percentage point (or 32 per cent) contribution of increase in productivity in the US for 1929-57, the contribution of advance in knowledge was 0.59 percentage point (or 20 per cent); of resource shifts from agriculture to industry was 0.7 percentage point; and of economies of scale 0.34 percentage point (or 12 per cent). Denison distinguishes between advance in knowledge and education. The former factor accounted for 20 per cent of the total growth in national income in the US for 1929-57 and the latter factor for 23 per cent. According to him, the contribution of education increases the quality of labour force while advance in knowledge is a technical change. Denison regards advance in knowledge as the true residual and education as guesstimated. So far as other factors like resource shifts from agriculture to industry and economies of scale are concerned, they tend to lower the size of the true residual. Despite Denisons distinction between advance in knowledge and education, if advance in knowledge is considered as part of the contribution of education in the broad sense, it can be said that the contribution of education to the US growth rate was 43 per cent for 1929-57. ITS CRITICISMS Denisons analysis of the sources of growth differs from that of Solows in many respects. Solow attributes the residual to technical change. But Denison breaks the residual into further components. He attributes increase in growth to improvement in the quality of labour force as a consequence of better and more education. He disaggregates labour and capital inputs and gives separate estimates of the effect of change in age-sex composition of the labour force and of various types of capital. However, Denison has ben criticised for the following weaknesses in his study: 1. Economists have questioned the effect of education on earnings which is the index of quality of labour. They find the adjustment factor of 40 per cent for ability, leaving 60 per cent of differences in income differentials due to differences in years of schooling as arbitrary. Denison himself admits that a good deal of guesstimating is involved when he calculates the contribution of education to growth on these assumptions. 2. Lundberg3 has criticised the use of the Cobb-Douglas production function by Denison for
3. E. Lundberg, in John Vaizey (cd.), The Residual Factor and Economic Growth,1964.

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calculating the contribution of factor inputs to growth rate of national income. According to him, the specific Cobb-Douglas production function attributes large share of labour income, 75 per cent, gives this factor its subordinate position and instead permits more room for the residual. He further points out that a static equilibrium concept like the production function is a doubtful tool for analysing the dynamics of growth. 3. Sen finds an internal inconsistency in Denisons simultaneous use of the assumptions of marginal productivity theory of distribution and persistent economies of large scale, when all economies are internal.4 4. Again, Denisons estimates are based on constant returns to scale which are available after making payments to all factors according to their marginal products. Consequently, the growth rate of real output either increases more than the growth rate of factor input or deceases. 5. Denison has been criticised for assuming disembodied technical progress. In fact, technical progress should be embodied in plant and equipment. According to J. Sandee, The believer in embodied progress usually finds atleast twice the yield deduced by the classical Cobb-Douglas cum disembodied trend analyst, because he considers the whole residual (and some of Denisons other effects) as the result of new investment.5 6. Denison does not take into account the joint effects of capital and technology. Rather, he treats them as separate elements and does not attribute technical progress to the extra capital. Conclusion. Despite these criticisms, Denison has performed an extremely useful task in quantifying the contribution of increase in physical inputs to growth.. .,and that his estimates can be accepted with some degree of confidence. His attempt to quantify the sources of increases in output per unit of input, however, falls short of complete success, and some of his conclusions must be considered of doubtful worth. . . .The residual factor in economic growth remains the coefficient of our ignorance.6

JORGENSON-GRILICHES SOURCES OF GROWTH

Jorgenson and Griliches7 in their study of the sources of economic growth in the US private domestic sector economy examined a hypothesis concerning the explanation of changes in total factor productivity (TFP). The hypothesis is that if quantities of output and input are measured accurately, growth in total output is largely explained by growth in total input. The rate of growth of TFP is the difference between the rate of growth of real product and the rate of growth of real factor input. Within the framework of social accounting, the hypothesis is that if real produce and real factor input are accurately accounted for, the observed growth in TFP is negligible. According to Jorgenson and Griliches, in their system of social accounting for real product and real factor input, there are many sources of error that frequently creep into the measurement of movements in TFP which bias the estimates upwards. They are (1) errors of aggregation; (2) errors of measurement in the prices of investment goods; (3) errors in relative utilisation of labour and capital stock; (4) errors in aggregation of capital services; and (5) errors in aggregation of labour services.
4. A.K. Sen (ed.), Growth Economics, 1970. 5. In John Vaizey (ed.). op. cit. 6. A.P. Thirlwall, Growth and Development, 3/e, 1983. 7. D.W. Jorgenson and Z. Griliches. The Explanation of Productivity Change, R.E.S., July, 1967.

