A Note on the Identification of Demand and Supply Shocks in Production: Decomposition of TFP

Total factor productivity (TFP) is considered as a good measure of productivity. However, empirical TFP, often calculated from ordinary least squares (OLS) residuals from production function estimates, normally includes demand shocks as well as productivity shocks. The appropriate policy differs depending on which factor is the main cause. Konishi and Nishiyama (2013, KN hereafter) attempt to provide a method in this direction to decompose the TFP shock into demand and supply shocks using the Current Survey of Production and Census of Manufacture. They do not consider a demand side model and implicitly assume that the difference in the production capacity and the realized production identifies the demand shock. This note extends their approach to model explicitly the demand side structure and its shock. Assuming a log-linear demand function, we allow a demand shock of a constant shift as well as a slope change. We show that different quantities identify the demand shock in the two cases. The KN method works in the case of additive demand shocks, but not for slope changes under perfect competition. We further discuss the case of monopolistic competition and find a qualitatively similar result.