Discussion Paper: Factor substitution and productivity in NZ

DP2016/12: Factor substitution and productivity in New Zealand

Summary

It is puzzling that New Zealand's productivity performance has been poor compared to other advanced economies, particularly in light of wide-ranging economic and institutional reforms starting in the mid-1980s. This paper unpacks New Zealand's disappointing productivity growth by taking an industry-level view and estimating the contribution of capital and labour to productivity growth in New Zealand.

Total factor productivity (TFP) is often estimated as a residual from a regression of output against estimates of inputs such as capital and labour. A common assumption when estimating TFP in this way is that capital and labour are substituted one-for-one when their relative prices change. However, this can bias estimates of TFP if the elasticity of substitution is in fact significantly different from one.

Deviating from the assumption that the elasticity of substitution is unity can also help us understand the nature of structural changes in the economy. In a `traditional' neo-classical growth model, when the elasticity of substitution is one, changes in the capital to labour ratio or the relative price of labour to capital do not cause capital and labour income shares to change since capital intensity and the relative price of labour adjust. However, when the elasticity is different from one, changes in capital and labour productivity and the relative growth rates of capital and labour can generate variation in the share of income received by each factor.

This paper produces TFP estimates based on Constant Elasticity of Substitution (CES) production functions that allow the elasticity of substitution between capital and labour inputs to be estimated. The CES approach simultaneously explains changes in factor share and output over time, and provides estimates of the contribution of capital and labour to productivity. The results show that the elasticity of substitution is significantly different from one in all industries. Technical change has made capital less productive in many industries, implying that additional increments of capital have tended to weigh on productivity.

The paper is available for download at

http://www.rbnz.govt.nz/research-and-publications/discussion-papers/2016/dp2016-12

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