Total Factor Productivity∗

Total Factor Productivity (TFP) is the portion of output not explained by the amount of inputs used in production. The following definition describes the measurement and importance of TFP for growth, fluctuations and development as well as likely future directions of research. Total Factor Productivity (TFP) is the portion of output not explained by the amount of inputs used in production. As such, its level is determined by how efficiently and intensely the inputs are utilized in production. TFP growth is usually measured by the Solow residual. Let gY denote the growth rate of aggregate output, gK the growth rate of aggregate capital, gL the growth rate of aggregate labor and alpha the capital share. The Solow residual is then defined as gY − α ∗ gK − (1− α) ∗ gL. The Solow residual accurately measures TFP growth if (i) the production function is neoclassical, (ii) there is perfect competition in factor markets, and (iii) the growth rates of the inputs are measured accurately. TFP plays a critical role on economic fluctuations, economic growth and cross-country per capita income differences. At business cycle frequencies, TFP is strongly correlated with output and hours worked. Based on this observation, Kydland and Prescott (1982) initiated the real business cycle (RBC) literature. In the standard business cycle model, shocks to TFP are propagated by pro-cyclical labor supply and investment, thereby generating fluctuations in output and labor productivity at business cycle frequencies with an amplitude that resembles the U.S. data. Subsequent work has introduced pro-cyclical fluctuations in measured TFP by incorporating unmeasured labor hoarding and/or capacity utilization in the standard framework (e.g. Burnside et al. (1995) and King and Rebelo, 1999). As shown in the landmark article by Robert Solow (1956), long-run growth in income per capita in an economy with an aggregate neoclassical production function must be driven by growth in TFP. For over 30 years, the conceptual difficulty when trying to endogenize ∗S. N. Durlauf and L. E. Blume, The New Palgrave Dictionary of Economics, forthcoming, Palgrave Macmillan, reproduced with permission of Palgrave Macmillan. This article is taken from the authors’ original manuscript and has not been reviewed or edited. The definitive published version of this extract may be found in the complete New Palgrave Dictionary of Economics in print and online, forthcoming. †[email protected]