Total Factor Productivity

The total factor productivity (TFP) is a number that showcases the productivity of a business by determining how much it produces versus what it needs to spend to achieve that result. In simpler terms, it is calculated by dividing your total production (output) by average costs (inputs).

The total factor productivity is used to identify the performance level of a business and its efficiency. It tries to reach a definite value of how well the inputs have been transferred to the output. The TFP is also known as Solow residual, named after the American economist Robert Solow.

• Total factor productivity is the degree of operational efficiency of a business. We need to divide the total products by the number of weighted average inputs to discover our TFP.
• Several factors can impact the TFP. The better the technology, management, and human resources are, the better the result will be.
• It's important to determine how well a business is using its resources. If a business scales its production but not in a productive way, the final product becomes less profitable.

Total factor productivity is usually measured as the ratio of total production to the weighted average of inputs. However, unless one has the specific numbers for their weighted average inputs, they need to use a fairly more complex total factor productivity formula known as the Cobb-Douglas function. This equation was created back in 1927 by two economists named Paul Douglas and Charles Cobb. 

The Cobb-Douglas equation is given by:

Y = A x Kα x Lβ

This is what each letter represents in the equation:

• Y: Total product
• A: Total factor productivity (TFP)
• K: Available capital.
• α: Elasticity of the capital.
• L: Labor (human resources).
• β: Elasticity of human resources.

In essence, both formulas represent the same thing but are interchangeable and described differently.

The formula can seem pretty complicated at first. Therefore we'll use an example to show how to use it for total factor productivity calculation. 

Let's consider a chain of supermarkets in the United States for our example. The total growth of the company during last year was 6%. At the same time, the capital growth was 2% (with an elasticity of 0.7%), and the growth of labor was 5% (with an elasticity of 0.45%).

By using the Cobb-Douglas function, we get the following numbers:

6% = A x (2x0.7) x (5x0.45) 

Therefore, 

A = 1.4% x 2.25% ÷ 6%

   =0,525%

The company’s TFP is hence, 0,525%.

Several factors can directly affect the TFP. Obviously, economic factors have a huge role to play in it. But, the country of business, the level of expertise and education of its employees, and even other market trends can also make a big impact.

Let's take a look at some of these.

#1 - Market and the Economy

The economy may affect the TFP indirectly in several ways. However, it will probably affect profitability more than productivity. Despite this, a recession may push prices down because of diminishing demand, which will affect production.

For example, if there's a shortage of any material needed for a business or if we need to buy less because the prices are too high, there will be a loss of productivity.

While there's not much a person can do to fix the market by themselves, they can increase productivity by playing smart with what they've got. For example, diversifying production or offering new solutions are ways to keep up productivity if any of the services a business offers gets hit during an economic recession.

#2 - Technology and Innovation

Technology is perhaps one of the factors that severely impacted total factor productivity in the last two hundred years. Before the Industrial Revolution, it was impossible to scale and automize business as efficiently as anyone can do today.

When a business has access to the best technology in the market, it can increase the TFP by optimizing all aspects of production.

The location of a business may also affect its access to technology. There's a huge technology gap between underdeveloped and developed countries. It plays in favor of countries that developed strong technologies and can use them to get an edge in the market.

#3 - Cultural and Social Factors

Cultural and social factors such as the country someone is in also affect the TFP.

If it is a country with a poor education system, a business is likely to get access to workers who don't have the same know-how as countries in which the education system works well.

Restrictive laws and regulations may also impact how productive a business is .i.e If it needs to follow them, the business needs to spend more resources then.

The main reason to calculate TFP is to understand how cost-effective a business is. It is common sense that when input increases, the output will also increase. While this will naturally happen, there are different levels of how effective the process is.

If the output increases slower than the input, the business may be diminishing profits per investment with the reforms in the business structure. Of course, it will still be getting more money unless it makes a mistake and actually starts to lose it, but the business will be losing the chance to make much more with proper planning.

According to Robert Solow, a prominent economist from the 20th century, only ⅛ of the increase in productivity in the United States during the first half of the century was because companies invested in more capital. Instead, he believes that most of the production growth happened because the employees were more qualified than before.

As a company is looking for profits, it will certainly want to find a model that will bring it more output with less input. For example, investing in technology and education for a workforce can increase the TFP over time and diminish costs. However, only scaling the process without considering its cost-efficiency may not.

This has been a Guide to Total Factor Productivity and its meaning. Here we explain TFP formula, calculation, what affects TFP and why it's important. You may also have a look at the following articles to learn more –

• Labor Productivity
• New Economy
• Knowledge Economy