Why Productivity Matters

Speech

Notes

Why Productivity Matters Michael Plumb [ * ] Head of Economic Analysis Department Australian Business Economists Annual Forecasting Conference Sydney – 27 February 2025 Audio 29.6MB Q&A Transcript Watch video: Why Productivity matters Introduction Thank you for the opportunity to speak here today at the Australian Business Economists’ Annual
Forecasting Conference. There has been lots of discussion about productivity in recent years. In some
economies this discussion has been about subdued growth in overall productivity, including in Australia
since just before the pandemic. There has also been discussion about the outlook for productivity. For
example, the extent to which artificial intelligence, quantum computing and other technologies will
support future productivity growth. These are important issues that I expect will come up in discussions
today. In my remarks I’m going to focus on a different question: why does productivity matter? At the
central bank we’re not experts in how to improve productivity. But trends in productivity are very
important for the macroeconomy. In the context of the Australian economy, I will discuss how stronger
productivity growth can support growth in aggregate supply, incomes and aggregate demand. I will then
spend some time discussing recent productivity outcomes in Australia and how we’ve been thinking
about those in our assessment of economic conditions. But first, what is productivity? When we talk about productivity, we’re talking about how much output
we get relative to what we put in. At an individual level, I increase my own productivity by making a
shopping list before I buy groceries, so I don’t forget anything and avoid multiple trips to the
supermarket. At the firm level, productivity might be improved by implementing customer relationship
management software to streamline communication with clients and automate routine tasks. At the
economy-wide level – which is what matters for the central bank and our dual mandate of full
employment and low and stable inflation – productivity reflects a multitude of decisions like
these. Ultimately it’s about how efficiently capital and labour are employed across the economy to
produce goods and services. How do we measure productivity? Economists typically focus on two measures: labour productivity, which
measures how much output is produced for every hour worked; and multifactor productivity (MFP), which
reflects how efficiently all inputs to production – such as labour, capital, energy and raw
materials – are combined to produce output. In a simple production function framework where a firm produces output using two inputs – labour and
capital – labour productivity depends on two things. The first is how much capital each person has
to work with. Providing workers with more or better capital – like machines or faster computers
– can increase the amount of output each worker produces. This is referred to as ‘capital
deepening’. The second is MFP. Improving MFP involves finding new ways to combine labour and capital
to produce more output. For example, by reorganising a production line or using GPS technology to
precisely guide machinery for planting, fertilising and harvesting. In this respect, labour productivity
is not just about labour efficiency; it depends on firms’ decisions about how much capital to employ
and how efficiently labour and capital work together to produce output. In thinking about the relationship between productivity and aggregate supply, incomes and demand, I will
focus mainly on labour productivity. This is because labour productivity most closely aligns with
measures of economic living standards. It’s also easier to measure than MFP. As you might sense, productivity is not about working harder, but working smarter. Many of the biggest
productivity improvements have come from things that have made our lives easier, like computers, robots,
the internet and smartphones – though personally I’m still questioning whether smartphones are
productivity enhancing or a productivity sapping distraction. Economists talk about productivity a lot. So I’ll now turn to the question of why productivity
matters. Productivity and supply If productivity increases, the economy can produce more goods and services from all the available economic
inputs. As such, productivity is a key driver of growth in the supply capacity of the economy, or
potential output. Productivity in Australia has been volatile in recent years but, looking through the volatility, is around
the same level as in the few years before the pandemic. Productivity growth has also been consistently
below the RBA’s projections for some time now (Graph 1). This has generated internal
discussions about what trend labour productivity growth might look like in the period ahead, and what
that means for estimates of potential output growth over the forecast period. The current assumption is
that annual labour productivity growth will pick up to around one per cent in the medium term, which
is close to its longer run average. This could be consistent with, for example, the rapid adoption of
technology across many industries leading to higher productivity outcomes. However, the projected pick-up
in productivity growth has not materialised in recent years and staff are currently assessing whether
weak productivity outcomes are likely to persist. Graph 1 Weak productivity growth in recent years has contributed to slower growth in the supply capacity, or
