Productivity Revolution: Drastic implementation will trigger conflicting interests and push inefficient businesses out of market

MORIKAWA Masayuki Vice President, RIETI

In the last House of Representatives election held in October 2017, Prime Minister Shinzo Abe set productivity revolution as one of the future priority policies. Japan's average annual real economic growth rate over the four years and nine months since the launch of Abe's second administration is 1.4%. Although falling below his 2% real growth target, it exceeds the potential growth rate (or Japan's real economic power) which is estimated to be less than 1%.

However, amid the Japanese economy reaching full employment and facing an increasingly serious labor shortage, it is essential to set policies for boosting the growth potential to maintain and even further increase the economic growth rate to above 1%, which makes it quite natural to put the productivity revolution as a centerpiece of economic policy.

Macroeconomics forecasts are readily understood from the demand side, as the relevant factors are usually discussed based on demand components including consumer spending, capital investment, and foreign demand. On the other hand, supply side factors, which define the medium- to long-term economic growth rate, and the concept of productivity, which is the core of these factors, are not necessarily accurately understood.

Productivity is a figure representing the output in terms of goods and services (i.e., value added) that is generated from inputs including labor. There are various methods to measure productivity. Academic researchers consider total factor productivity (TFP) which takes into account all inputs including labor and capital to be a preferable indicator, however, I will focus on labor productivity here to avoid a complicated explanation.

Economic growth potential is defined by the rates of growth of labor input and labor productivity growth. An increase in the working population naturally pushes up production. For example, the Promoting Dynamic Engagement of All Citizens initiative aimed at engaging more women and elderly people as part of the workforce may contribute to enhanced growth potential. However, the potential for additional economic growth through this initiative would be rather small, as the employment-population rates of women and elderly people are already on the increase, and they tend to work relatively short hours. Thus, it is necessary to improve labor productivity.

Labor productivity is a figure obtained by dividing the value added generated in a certain period of time (or real gross domestic product (GDP) in terms of macroeconomics) by [number of workers × work hours] (see Figure). By definition, means to improve labor productivity are to (i) reduce the labor input (denominator) or to (ii) increase the value added (numerator).

Figure: What is Labor Productivity?
Figure: What is Labor Productivity?

More efficient use of valuable human resources by reducing unnecessary work and streamlining work processes, for example, kaizen initiative at production sites, may lead to a lower denominator value. On the other hand, development of attractive products or services matching to consumer needs and the attendant increase in production and sales can increase the value added.

The following are several points which are often misunderstood.

- Selling the same product or service at a higher price can raise productivity.
⇒As with the case of real GDP, value added is measured after controlling for the effect of change in price. Therefore, a simple rise in the price is adjusted and does not lead to a real increase of value added.

- The only way to improve productivity based on the same number of workers working for the same hours is to increase production volume of goods or services.
⇒Quality improvement of goods or services can also lead to productivity improvement. For example, the performance of computers and digital cameras is improving at a very fast pace. Even if the price of a new model product is the same as an old model, it is considered as a price reduction if it has better quality, and the real value added is increased. Likewise, improved service quality, such as an increase in the survival rate in medical care and enhanced academic performance via education, although difficult to measure and not sufficiently reflected in GDP statistics, actually means a real increase in value added and improved productivity.

- Increase in equipment investment, such as machinery, can raise labor productivity to its maximum level.
⇒Equipment investment presupposes the achievement of return on investment exceeding cost of capital. Return on investment is not raised unless there is increased labor input or productivity. Thus, the possibility of increased capital investment is limited.

- Japan has seen a slowdown in productivity over the years.
⇒In the last few years, although partly due to the temporary factor of economic recovery, Japan has seen a 1.0% annual growth in labor productivity which is the highest among seven industrialized countries, far surpassing that of the United States (0.4%) and the United Kingdom (0.1%).

Such challenges as wage hikes to achieve a virtuous economic cycle and working style reform are also related to productivity.

How are wages and working hours related to productivity?

It is clear that countries and businesses with higher productivity are paying high wages. This is also true with individual workers, and wage is an approximate indicator of a worker's productivity. Although it may be possible temporarily for a company to raise wages at the expense of profit, the company will lose competitiveness and its survival will be affected. Thus, in order for the company to maintain sustainable wage hikes, it is necessary to increase productivity.

In order to improve the pay and benefits of relatively low-wage workers, it is essential to take measures for raising their productivity through education and training.

Extensive research has shown that long working hours will increase fatigue and have a negative impact on productivity. It is likely that curbing excessive overtime work will improve per-hour productivity. Furthermore, reduced working hours and more flexible working styles can lead to higher productivity in the long run, by streamlining work processes and contributing to the conception of good ideas.

However, it is difficult to expect the positive effect of higher productivity exceeding the negative effect of less labor input in the short term.

Would a productivity revolution be possible?

Policies for raising productivity include stimulation of research and development (R&D), skill enhancement of workers, and promotion of competition through regulatory reform. Innovation such as artificial intelligence (AI) and robotics and their diffusion may boost productivity in the future. Improved quality of human resources will also surely help.

However, as time is required for these supply side policy measures to work, one should not expect readily visible effects.

It should be noted that, for the dramatic improvement of productivity, daring to proceed with structural reform requiring people to endure pain in the short term may be necessary, which extends beyond the policy measures to assist existing businesses.

Policies for spurring competition through regulatory reform would not benefit all businesses. However, such policies are expected to boost the productivity of the industry as a whole through creative destruction comprising of the market exit of low-productivity businesses and increased market share of high-productivity businesses. For instance, social regulations including an occupational licensing system are useful for achieving a safe and secure society. However, excessive regulations need to be lifted as they may involve side effects including restrictions on market entry, exit, and competition.

In addition, in some cases, policy measures for different purposes, such as regional revitalization and protection of the socially vulnerable, may bring about a negative impact on productivity. For example, the service industry, which is the priority sector for productivity improvement, can benefit from economies of agglomeration, and businesses in larger cities tend to be higher in productivity. Thus, delivering the regional promotion programs in the wrong way may result in the reduction of the vitality of large cities and cause a slowdown in the productivity of the entire economy.

Tackling these challenges from the standpoint of the improvement of productivity would not be politically popular as it involves conflicting interests and values. However, it will be unavoidable to do so if we seek drastic implementation of a productivity revolution.

>> Original text in Japanese

* Translated by RIETI.

October 24, 2017 Weekly Economist (Mainichi Shimbun Publishing Inc.)

November 10, 2017