Productivity is important to the well-being of an economy. Today each man and woman enjoys a standard of living much higher than that of their ancestors as an outcome of higher productivity.

Mainstream economists – these are the economists trained by the majority of colleges, universities and MBA programmes - rightly appreciate this fact. Paul Krugman, Nobel Prize winner and self-proclaimed Grand Master of the mainstream states that productivity isn’t everything, but in the long run it’s almost everything. And that is an interesting statement.

The Pieces of the Puzzle
But from here things get a bit confused. Around 1956, a Robert Solow together with a gentleman named Swan created a mathematical contraption, and aptly called it the Solow-Swan Model. It is one of these very simple things that everybody and yet nobody really understands where a nonlinear system of ordinary differential equations models the evolution of the per capita stock of the capital. You follow what I mean.

In plain language, Robert Solow calculates the separate effects on economic growth caused by labour, capital and a most mysterious residual called total factor productivity. He was awarded the Nobel Prize in Economics for his work in 1987.

Today mainstream economists use the Solow-Swan Model (plus its derivatives) and proudly speak of the productivity of labour and the productivity of capital.

This is nonsense. It is based on the illusion that it is possible to determine the shares that each of the various complementary factors of production has physically contributed to the turning out of the product. It doesn’t make sense.

The Scissors
If a man cuts a sheet of paper with a pair of scissors, it is impossible to ascertain quotas of the outcome to the scissors (or to each of the two blades) and to the man who handled them. We could ask, for the sake of the argument, which of the two factors at work here caused the increase in productivity. Is it labour or capital? Put in this way, the answer must be: capital (the scissors).

And then there is the small matter of total factor productivity (TFP). I never really grasped what TFP exactly stands for, but it is something like “Things got a bit better. We don’t know exactly why. We can’t explain it through physical capital or labour. Best guess there is some improved knowledge, technology, likely enhanced efficiency.” TFP in other words, alludes to efficiency.

The great economist Israel Kirzner says this about efficiency: If you want to go uptown, don’t take the downtown train. To transcribe this to the man with the scissors, “If it gets a bit dark, ask someone to switch on the light.”

The Puzzle in Pieces
More seriously, the year Robert Solow received his Nobel Prize he is quoted as saying you can see the computer age everywhere but in the productivity statistics. Here is the Nobel laureate who calculates how productivity grows an economy. And he says computers contribute nothing because he can’t see it!

This is shocking. If Robert Solow is correct, it means that the whole IT industry – IBM, Microsoft, Oracle, SAP, Amazon...you name it – have no reason to exist because they don’t provide any value to their clients. The clients buy useless unproductive stuff.

Maybe there is something seriously wrong with the Solow-Swan model. And maybe - unlike the IT industry! - it has no value. And maybe we should hand Robert a pair of scissors.

The Productivity of Labour
Some proclaim that the correct approach to calculate productivity is to take into account no more than the input of labour. The logic here is that labour is the only input that can be measured in units, in example, worker-hours.

The input of capital - not even to mention the mysterious TFP - should not be considered because it can’t be measured in units. For starters, what exactly is capital? There is bank capital, liquid capital, fixed capital, working capital, human capital, capital stock, capital structure, capital value.

How to define out of all these different types of capital a common unit for measurement? Meters, litres, cups, pints, tablespoons, kilos, pounds, chunks or why not scissors? Perhaps in case a company has good looking male workforce,... hunks? Because it is impossible to sensibly measure a unit of capital, better is to ignore capital – and its contribution to productivity - altogether.

Unfortunately a labour-only based approach also quickly reaches confusion.

The Scissors and the Fingers
Which of the three fingers holding the scissors contributes more to output? In the picture you see above, it was my hand that was holding the scissors. And I honestly couldn’t tell you which of my fingers contributed more to the outcome of cutting the paper. My thumb, my index or my middle finger?

And just as with the fingers on the scissors, in the real world it is impossible to calculate exactly what the contribution is of every employee to the bottom line of the company. Surely, some employees are more productive (and hence more valuable) than others. But how to calculate each individual’s productivity and the resulting contribution to the company?

Marginal Productivity
Here is where mainstream economists introduce the concept of marginal productivity in an attempt to solve this piece of the puzzle. Marginal productivity is the deduction in net output caused by the elimination of one worker. The employer can use this information to calculate how much that person brings to the business and how much he or she should be paid.

But things are not as simple as it sounds. In some cases there are several factors that are indispensible to create the final output. To isolate the “marginal productivity” of one worker sounds easy but is difficult and impractical in reality.