potential output, of the economy than otherwise. Graph 2 shows one of our estimates of potential
output, which is based on actual productivity outcomes observed in the data. The graph also shows a
counterfactual path where productivity growth in recent years was higher, at its average rate in the two
decades prior to the pandemic. This suggests that the size of the economy is a lot smaller than it would
have been, had productivity growth been more like in the past (all else equal). It’s important to keep in mind that, in this counterfactual world where supply capacity was much
higher, incomes and demand would also have been higher too. Let me turn to that now. Graph 2 Productivity, incomes and wages While productivity growth contributes to growth in the supply capacity of the economy, it also contributes
to growth in incomes and demand. At times, labour productivity (output per hour worked) and real income per hour track one another closely
(Graph 3). Looking through the volatility, both are currently around similar levels as in the period
prior to the pandemic. Graph 3 Other factors besides productivity can affect growth in incomes per hour. For example, higher prices for
Australian exports can generate higher incomes domestically. So the terms of trade – the prices we
receive for our exports relative to the prices we pay for our imports – can also be an important
driver of incomes in the domestic economy. We can see this in the decade from the early 2000s: despite
the slowing in productivity growth, real incomes per hour continued to increase, partly owing to
substantial increases in the prices received for Australian exports like iron ore and coal. The surge in
demand for our exports, particularly from China, supported profits in the mining industry and related
parts of the Australian economy, as well as demand for labour and wages growth. Over the longer run, labour productivity and real wages – as measured by average earnings from the
national accounts – also tend to move together (Graph 4). ¹ Over the inflation targeting
period, labour productivity has grown at an average annual rate of 1.1 per cent and real labour
earnings have grown at 0.9 per cent. ² So, higher productivity not only benefits firms, it
also benefits workers by increasing their purchasing power. The Productivity Commission has previously
pointed to the productivity of bakers as a reason we can consume more bread or spend that extra money
elsewhere – in 1901 it took 18 minutes of the average worker’s time to afford a loaf of
bread, while today it’s just 4 minutes. ³ There must be a joke in there somewhere about how we
spend our dough. In the short run, however, growth in real wages and labour productivity can and do diverge as the economy
adjusts to economic shocks. For example, and as noted previously, increases in the prices received for
Australian exports can have an impact on domestic profits and wages (and without an increase in labour
productivity). Ultimately, however, it is very hard for an economy to support real wages growth in the
longer run without productivity growth. Graph 4 Productivity and consumption Productivity growth also tends to support consumption growth. When productivity and incomes are growing
more strongly, people are able to spend more and consumption grows more quickly. Weak growth in
consumption per capita over recent years has coincided with weak growth in productivity, real incomes and
real wages (Graph 5). ⁴ Graph 5 Similar patterns have been evident in other economies, where subdued productivity growth has been
associated with slower growth in household incomes and consumption (Graph 6). The exception is the
United States, where growth in both productivity and consumption has been relatively strong. Graph 6 Recent trends in productivity So far I’ve focused on the importance of productivity growth for aggregate supply, incomes and demand
over the longer run. I’ll now turn to recent trends in productivity growth in Australia and some
potential implications for the near-term economic outlook. Discerning recent trends in productivity is difficult because of volatility in the data associated with
the pandemic and other supply disruptions. Looking through the volatility, labour productivity growth has
been low, averaging 0.2 per cent per year between 2017/18 and 2023/24 (Graph 7). Graph 7 Reverting to the simple production function framework that I noted earlier, the slow growth in labour
productivity over recent years has reflected slow growth in both MFP and the amount of capital available
to each worker. MFP growth averaged 0.2 per cent per year between 2017/18 and 2023/24 , which was well below its historical average. Some have argued that
slower MFP growth could reflect temporary factors. For example, tight labour market conditions over
recent years have been associated with large numbers of individuals entering the workforce or changing
jobs; this may have weighed on productivity as some individuals were trained or retrained and some firms
adapted production processes to accommodate strong employment growth. If this was the case, MFP growth
could pick up as the economy adjusts. However, work by some RBA staff finds that temporary factors like
these have not been the primary cause of slow MFP growth, suggesting that structural factors could be
weighing on productivity growth. ⁵ Slow growth in the amount of capital available for each worker in the Australian economy – or a lack
of ‘capital deepening’ – has also contributed to slow growth in labour productivity