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MEASUREMENT OF SOURCES OF GROWTH In order to prove their hypothesis, Jorgenson and Griliches first constructed the indices of total output and total input for the US for the period 1945-65 without correcting for errors of measurement. As an initial index of total output, they take the US domestic private product in constant prices. For an index of total input, they take the sum of labour and capital services in constant prices. Labour and capital services are assumed to be proportional to stocks of labour and capital respectively. The stock of labour is taken as the number of persons engaged in the private domestic sector of the US economy. The stock of capital is the sum of land, plant, equipment and inventories employed in this sector. The rate of growth of TFP is equal to the difference in rates of growth of total output and total input. They found that the average annual growth rate of total output over the period 1945-65 was 3.49 per cent; the average rate of growth of total input 1.83 per cent; and the average rate of growth of TFP as 1.60 per cent. Thus the growth rate of total input was 52.4 per cent of the growth in output and the remainder 47.6 per cent was explained by changes in TFP. ELIMINATION OF ERRORS After these initial estimates of growth rates of output, input and TFP, Jorgenson and Griliches eliminated the errors of aggregation and errors of measurement and reached the estimates shown in Table 2. Table 2 : Total Output, Input and Factor Productivity of U.S. 1945-65 Estimates Average Annual Growth Rates (Percentage) Output (2) 3.49 3.39 3.59 3.59 3.59 3.59 Input (3) 1.83 1.84 2.19 2.57 2.97 3.47 TFP (4) 1.60 1.49 1.41 0.96 0.58 0.10 Col. (3/2)% =(5) 52.4 54.3 61.0 71.6 82.7 96.7 Change in TFP(%) (6) 47.6 45.7 39.0 28.4 17.3 3.3

(1) 1. 2. 3. 4. 5. 6. Initial After correction for : Errors of Aggregation Errors in Investment Goods Prices Errors in Relative Utilisation Erros in Aggregation of Capital Services Errors in Aggregation of Labour Services

column (5) and (6) calculated from Table 9 of J&G. Errors of Aggregation. The average annual rate of growth of total output for 1945-65 after the elimination of errors of aggregation of consumption and investment goods output comes to 3.39 per cent. The average rate of growth of total input after elimination of labour and capital services is 1.84 per cent and of TFP is 1.49 per cent. With errors eliminated, total input explains 54.3 per cent of the growth in total output and the remainder 45.7 per cent is explained by changes in TFP. Errors in Investment Goods Prices. By eliminating the errors of measurement of investment goods

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prices for 1945-65, the average growth rate of total output is 3.59 per cent. The average rate of growth of total input is 2.19 per cent and of TFP is 1.41 per cent. Thus with errors in measurement of the prices of investment goods eliminated, the growth rate of total input to total output is 61 per cent, leaving 39 per cent due to TFP. Errors in Relative Utilisation of Labour and Capital Stock. By eliminating errors in the measurement of relative utilisation of labour and capital stock, the average annual growth rate of total output is 3.59 per cent. The average growth rate of total input is 2.57 per cent and of TFP is 0.96 per cent. Now the total input explains 71.6 per cent of the rate of growth in total output, leaving the remainder 28.4 per cent due to TFP. Errors in Aggregation of Capital Services. When errors in aggregation of capital goods are eliminated, the average annual growth rate of total output for 1945-65 is 3.59 per cent. The average growth rate of total input is 2.97 per cent, and of TFP is 0.58 per cent. With these errors eliminated, total input explains 82.7 per cent of the growth in total output, leaving 17.3 per cent due to TFP. Errors in Aggregation of Labour Services. By eliminating errors in aggregation of labour services, the average annual growth rate of total output for 1945-65 is again 3.59 per cent. The average growth rate of total input is 3.47 per cent and of TFP is 0.10 per cent. Conclusion. Thus after making corrections for aggregation errors and measurement errors, Jorgenson and Griliches find that 96.7 per cent of the rate of growth of the US output over the period 1945-65 is explained by the growth in input, leaving only 3.3 per cent due to change in TFP or residual. The latter is in marked contrast to 47.6 per cent before correction of data. ITS CRITICISMS Jorgenson and Griliches present more realistic estimates of the sources of growth of the US economy than given by Denison. They correct changes in TFP for errors in aggregation and in measurement of output, capital services and labour services, while Denison corrects only for errors in the measurement of labour services. By eliminating aggregation errors and measurement errors, Jorgenson and Griliches have shown that the residual or change in TFP is very small, 3.3 per cent, as compared with Denisons 20 per cent due to advance in knowledge. However, certain economists do not accept the Jorgenson-Griliches view when the latter attribute virtually the whole of measured growth to increases in factor inputs. In his review of the Jorgenson-Griliches study, Denison8 claims that their extremely low estimate of change in TFP is almost entirely due to the wholly unwarranted adjustment to the capital utilisation series. He further points out that very little of the difference between the results of Jorgenson and Griliches and traditional estimates of the TFP growth is accounted for by the removal of errors in the output series. Jorgenson and Griliches themselves point out that the most serious weakness of their study is in the use of long-term trends in the relative utilisation of capital and labour to adjust capital input and labour input to year-to-year variations. As a result of discrepancies between them, substantial errors of measurement have remained in the index of TFP.

8. E.F. Denison. Some Major Issues in Productivity Analysis, S.C.B., May, 1969.