Growth accounting

Growth accounting is a method to determine the contribution of each of the three sources of economic growth: physical capital, labor, and productivity. A formal presentation of this is as follows:

Economic growth = α * Growth in capital + ( 1- α ) * Growth in labor + Solow residual

The parameter α, which is a number between 0 and 1, measures the contribution of physical capital (machines, equipment, land, etc.) to economic growth. Respectively (1- α) is the contribution of labor to economic growth. Greater α means that capital is more important for economic growth.

The World Bank and other institutions provide data on economic growth, on physical capital and on labor. Using these data and relatively simple statistical methods we can calculate α, i.e. the importance of physical capital for economic growth.

Notice the third term in the equation above: the Solow residual. That is the fraction of economic growth that cannot be explained by investment in physical capital and additions to the labor force. This left-over component to economic growth is productivity, a measure of how well capital and labor are put to use.

We do not have a direct measure of productivity. We only know that there is a third component to economic growth, besides capital and labor, and we measure it with the Solow residual. The residual is named after Robert Solow, a Nobel prize winning economist, who sorted out the insights presented here.

The chart shows that Germany uses more effectively than Russia a key ingredient of production: energy. For every energy unit that powers the plant and equipment in Germany, there is more output. In other words, resources are used more productively.

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