(Graph 8). Capital per worker was broadly unchanged for around five years leading up to the pandemic
and – looking through the volatility in the data during the pandemic – is currently a bit
below those levels. In other words, overall investment has not kept pace with the strong growth in
employment recently. Graph 8 To help understand the recent slow growth in productivity, I’ll look at productivity outcomes in
various parts of the economy. I’ll start with the non-market sector – which includes the health care, education and public
administration industries – where employment growth has been very strong over recent years. The
level of measured productivity in some parts of the non-market sector is low relative to the
aggregate economy. So, as the non-market sector has become a larger share of the economy in recent years,
this has weighed on overall productivity growth in the economy. Our estimates suggest that the rising
share of non-market employment lowered the economy-wide measure of labour productivity growth by around
0.3 percentage points per year on average from 2017/18 to 2023/24 , as shown by the yellow bars in Graph 9. ⁶ This
compares with around 0.15 percentage points per year over the previous decade, and so the recent
effects have been a bit larger than in the past. But there is more to the story about productivity and the non-market sector. I have emphasised measured productivity because it is very difficult to measure output – and therefore
productivity – in parts of the non-market sector. The central measurement problem is a lack of
meaningful prices for some non-market output, such as public hospital services provided to public
patients. ⁷ This makes it very difficult to accurately identify
quantities of output, which are needed to measure productivity. For example, research by the Productivity
Commission suggests that productivity in the health care industry is higher than official estimates. ⁸ As such,
the drag on productivity from the non-market sector may be overstated. Graph 9 Noting the challenges of measuring productivity in the non-market sector, what’s been going on in the
rest of the economy? Labour productivity growth in the market sector averaged around
0.6 per cent per year from 2017/18 to 2023/24 – below its average of 1.6 per cent over the previous
two decades – though it picked up in 2023/24 . Table 1: Growth in Labour Productivity Average annual growth rates
(per cent) (a) Sector 1998/99 to 2017/18 2017/18 to 2023/24 All industries 1.3 0.2 Non-farm 1.1 0.1 Market sector 1.6 0.6 Market sector ex mining 1.4 1.0 (a) Average growth rates calculated between financial years. Sources: ABS; RBA. While the level of productivity in the mining industry in Australia is higher than in other
industries, productivity growth in that industry has declined over recent years. Excluding
mining, productivity growth in the market sector since 2017/18 has
averaged 1 per cent per year, though this is still lower than its average over the preceding
two decades and well below the rates recorded during the high productivity growth period in the
1990s. ⁹ More generally, a range of explanations have been provided for the slowing in productivity growth globally
since the 1990s. A well-documented one for Australia is declining ‘economic dynamism’ –
it now takes longer for inputs to production to move to higher productivity firms, and it also takes
longer for firms to catch up to the global frontier of performance and technology. ¹⁰
Evidence suggests that at least part of the decline in economic dynamism relates to declining competition
in the economy. ¹¹ Regulatory barriers also appear to have played a
role in Australia, notably in the construction industry. ¹² Other explanations include slowing human
capital accumulation, declining trade integration, and mismeasurement. ¹³ What does the recent subdued growth in productivity mean for our assessment of economic conditions? While
productivity growth is associated with growth in incomes and wages over the longer run, in the short run
there can be material divergences between these variables. ¹⁴ Over the past year or so, real average
hourly earnings in the economy have grown faster than labour productivity. This exerts upward pressure on
firms’ unit labour costs and is consistent with our assessment that labour market conditions are
still tight, notwithstanding some easing in those conditions over the past couple of years. What will happen from here? Our latest forecasts in the Statement on Monetary Policy
incorporate a pick-up in productivity growth over the next couple of years, which would add to the
economy’s supply capacity and help alleviate cost pressures. But there is considerable uncertainty
around this projection. If productivity growth remains weak, the near-term outlook will depend critically
on how the economy adjusts. If growth in demand is also weaker and wages adjust quickly to this slower
growth in the supply capacity of the economy, there might not be a material impact on cost pressures. But
if demand picks up as expected or wages adjust slowly to continued weak productivity outcomes, cost
pressures could be higher than we expect. We will continue to monitor these developments carefully,
alongside the full range of indicators we use to assess current economic conditions. Concluding remarks To conclude, productivity matters because it is a key driver of economic living standards. Over the longer
run, higher productivity growth expands the supply capacity of the economy and supports growth in
