Total factor productivity measures the residual growth in total output of a firm, industry, or national economy that cannot be explained by the accumulation of traditional inputs such as labor and capital . Increases in total factor productivity reflect a more efficient use of inputs, and total factor productivity is often taken as a measure of long-term technological change or dynamism brought about by such factors as technical innovation.
Total Factor Productivity
Total output is not only a function of labor and capital, but also of total factor productivity, a measure of efficiency.
Total factor productivity cannot be measured directly. Instead, it is a residual which accounts for effects on total output not caused by inputs. In the Cobb-Douglas production function, total factor productivity is captured by the variable A:
In the equation above, Y represents total output, K represents capital input, L represents labor input, and alpha and beta are the two inputs' respective shares of output. An increase in K or L will lead to an increase in output. However, due to to the law of diminishing returns, the increased use of inputs will fail to yield increased output in the long run. The quantity of inputs used thus does not completely determine the amount of output produced. How effectively the factors of production are used is also important. Total factor productivity is less tangible than capital and labor inputs, and it can account for a range of factors, from technology, to human capital, to organizational innovation.
Total factor productivity can be used to measure competitiveness. The higher a country's total factor productivity, the more competitive it is likely to be (subject to constraints such as resources). It is also generally viewed as one of the main vehicles for driving economic growth.
When a country is able to increase its total factor productivity, it can yield higher output with the same resources, and therefore drive economic growth.