Growth Accounting

Growth accounting is an economic method designed to measure the relative and absolute contributions of different factors to economic growth and development. Developed by Robert Solow in 1957, this methodological approach disaggregates or decomposes the different elements of economic growth. The most important assumption of this method is that the gross output of an economy can be analyzed into increases in the range of factors (primarily increases in labor and in capital) and which cannot be accounted for by discernible changes in the utilization of these factors.

Another way of explaining Solow's model is this: The unexplained part of growth in an economy's GDP is best understood as a simple increase in productivity, with productivity being defined in common-sense terms as achieving a larger output without an increase in the input levels of any factor. Solow's model also suggests that this increase in GDP is the result of technological progress. This model has been used to assess a wide range of economies around the world and has tended to produce similar results, including the fact that in a range of situations the actual levels of economic growth cannot be accounted for by increases (or, conversely, decreases) in capitalization or labor force growth (or loss) rates.

Growth accounting allows for the extrapolation of different factors from a total economic profile to determine if factor accumulation is sufficient to explain economic growth. This form of methodological approach allows economists to isolate what we might call "a certain something extra" (because there is no reason that economics cannot support a certain amount of whimsy). This additional factor is called the Total Factor Productivity (TFP) (or the Solow residual) and serves as a measure of technological progress.

Krugman (1994) provides an elegantly commonsensiical explanation of growth economics:

We all do a primitive form of growth accounting every time we talk about labor productivity; in so doing we are implicitly distinguishing between the part of overall national growth due to the growth in the supply of labor and the part due to an increase in the value of goods produced by the average worker. Increases in labor productivity, however, are not always caused by the increased efficiency of workers. Labor is only one of a number of inputs; workers may produce more, not because they are better managed or have more technological knowledge, but simply because they have better machinery. A man with a bulldozer can dig a ditch faster than one with only a shovel, but he is not more efficient; he just has more capital to work with. The aim of growth accounting is to produce an index that combines all measurable inputs and to measure the rate of growth of national income relative to that index to estimate what is known as "total factor productivity."

Solow's initial use of this method was an attempt to determine the effect of technological growth on total economic growth. To do this (and this seems very simple in retrospect) he subtracted the growth rates of both labor and capital (both were weighted) from the growth weight of the total output. The residual (Solow posited) was the result of the growth of technology.

This initial use of growth accounting is now referred to as the primal approach and some economists have a significant doubt about its efficacy, which is that it is based on measurements of key economic inputs such as labor and capital. Measuring these input values can be very complicated -- in fact, are very complicated. This is true in the First World in which data are relatively clear-cut and relatively likely to be free of substantial manipulation and fraud for political reasons. Analogous data from developing nations are likely to be even more problematic since these figures are produced by government agencies that may lack expertise in calculating the needed figures. Or -- and this is far more likely than any lack of expertise -- is the fact that government agencies (and this is of course true in both the developing world and the developed world) may manipulate figures for a variety of political reasons. It is, of course, possible that governments may move beyond simple manipulation to outright mendacity in terms of their published statistics -- again, for a variety of either internal or external political reasons.

As a result of these facts, a dual approach of growth accounting was developed that is based not on quantities but on factor prices -- a shift based on the fact that factor prices are usually easier to measure in accurate ways. Prices tend to be much more accurate because they are determined at the market, where there are a range of incentives to get the prices right. (Of course, marketplaces are not immune from the possibility of manipulation, but for the moment we will...

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Barro (1998) provides an excellent overview of the usefulness of growth accounting in the assessment of economies undergoing rapid change. Growth accounting, he writes "is generally viewed as a preliminary step for the analysis of fundamental determinants of growth and is especially useful if the determinants of factor growth rates are substantially independent from those that matter for technological change" (p. 1). He also underscores one of the most significant limitations of growth accounting, which is that factor prices coincide with social marginal products. (Although, as he notes, there are methods for calculating what occurs when this is not the case.)

However, while there are differences between primal and dual approaches in growth accounting that lead to different results, this difference can sometimes be more theoretically important than factually so, as Hlousek (n.d.) determines through a study of Czech economics:

The primal and dual measures of TFP growth rate should be the same with only the condition that output equals factor incomes. No other assumptions about the form of the production function, bias of technological change or relationship between factor prices and their social marginal products need to be made.The two measures will differ only if the national accounts are inconsistent with the data on factor prices.

One thing that is not clear from Hlousek's study is to what extent his analysis holds steady for developing nations. While, theoretically, economic models should in fact be applicable in different circumstances, the highly variable accuracy of economic data (as noted above) ensure that such transferability may not be possible. (Hlousek is fully cognizant of this, writing that "Further research will be also focused on other countries and cross-country comparisons of TFP growth rates.") However, setting this aside, it is important to acknowledge the similarity in accuracy between the two methods of growth accounting -- both of which methods determined that in the case of the Czech republic that TFP (Total Factor Productivity) is more important that factor accumulation in understanding Czech economic dynamics.

This paper examined two approaches to growth accounting: primal that is based on quantities of factor inputs and dual that is based on factor prices. The analysis used Czech time series of aggregate variables. The results of the exercise are quite satisfactory. Both estimates of TFP growth are very similar and dual approach is useful alternative to measuring TFP (Hlousek, n.d.)

Having providing an overview (albeit a brief one) of growth accounting, I now turn to a discussion of the ways this methodology interacts with neoclassical economic models.

Neoclassical Economic Models

Neoclassical economics is not a perfectly homogeneous entity, with different practitioners in different eras (and with different motivations) defining the subfield somewhat differently. However, there is certainly a core of beliefs and intellectual assumptions in the field. These assumptions include the following:

People are rational beings who have the ability to assess the value of different options and choose the most valuable among them

Individuals (being both rational and perceptive) work to maximize utility (or worth)

Businesses (being analogous to people and so capable of reason and intelligent choices) work to maximize their profits

Individuals interacting with the marketplace act independently of each other and in possession of complete and accurate information.

In other words, the marketplace is filled with individuals and groups who purse their own (and only their) interests in rational and accurate ways to increase the amount of goods or other forms of wealth that they have.

One of the essential methodological aspects of neoclassical economic models and analyses is that in such models market supply and demand are aggregated across firms and individuals, thus allowing for patterns to emerge through a reduction in natural variation (as well as what might be seen as less-than-fully rational behavior on the part of individuals or firms. Neoclassical models emphasize the importance (and, some would argue), the inevitability of equilibria.

Hsieh argues that growth accounting techniques strongly support a neoclassical explanation for growth in these four nations:

These studies suggest that…