incomes, wages and aggregate demand. In the short run, however, there can be meaningful divergences in
the growth rates of these important macroeconomic variables. Recent weak growth in productivity has
constrained growth in aggregate supply. Whether productivity growth improves from here and how the
economy adjusts are important questions for the economic outlook. Thank you for your time today. I look forward to your questions. Endnotes I would like to thank Angelina Bruno, Jonathan
Hambur and Kevin Lane for their help preparing this speech, and also Sarah Hunter, Natasha
Cassidy, Leon Berkelmans, Tim Taylor, Thomas Williams, Oscar Douglas, Martin McCarthy, Michelle
Bergmann, Stephanie Parsons, Gordana Peresin, Christopher Schwartz, David Bold, Hamish Sullivan,
Georgia Face and Kieran MacGibbon for their comments and contributions. [*] The measure of ‘wages’ used for these
comparisons is average hourly earnings from the national accounts. It captures various forms of
labour compensation (such as base salaries and wages, bonuses and overtime), as well as
compositional change in the economy (such as workers moving from lower paying jobs to higher
paying jobs). ¹ These averages exclude the farm sector, owing to
challenges around measuring labour income in that sector. ² Productivity Commission (2024), ‘ Higher
Education and Productivity ’, Speech by Danielle Wood, Chair, at the National Conference on
University Governance, 23 October 2024, Canberra. ³ In terms of the productivity cycles in
Graph 5, the Australian Bureau of Statistics (ABS) determines productivity cycle peaks by
comparing the annual MFP estimates with their corresponding long-term trend estimates. The peak
deviation between these two series are the primary indicators of a growth cycle peak, although
economic conditions at the time are also considered. ⁴ See Bruno A, J Hambur and L Wang (2024), ‘ Measuring
Labour Quality in (Closer to) Real Time Using Emerging Microdata Sources ’, Paper for
Joint ABS-RBA Conference on Human Capital, June; Wiley G and L Wang (2024), ‘ Skills
Match Quality Following the COVID-19 Pandemic ’, RBA Bulletin , July. ⁵ These calculations include housing services as
part of the market sector. ⁶ See Luo Q (2020), ‘ Hospital Output Measures
in the Australian National Accounts: Experimental Estimates, 2004-05 to 2017-18 ’, ABS
Paper, Canberra; Annabel J (2020), ‘ Non-market Output Measures in the Australian National
Accounts: Conceptual Framework Enhancements ’, ABS Paper, Canberra. ⁷ See Productivity Commission (2024),
‘ Advances in Measuring Healthcare Productivity ’, Research Paper, Canberra. ⁸ The market sector excluding mining accounted for
a little over two-thirds of total employment in 2024 and around two-thirds of gross value added
in the Australian economy. See Australian Bureau of Statistics (2024), ‘Labour Account
Australia, September 2024’, Canberra and Australian Bureau of Statistics (2024),
‘National Income, Expenditure and Product, September 2024’, Canberra. ⁹ On reallocation, see Hambur J and D Andrews
(2023), ‘ Doing Less, with Less: Capital
Misallocation, Investment and the Productivity Slowdown in Australia ’, RBA Research
Discussion Paper No 2023-03; Andrews D and D Hansell (2021), ‘Productivity-Enhancing Labour
Reallocation in Australia’, Economic Record , 97(317), pp 157–169. On
convergence, see Andrews D, C Criscuolo and P Gal (2016), ‘The Best versus the Rest: The
Global Productivity Slowdown, Divergence across Firms and the Role of Public Policy’, OECD
Productivity Working Paper No 5; Andrews D, J Hambur, D Hansell and A Wheeler (2022),
‘Reaching for the Stars: Australian Firms and the Global Productivity Frontier’,
Treasury Working Paper No 2022-01. ¹⁰ Hambur J (2023), ‘ Product Market
Competition and its Implications for the Australian Economy ’, Economic Record ,
99(324), pp 32-57. ¹¹ On the construction sector, see Productivity
Commission (2025), ‘ Housing construction productivity: Can we fix it? ’, Commission research paper, Canberra. On occupational entry regulations, see Bowman J, J Hambur and M Markovski (2024),
‘ Examining the Macroeconomic Costs of Occupational Entry Regulations ’,
RBA Research Discussion Paper No 2024-06. ¹² On slowing human capital accumulation, see OECD
(2024), ‘ From decline to revival: Policies to unlock human capital and productivity ’, OECD Economics Department Working Paper No 1827. On trade, see Goldin I, P Koutroumpis, F Lafond and J
Winkler (2024), ‘Why is Productivity Slowing Down?’, Journal of Economic
Literature , 62(1), pp 196–268. Note that it has been argued that
mismeasurement is unlikely to account for the slowdown globally and in Australia. See Syverson C
(2017), ‘Challenges to Mismeasurement Explanations for the US Productivity Slowdown’, Journal of Economic Perspectives , 31(2), pp 165–186; Burnell D and M
Elsnari (2020), ‘ Does Measurement of Digital Activities Explain Productivity Slowdown? The Case for Australia ’,
Institut National de la Statistique et des Etudes Economiques (INSEE), issue 517-518-5, pages 123-137. For a broader discussion
of the slowdown and its causes, see Duretto M, O Majeed and J Hambur (2022), ‘ Overview: Understanding productivity in Australia and the global slowdown ’, Treasury Working Paper No 2022-05. ¹³ A caveat to this shorter run analysis is that
data on productivity and average hourly earnings can be volatile, which is why we tend to look at
productivity over ‘cycles’ that span a number of years. So we need to be cautious when
comparing growth rates over short periods. ¹⁴