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Appendix: The components of productivity

Appendix: The components of productivity

Productivity is simply what you get out for what you put in. It is made up of economies of scale, economies of scope, technical efficiency, allocative efficiency, and technology or knowledge. True productivity can differ from measured productivity, due to measurement, which is another important component of productivity.

All these phenomena can operate at any level of the economy: the individual task or person, branches or plants within companies, firms, regions, countries, and the whole world. For example, cities benefit from economies of scale, through deeper labour markets and hence better matching of the skills of workers to the needs of employers. Firms also benefit from economies of scale, as fixed inputs can be shared across a larger number of workers or customers, reducing their average cost.

Economies of scale

Economies of scale are the benefits of size in economic activity. Larger firms can share fixed costs across a broad range of activities: one machine can be shared across many workers; buying power can push down purchasing or transport costs. Small business owners often must be HR, marketing, accounting and production managers. Few people are highly skilled in all these areas, and switching from one task to another can take time and mental effort. On the other side, there can be diseconomies of scale, as an organisation becomes unwieldy or multiple layers of management stifle innovation and increase the distance between leadership and staff.                                                                                                                                                                           

Economies of scale are generally divided into internal and external economies.

Internal economies of scale include the following.

  • Financial As firms get larger, it becomes easier to seek investment and the cost of borrowing decreases, as larger firms are seen as more reliable.
  • Purchasing Larger firms require more raw materials and can get discounts from buying in large quantities.
  • Marketing The cost of advertising per unit of output decreases, as advertising is a fixed cost.
  • Technical Larger firms can invest in more efficient machinery and technology.
  • Managerial As firms get larger, they are more able to attract skilled managers.
  • Risk-bearing Larger firms are more likely and able to produce a variety of products, reducing risk, as they are not dependent on the sale of one product.

External economies of scale include the following.

  • Skilled When activity is concentrated in an area, it can attract skilled workers around that location. This makes it easier for firms to recruit new workers and reduces the training costs they might otherwise incur.
  • As an industry grows in an area, suppliers of raw materials and services for that industry are likely to be set up nearby, due to the abundance of demand. This will reduce the transport cost of raw materials and lead to more and higher-quality services provided by firms.
  • Investment in infrastructure around concentrated locations of activity is likely to be tailored to the needs of that industry.
  • As an industry grows in an area, similar or related firms may find it beneficial to cooperate with each other and share resources.

Economies of scope

Economies of scope arise when there are benefits to producing multiple goods or services in tandem. In some cases, by-products that might be seen as waste and incur a cost of disposal become products, or an input to other processes (for example, biofuels or tallow from beef production).

Technical efficiency

Technical efficiency refers to the effectiveness with which inputs are turned into outputs, relative to what is currently possible. Technical efficiency can be measured from the perspective of inputs: is the firm, industry or country using the least amount of input to produce its outputs (“input-orientated technical efficiency”)? Alternatively, we can ask the question from an output orientation: is the firm, industry or country producing the maximum output it could feasibly produce, given the inputs it is using?

Allocative efficiency

Allocative efficiency refers to using the combination of inputs or outputs that maximise overall wellbeing. For example, if both surgery and a course of drugs have the same impact on health outcomes, but the former has a higher cost, overall wellbeing could be maximised by shifting provision from surgery to drugs, as the cost savings could be spent on additional health services (or a holiday).                                                                                   

Technology and knowledge

The greatest of all influences on productivity and material wellbeing is the level of technology and knowledge.

That humanity has enjoyed a phenomenal improvement in its material wellbeing is not due to us getting out of bed earlier in the morning or working longer hours than our forebears; it is due to innovation. The means whereby new things to do and new ways of doing them are created, dispersed, adopted are – and will continue to be – a key determinant of the wellbeing of New Zealanders.

Stevens, 2011, p. 22


As productivity cannot be explained by observed inputs, empirical estimates of productivity include elements of mismeasurement. If we measure labour input by hours worked, this does not account for the skills of those workers. If the skills of the workforce increase, and we do not measure them, this will appear as an increase in productivity. Research and development, and other investments in innovative activity, create knowledge or intangible capital that can be used to produce output more efficiently. However, because the inputs used to create this knowledge are often indistinguishable from the capital, intermediates and labour inputs directed towards current production, measurement error can lead to both over- and underestimates of actual productivity growth.