The Power of Productivity

The McKinsey Quarterly has an excerpt from the book “The Power of Productivity: Wealth, Poverty, and the Threat to Global Stability”, by William Lewis:

At the McKinsey Global Institute (MGI) we have had, since 1990, the luxury of studying the dynamics and evolution of a representative group of industries in 13 countries: Australia, Brazil, France, Germany, India, Japan, the Netherlands, Poland, Russia, South Korea, Sweden, the United Kingdom, and the United States. In each, we analyzed the performance of 6 to 13 industries and compared it with the performance of the same industries in a handful of other countries. Our work is thus based on detailed studies of individual businesses, from state-of-the-art auto plants to black-market street vendors. It builds an understanding of the economy from the ground up, not the top downa grassroots rather than a birds-eye view.

This research has produced a new and unexpected understanding of the persistence of income disparities among nations. Economic progress depends on increasing productivity, which depends on undistorted competition. When government policies limit competition, even unintentionally, more efficient companies cant replace less efficient ones. Economic growth slows and nations remain poor.

GDP per capita is widely regarded as the best single measure of economic well-being. That measure is simply labor productivity (how many goods and services a given number of workers can produce) multiplied by the proportion of the population that works. This proportion varies around the worldthough, interestingly, not by much.

Productivity, however, varies enormously and explains virtually all of the differences in GDP per capita. Thus, to understand what makes countries rich or poor, you must understand what causes productivity to be higher or lower. This understanding is best achieved by evaluating the performance of individual industries, since a countrys productivity is the average of productivity in each industry, weighted by its size. Such a micro approach reveals the important fact that the productivity of industries also varies widely from country to country.

This approach yields two crucial insights. First, to understand why some countries are mired in poverty, it is necessary to look beyond broad macroeconomic policies, such as interest rates and budget deficits, and also consider the myriad zoning laws, investment regulations, tariffs, and tax codes that hold back the productivity of industries and thus a nations prosperity. Of course, macroeconomic stability is necessary. MGIs studies of Brazil, India, and Russia show that without it companies concentrate on making money by exploiting the instability rather than by raising their productivity. Yet a stable economy alone isnt enough to make countries prosper and grow: Japan has had a stable economy for decades but has suffered from ten years of stagnation.

The second insight is the realization that the income level of a country is determined, above all, by the productivity of its largest industries. High productivity in the unglamorous “old-economy” sectorsretailing, wholesaling, constructionis most important, since more people work in them. The fabled high-tech enclaves and financial markets are less so. MGIs study of rapid US productivity growth in the 1990s found that it was caused by just six industries, including retailing and wholesaling, not by the vaunted “new economy.” IT investments played a modest role. In India, the fast-growing IT industry has yet to raise the living standards of more than a minuscule part of the population.

Differences in labor and capital markets dont matter, [so] what does? In each of 13 country studies, MGI found that the primary answer was the nature of competition in product markets.

Competition is the mechanism that helps more productive and efficient companies expand and take market share from less productive ones, which then go out of business or become more efficient. Either way, consumers benefit as companies offer better goods at lower prices, and this may in turn unleash a burst of new demand.

How can countries muster the political will to do all these things? The answer lies in focusing on consumers, not producers. Many people think that production itself creates economic valuean idea that sometimes makes governments protect businesses regardless of their performance. This approach is mistaken. Such people and governments fail to understand the link between production and consumption. Goods have value only if consumers want them. Otherwise sheer production does little to raise standards of living.

Most poor countries are far from having a consumption mind-set. Their governments and leaders, like those of the former Soviet Union, focus instead on output. A consumption mind-set requires some notion of individual rights, including the right to buy what you want from anybody who wishes to sell it to you. Consumers want to patronize companies that offer better products and services or lower prices. Those are the companies that survive if competition is equal. Thus, consumer interests are served when competition isnt distorted.

If policy makers in poor countriesand the many development experts who advise themcan accept this overlooked fact, those countries could unleash rapid growth. Only then will the shape of the global economic landscape begin to change for the better.

Published by

Rajesh Jain

An Entrepreneur based in Mumbai, India.