Improving Productivity amid Declining Population and Increasing Environmental Constraints

Vice President, RIETI

It goes without saying that improving productivity is the key to the sustainable growth of the Japanese economy. In the course of discussions on a growth strategy for Japan, it has been disputed whether the focus should be on the supply or demand side of the economy. However, the level of gross domestic product (GDP) is determined as the equilibrium at which supply meets demand. Thus, neither one should be considered more important than the other. Yet, in textbook terms, demand-side factors dominate as short-run determinants of GDP, and supply-side factors as medium to long-term determinants. Furthermore, in Japan where the working population is in decline, the biggest factor determining growth potential over a medium to long-term time horizon is productivity growth. In particular, the productivity of the service sector, which accounts for about 70% of the national economy, is the single most crucial factor that determines the course of the entire Japanese economy.

Productivity is one of the priority research themes at the Research Institute of Economy, Trade and Industry (RIETI) and, since its inauguration in 2001, more than 60 research papers have been published on this theme. I have published my research findings regarding the productivity of the service sector in some of those research papers. In what follows, based on those research findings, I would like to present my personal view on challenges faced by Japan in enhancing the productivity of its service sector.

Unlike goods, services are mostly neither storable nor transportable. They are, by their unique nature, consumed as produced. Because of this simultaneity of production and consumption, service industries are exposed to less international and inter-regional competition resulting in greater inter-company productivity gaps, compared to manufacturing industries. Conversely, this means that industry-wide productivity can be improved by enhancing "metabolism" through market share expansion by high-performance companies and the exit of inefficient companies. Subject to several assumptions, it is estimated that the productivity of Japanese service industries can be raised by as much as 20% to 30% from the current level. It is thus important to put in place institutional mechanisms that would facilitate industrial metabolism.

Service industry productivity at the levels of individual firms and establishments is also significantly affected by the simultaneity of production and consumption. The "simultaneity" referred to here has two aspects, namely, temporal simultaneity and spatial simultaneity. For instance, demand for travel and entertainment services differs significantly between weekdays and weekends. In the case of eating and drinking establishments, demand fluctuates greatly across different time periods of a day. An analysis using data on leisure service industries has found that even among establishments in the same industry, productivity is lower for those whose services are subject to greater inter-temporal fluctuations, whether between weekdays and weekends or across different months. This suggests that, along with efforts on the part of companies to level off demand through price adjustments and other means, "greater temporal flexibility" in the form of flexible work hours, dispersing the timing of annual leave, and so forth, which has been called for primarily in the context of reforming the way people work, can help improve the productivity of service industries.

Meanwhile, in some service industries whose market is segmented geographically, the productivity of a specific company is significantly affected by the population density of the area of its location, that is, establishments located in densely-populated large cities tend to have high productivity. This is because even a fabulous store with excellent staff would be able to produce very little value added if customers visit the store only once in a blue moon. My empirical analysis of some personal-service industries found that there are significant economies of demand density in the examined industries with a doubling in the population density of a municipality corresponding to an increase of 7 to 15 percentage points in productivity. This shows that dense population has a positive effect on service industry productivity. In terms of government policy, measures affecting population mobility and the geographic distribution of economic activities, such as city planning and land regulations, would be involved.

It is a well-known fact that massive rural-to-urban population flows supported Japan's postwar high growth, which involved drastic changes in the nation's industrial structure. In parallel with this, infrastructure such as industrial roads and ports was developed. Japan's internal migration rate, i.e. the ratio of people who migrated across municipal borders to total population, peaked at 8% in 1970 and has since followed a gradual declining trend to reach slightly above 4% in recent years. Given the fact that Japan has turned into a service-oriented economy over the years, we should have witnessed a surge in the flow of population into large cities in parallel with such structural changes. But what we have seen in reality was the continuous decline of the internal migration rate. Probably among the factors behind this are an increase in retired elderly households, the rising proportion of firstborns, and institutional and market mechanisms governing real property transactions. Japan's population has already begun to decline and is estimated to decrease by approximately 30% in the next 50 years. If Japan's population density were to decrease uniformly across the country, it would work to lower the productivity of the entire service industries. Thus, from the viewpoint of enhancing service industry productivity, promoting the concentration of population into urban areas is an effective policy whereas trying to revitalize all cities and towns across the country is negative to Japan's productivity as a whole.

It should be noted, however, that the existing productivity gaps in the service industry are mostly accounted for by inter-establishment gaps within individual prefectures with little contribution made by inter-prefectural gaps. Therefore, the intra-prefectural redistribution of population across municipal boundaries - rather than the nationwide redistribution across prefectural boundaries (typically, the rise of Tokyo as Japan's only population center) - would contribute to the improvement of service industry productivity. The concept of "compact cities," which has been promoted by some local governments from the viewpoint of improving efficiency in the provision of public services and the development infrastructure and/or rationalizing energy consumption, will probably prove to be effective also as a means to enhance the productivity of private-sector service industries.

The Japanese economy is faced with various challenges ranging from the rapidly aging population driven by low fertility to increasing environmental constraints, mounting government debt and fiscal constraints, and the need to revitalize regional economies. In this regard, urban agglomeration will be able to solve many - if not all - of those problems as it offers a number of advantages which include: increasing the growth potential of the Japanese economy as a whole; improving public service efficiency; achieving greater energy efficiency; enabling people to live close to where they work; and providing a living environment where elderly people feel assured and comfortable. Thus, in considering growth strategy, the question is what regulatory and/or policy incentives Japan can and should provide to promote the development of urban agglomeration at a time when population mobility is in decline.

Figure: Economies of Demand in Service industriesFigure: Economies of Demand in Service industries
Note: Figures indicate the impact of a doubling in municipal population on productivity (log points).
Source: Morikawa, M. (2008), "Economies of Density and Productivity in Service Industries: Analysis of personal service industries based on establishment-level data," RIETI Discussion Paper 08-J-008.

>> Original text in Japanese

* Translated by RIETI from the original Japanese article published in the April 2010 issue of Keizai Trend from Nippon Keidanren (Japan Business Federation).

June 25, 2010 Keizai Trend

June 28, 2010

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