In growth theory, changes in output (GDP) are explained through changes of production factors, i.e. changes in labour or capital. Economists consider the residual, i.e. the part of changes in output that one cannot explain with changes of production factors, as total factor productivity (TFP) or technological change. In contrast to labour productivity, that relates output only to labour, total factor productivity states how efficiently an economy uses all its production factors.
Total factor productivity is hard to measure, differs between countries and fluctuates over time. Total factor productivity contains mainly immaterial values including technology, knowledge and ability. Hence, total factor productivity strongly relates to capital. For instance, due to technological change we are able to develop more efficient machinery and equipment that firms will adapt in their production process. However, the System of National Accounts (SNA) attributes machinery and equipment to a country’s capital stock. Hence, if we observe an increase in GDP, it is difficult to identify if the increase in GDP is due to an increase in the capital stock or due to capital that is more efficient. Consequently, it can be problematic to consider TFP and capital separately.
There exist various methods to measure total factor productivity. One prominent way of measuring TFP is Growth Accounting. According to this method, total factor productivity accounts for approximately two third of GDP growth in OECD countries. However, Growth Accounting does not permit to establish a causal link between TFP growth and GDP growth. For instance, technological change could cause both an increase of an economy’s capital stock as well as an increase in TFP. Alternative methods to measure TFP that consider these causal links suggest that technological change drives the entire GDP growth in the long-run.