Productivity and The Beatles
Robert Murphy, a young and brilliant economist, explains this issue with a nice example. How do The Beatles split the proceeds from their concert performances? How much would the proceeds fall if Paul McCartney didn’t play? Or John Lennon? In each case most likely by more than 50%. And therefore McCartney and Lennon would each seem to deserve more than half of the proceeds. That doesn't make sense.

A similar logic could be applied to the scissors. If I was to hold the scissors with just my thumb and my index finger, and I calculate the marginal productivity of each finger by eliminating the other ... very difficult to cut a piece of paper with one finger! The elimination of one worker changes the marginal productivity of the other workers.

Not Almost Everything
Going back to Paul Krugman’s statement. Productivity isn’t everything, but in the long run it’s almost everything. It is not a bad statement. But productivity isn’t everything. What if almost all companies achieve great productivity, but sadly they all produce the wrong product, things that nobody wants. The Soviet Union was very productive at producing the wrong stuff.

Productivity is not almost everything. Productivity is the by-product of the free market economy at work.

Do you think that Mark Zuckerberg is lying awake at night wondering whether his 10,000 or so Facebook software developers are more productive than Satya Nadella’s 50,000 Microsoft engineers? Or is Elon Musk, the electric car guy, having sleepless nights whether his employees are as productive as Starbucks’? If this were the case, then every business worth its salt would have a Chief Productivity Officer reporting directly to the Chief Executive Officer.

To research for this article, I spoke with Andrew Bryant, a self-leadership expert. Andrew has coached over 20+ years hundreds of entrepreneurs and business leaders across the world to answer the eternal question ‘Why, What, and How’. Andrew told me he experiences time and again how great self-leaders impact their organisation’s performance through influence, which itself is driven by intention. Labour that knows ‘Why’ it is acting takes (the ‘How’) more ownership, is creative and collaborates, aims to work productive and ... delivers (the ’What’) better results.

Solving the Puzzle
Here is how productivity comes about.

Competition, savings and investments lead to increased division of labour and accumulation of productive capital to the right place at the right time. As a result, presently available resources are used in a better and more efficient manner and generate a greater supply of future resources. Profit & Loss steers this process.

Tom Woods – Internet Entrepreneur, historian and prolific author - writes that “Profit & Loss is how a business determines whether it is serving its customers well or not. That is because there are countless resources that can be combined in a countless number of ways, to produce a countless number of goods and services.”

How can a business know whether it is using scarce resources in the most value-productive way? And once it knows what to produce, how can it know whether it is producing that thing in a way that’s least wasteful? The answer is Profit & Loss, not productivity.

The lure of profit and the discipline of loss is what keeps Mark Zuckerberg, Satya Nadella, Elon Musk and for that matter - all other businessmen and entrepreneurs - alert!

One more for the Road
While mainstream economists insist on the importance of productivity, they also insist that an economy functions smoother when there is a bit of inflation. Now, one of the key outcomes of productivity is that it leads to lower prices. While inflation leads to ... higher prices.

So on one hand, it is good that prices go down, while on the other hand, it is good that prices go up. Which one shall it be? This is an inconsistency in mainstream economics which I pointed out in an earlier article titled “Productivity, Inflation and Chickens”.

To be continued
This is part 2 in a series of articles I wrote to highlight some of the many subjects where mainstream economists have lost their common sense.

Part 3 in this series will be about debt and how mainstream economists want us to believe that some debt is more equal than other.

This article is dedicated to J.


Sources:
Andrew Bryant, Self-Leadership – How to be a more Successful, Effective & Efficient Manager from the Inside Out (McGraw-Hill - 2012)
Bob Murphy, Lessons for the Young Economist (Lesson 9 – p129-131)
Henri Ghesquiere, Singapore’s Success, Engineering Economic Growth (Chapter 1 - p19-21)
Ludwig von Mises, The Anti-Capitalistic Mentality (Chapter 4 – p86-87)
Robert Solow, We’d better watch out, New York Times Book Review (July 12 1987 – p36)
Roger Garisson, Austrian Capital Theory, presented at Mises Week 2017 (July 24 2017)
Tom Woods, Economics should teach about “Queerness”, say students (Email Oct 4 2017)



Bart is the Founder of Economica Action Pte Ltd, an international coaching and strategy provider. He also advises on the economics of climate change as a director at Climatekos. His specialties are in economics, business strategy, coaching and digital marketing. This article was first published here: https://www.linkedin.com/pulse/common-sense-vs-economics-part-2-puzzle-bart-remes/
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